As a high-net-worth individual, one of your greatest concerns is probably going to revolve around how you’re going to be able to pass on the wealth you’ve built to future generations.
The IRS has strict rules around how it taxes your estate — which can potentially land you and your loved ones with a big tax bill. One way to minimize that tax burden and plan your estate is to set up a trust.
But it’s important to note there are a range of different types of trusts, and each type is specifically designed for different types of taxpayers who find themselves in various scenarios.
Key Takeaways
A trust is a legal contract that enables high-net-worth individuals to manage and pass along their wealth while avoiding probate.
Both revocable and irrevocable trusts go hand in hand with a number of tax benefits, including the ability to avoid paying estate tax.
There are a number of different trust types, and setting one up usually requires help from attorney. If you’re considering starting a trust, make sure you get legal advice first.
What Is a Trust?
Simply put, a trust is a legal contract designed to effectively protect and manage your assets.
Trusts are generally drafted or notarized by an attorney, and they utilize your wealth according to the instructions you’ve spelled out in your trust document. These instructions could apply either during your lifetime, after your death or both.
Your typical trust has three primary roles:
A grantor is the individual who’s created the trust and placed assets into it.
A trustee is the individual (or organization) responsible for managing the trust.
A beneficiary is the individual who ultimately gets the assets contained in the trust.
It’s important to note that trusts aren’t specifically designed for high-net-worth individuals. Trusts can play a critical role in anyone’s financial strategy as a way to plan their estate and provide some peace of mind that loved ones will be well looked after in the future.
That being said, trusts are particularly helpful for high-net-worth individuals because they can help you to avoid probate — which is the long and public process in which a court determines the validity of your will and distributes your assets.
“Probate is awful,” says Chad W. Holmes, the founder of Formula Wealth, a financial planning company based in Alabama.
“It's time-consuming and can be expensive. Most states have a simplified version of probate for small estates. I encourage all clients to arrange their (or their parents') affairs in such a way to be below this small estate limit.”
Fortunately, there are a range of trust options available that can help high-net-worth individuals to avoid these complications.
How Trusts Can Help With Tax Planning
While avoiding probate is a key consideration you should bear in mind when deciding whether a trust is right for you, it’s important to note there are a range of tax benefits at play.
First, trusts exhibit a degree of flexibility that many other wealth vehicles don’t. We’ll go into more detail on the different types of trusts in a moment, but in terms of tax planning, the two most popular types are revocable trusts and irrevocable trusts:
A revocable trust can be amended after you’ve created it to leverage both new and existing tax benefits. That means it’s possible to change your instructions, your trustee, your beneficiary, and anything in between. For reference, federal income tax and estate tax don’t apply to revocable trusts.
An irrevocable trust normally can’t be changed after you’ve set it up — and contributions you make are subject to the IRS gift tax. That means you can contribute up to the gift tax annual exclusion rate of $17,000 without having to pay taxes on the contribution.
There’s also a lifetime gift tax limit of $12.92 million. Both these exclusions can be incredibly helpful in minimizing your tax liability when depositing assets into your trust.
Meanwhile, because you’re essentially transferring assets from your estate into trust, your assets will be protected from estate tax when they’re passed on to your loved ones.
How Are Trusts Taxed?
As we’ve already touched upon, the key benefit of setting up a trust is that it empowers high-net-worth individuals with the ability to plan for the future while reducing their respective tax burdens. But it’s worth diving a little deeper into precisely how taxation works concerning trusts. Let’s take a look.
Difference Between Income and Principal
The IRS will typically class assets in trust as either income or principal:
Principal assets fall under the category of investments, such as common stock shares, bonds, and property deeds.
Income essentially covers everything else, including income generated from investments, like dividends and interest.
When taxing trust income, the IRS will treat a trust differently depending on whether it’s a grantor trust or a non-grantor trust. Grantor trusts include revocable and irrevocable trusts, and the IRS holds the grantor responsible for paying any tax owed on income generated by assets held in trust.
Simple Trust vs. a Complex Trust
The IRS taxes income from non-grantor trusts differently depending on whether it’s simple or complex.
A simple trust requires distributions of all income during each tax year. It also doesn’t allow distributions to charity or distributions of principal. A complex trust can allow flexible distributions of income and principal.
If you’ve set up a simple non-grantor trust, the beneficiaries of your trust will be responsible for any and all income taxes that are generated through trust principal assets. Meanwhile, the trust itself is responsible for paying capital gains tax.
As its name suggests, tax liability is a bit more complicated if you’ve set up a complex non-grantor trust. It could be the beneficiary, the trust or a combination of the two parties who end up being responsible for paying Income Tax or Capital Gains Tax.
What Tax Rates Are Applied to Trusts
The IRS applies the same maximum tax rate to individuals that it applies to individuals. But trusts have got to start paying taxes at a much lower threshold.
For the 2023 tax year, the IRS tax threshold for trust income is:
10% on income up to $2,900.
24% on income between $2,901 and $10,550.
35% on income between $10,551 and $14,450.
37% on income of $14,451 or more.
Trusts may also be subject to net investment income tax if they’ve accumulated undistributed income generated through investments. This takes the form of a 3.8% tax on that undistributed investment income or any adjusted gross income over the $14,450 threshold.
Types of Trusts You Can Set Up
We’ve already briefly touched upon two of the most basic types of trusts: revocable and irrevocable. But before making the decision to set up any particular type, it’s worth taking a deeper dive into various other options available to you and why they could be worth considering.
What Is a Revocable Trust?
Revocable trusts offer a degree of flexibility to make changes to the ways in which your assets are controlled while you’re still alive.
You can change who manages the fund, who your beneficiaries are or even dissolve the trust if you want to. Unlike some other trust types, revocable trusts also enable you to name yourself as a trustee.
As we’ve already outlined, the other benefit of revocable trusts is that they help high-net-worth taxpayers to avoid probate. By avoiding probate, your beneficiaries won’t have to go through the long and public process of acquiring your distributed assets.
A revocable trust also protects your privacy. Wills generally go on the public record after probate has occurred — wills executed in trust don’t go public.
What Is an Irrevocable Trust?
Unlike a revocable trust, an irrevocable trust can’t be dissolved or changed. That being said, a revocable trust will automatically become an irrevocable trust when the grantor or trustee dies.
This is the primary way an irrevocable trust is formed — and it’s also why you should ensure you appoint a successor trustee.
“The main benefit of irrevocable trusts is the granted amount is locked in at the gift and estate tax limits at the time of establishing,” says Kyle Newell, a certified financial planner and owner of Newell Wealth Management in Winter Garden, Florida.
“Assuming the assets granted to the irrevocable trust grow, the growth is protected from impacting the total net worth for estate tax purposes.”
What Is an Irrevocable Life Insurance Trust?
As the name suggests, an irrevocable life insurance trust is when you place your life insurance policy into an irrevocable trust
By setting up an irrevocable life insurance trust, you’ll be able to exclude any life insurance payout from your gross estate. By placing a policy in trust, you’ll also protect your assets from any legal action against you.
In addition, an irrevocable life insurance trust enables you to prevent life insurance payouts from going to a minor. Instead, you can instruct the trust to direct funds to a trustee or spouse until the minor reaches the age of majority (or any other age or conditions you specify).
What Is a Charitable Trust?
There are two main types of charitable trusts: charitable lead trusts and charitable remainder trusts:
A charitable lead trust allows you to gift assets to a charity within a particular time frame. You’ll normally be entitled to tax deductions for those gifts, too. Charitable lead trusts are designed as irrevocable trusts. When you hit the end of a specified gift period, the remaining trust assets need to be paid to non-charitable beneficiaries.
A charitable remainder trust is also irrevocable. Whenever you make a contribution to the trust, you’re eligible for a partial tax deduction — and you can also receive an income stream from your charitable trust for a period of up to 20 years (or less if you want).
After the specified time period or maximum time period elapses, any assets left in the trust are then gifted to the charitable beneficiaries you’ve appointed.
What Is a Generation-Skipping Trust?
As you might’ve guessed, a generation-skipping trust lets you skip a generation when passing down your assets in trust. In practice, that normally means you’re planning to pass generational wealth directly to your grandchildren.
The important stipulation with a generation-skipping trust is that any beneficiaries you name have got to be at least 37-and-a-half years younger than you are.
“A trust set up for generation-skipping purposes ensures that the assets never incur estate or generation-skipping tax so long as they stay in trust as they pass from generation to generation,” says David Bross, a senior estate planner at Truepoint Wealth Counsel in Cincinnati, Ohio.
“This is because the original grantor who funded the trust used his or her own estate or generation-skipping exemption to shield these assets from those taxes. The entire value of the trust is exempt, including the appreciation of the principal after the initial funding.”
This trust type is particularly well-suited for high-net-worth individuals because they utilize your gift tax exemption so that your beneficiaries could get up to $12.92 million through your trust without having to pay tax on it.
How to Set Up a Trust
1. Choose Your Trust
First, you’ve got to decide which type of trust you want to set up. If you’re unsure which type of trust is going to generate the highest level of benefits for your situation, it’s worth getting professional advice from a wealth planner or attorney.
2. Write Your Trust Document
Next, you’ll need to create your trust document. There are plenty of DIY services that can help you write your trust document, but this is a task often best suited to your attorney.
3. Get Your Trust Document Notarized
After you’ve created your document, you’ll need to sign it and get it notarized. Laws vary by state, and so you may also need witness signatures.
It’s also critical you maintain crystal-clear records of your trust document and any supporting documentation like a life insurance policy. That’s where Trustworthy can support you. Trustworthy's Family Operating System® that helps you curate, manage, and securely share your important information.
It ensures your Trust documents are safe — and to ensure your loved ones can access necessary information about your trust if something happens to you.
4. Set Up an Account for Your Trust
You can then start a trust account to hold various asset classes that you plan to place into your trust.
5. Transfer Assets
Finally, you’ll be able to transfer your assets into the new trust.
Above all else, it’s critical you seek out professional advice and accept guidance to ensure you’ve set up your trust correctly and understand the implications of your new trust.
“Whether trusts are the best approach for high-net-worth persons to lower their tax obligations actually relies on each person's unique circumstances and objectives,” says Sara Sharp, founder and partner at SK&S Law Group in Denver.
“I would advise high-net-worth individuals to work closely with their tax and estate planning advisors to determine whether a generation-skipping trust or other type of trust is appropriate for their situation, and to consider all potential costs and benefits before making a decision. It's important to approach estate planning with a long-term perspective and to regularly review and update plans as circumstances change.
Frequently Asked Questions
How Does a Trust Fund Reduce Tax?
Trusts enable you to deposit assets tax-free up to your annual or lifetime gift tax limit. Some trusts also enable both grantors and beneficiaries to avoid federal income tax and Estate Tax.
What Is a Complex Trust for US Tax Purposes?
According to the IRS, a complex trust is any type of trust that doesn’t meet the requirements of a simple trust. Complex trusts can accumulate and distribute income and make deductible charitable payments.
What Is the Best Trust to Avoid Estate Tax?
A charitable remainder trust is considered one of the most effective ways to avoid estate tax. It lets you divert capital gains tax and avoid estate tax — which makes it a smart option if you have highly appreciated assets.
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