Retirement Weekly: Why do people use trusts for estate planning?


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Dear Dan,

I understand trusts pay taxes on a harsher schedule than people. What I don’t get is why so many people are setting up trusts and exposing the assets to the higher taxes. What am I missing?

— Eddie

Dear Eddie,

You are correct that the marginal tax brackets applicable to trusts make the taxes payable much higher than that for people. For instance, for a single taxpayer to pay taxes at the highest marginal federal rate of 37%, she would need to have taxable income in excess of $578,125. A trust need only have more than $14,450 to reach that rate.

I am not a lawyer and do not give legal advice. What I can do is give you a simplified explanation of how trust taxation can work.

I think what you are missing is that not all trusts result in taxes at trust rates.

There are a lot of different types of trusts but at the basic level many are “grantor” trusts. A grantor, sometimes referred to as a settlor, trustmaker or trustor, is the person that creates a trust.

Trusts are a separate legal and taxable entity. The trust is the legal owner of assets titled in the name of the trust but a grantor trust is one where the grantor is treated as the owner for income tax purposes. 

Most trusts I see are a form of grantor trust commonly called a revocable living trust or inter vivos trust. The trust is created by the grantor while the grantor is alive, not through say, a last will and testament. The granter can amend or revoke the trust. The trust owns the assets but as a grantor trust, income, dividends, capital gains etc. are taxed to the grantor. In fact, the tax ID number for such trusts is usually the grantor’s Social Security number.

Typically, when the grantor dies, the trust becomes irrevocable. At that point, it is subject to trust tax rates for income that subsequently accumulates in the trust. Still, the higher rates may not apply due to deductions from income the trust can take when calculating its taxable income. The most significant deduction applies to distributable net income (DNI).

I mentioned earlier, I am not an attorney. I am also not a tax adviser, so I won’t go into the intricacies of calculating and managing DNI. However, the essence of it is that when distributions are made out of the trust to a beneficiary, the trust will issue a K-1 and the beneficiaries will report the income on their personal return at the rate applicable to them rather than at trust rates.

Trusts can be powerful asset management, estate planning and tax planning tools but even the simplest concepts can get complicated fast. As a result, I am not a fan of DIY trust documents and recommend retaining a qualified estate planning attorney to draft documents that are appropriate for you and your family and align with the applicable laws which can vary considerably from state to state.

If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line. 

Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa, Fla. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.

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Alexandra Williams
Alexandra Williams
Alexandra Williams is a writer and editor. Angeles. She writes about politics, art, and culture for LinkDaddy News.

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