When you create your estate plan, consider setting up a trust to pass your assets on to your beneficiaries. The holdings in some trusts do not go through probate, enabling your beneficiaries to receive them faster. They also can help you save a lot of money on taxes.
Types of Trusts
Taxes on a trust and who pays for them depend on the type of trust it is. Trusts generally fall into one of two categories: revocable and irrevocable. There are many varieties of trusts, and you can design them to fit many needs, but they fall into these two categories.
The Revocable Trust
A revocable trust, often called a living trust, means that the grantor—the person who created the trust—still has the assets under his control. He can add or remove assets when he wants, and he will pay the taxes on any gains. Gains get taxed at the grantor’s income tax bracket level.
The Irrevocable Trust
The assets in an irrevocable trust are under the control of a trustee, and the grantor has little or no control over them. They also are no longer in the grantor’s taxable estate. The trust pays all taxes on any gains except when distributed.
An irrevocable trust enables your assets to escape the hands of creditors, but only after the assets are in it. The more assets you put into the trust, the less taxes your estate must pay. TrustandWill says that the estate tax exemption for 2024 is $13.61 million. This figure will likely revert to $5 million in 2025. You can also reduce your estate by giving individuals up to $18,000 per person each year.
The Grantor Retained Annuity Trust
For those who have more money, you might want to create a grantor retained annuity trust (GRAT), which is a type of irrevocable trust. It can pay you a set amount of money per year (or monthly) for a specific number of years. Taxes are paid on the assets when you put them into the trust. At the end of the set time, any remaining assets pass to the beneficiaries tax-free.
When you create a GRAT, SuperMoney says that the interest market rate (the 7520 rate) is set and sent to the government annually. A successful GRAT will give considerable assets to your beneficiaries, but it requires that the market rate stays above the interest rate.
If you die before the end of the period, all assets in a GRAT will become part of the estate. Some people create a series of GRATs, which can have periods as short as two years. It helps ensure your beneficiaries receive some money—even if you do not outlive all of them.
Trust Beneficiaries Will Pay Some Taxes
A trust distribution may include part of the principal and some interest. Investopedia says that no taxes will be due on the principal, but you must pay taxes on the interest. The principal can be any amount deposited originally or in the year the distribution is made. Any distributions from a trust throughout the year are taxable as interest, SuperMoney says, because principal distributions are only made once a year after depositing all contributions.
If all the interest in the trust gained during the year is not distributed to the beneficiaries, the trust pays the taxes on the remaining amount. Beneficiaries receive a tax report (Form 1041) each year from the trust stating how much money is principal and how much is interest. It also shows them how much they need to pay in taxes.
Taxes From Trusts Are Much Higher Than Regular Taxes
Money received as a distribution from a trust is taxed at a higher rate than ordinary income. People in the first income tax bracket, the Internal Revenue Service says, including those with income ranging from $0 to $11,000, pay 10 percent in taxes. The next higher tax bracket ranges from $11,001 to $44,725, and they pay 12 percent in taxes.
In comparison, the first tax bracket on income from a trust, Forbes says, ranges from $0 to $3,100. They will pay 10 percent in taxes. The second tax bracket is from $3,101 to $11,150, and they must pay $310 plus an additional 24 percent of anything over $3,100. Taxes on regular income reach a maximum of 37 percent, which is the same (maximum) for trust income, but it starts on trust income as low as $15,201.
The Interest Earned Determines the Taxes
When a trust earns interest, there will be taxes, but Fidelity says that part of it may be considered principal. If the assets in the trust do not earn interest, any distributions made are principal.
A trust that distributes $10,000—but only has $5,000 in dividends and another $5,000 in capital gains will have a split between principal and income. Other amounts and situations may also see a split between income and principal, enabling the beneficiary to have lower taxes.
When selling assets out of a trust, Fool says, state laws determine when capital gains are principal or income. A trust can be created so that only income is distributed, but not capital gains. The recipient of the capital gains pays the taxes on it.
A trust can be created to prevent assets in it from going through probate. The laws concerning trusts change frequently and they must be set up correctly—and changed when necessary. When doing your estate planning, it is important to consult a trust lawyer or estate planning attorney to ensure it meets current laws.
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