What Everyone Needs to Know About Trusts and Taxes

People are often curious — or confused — about the ways that trusts can save on taxes. Given how frequently this is an issue, here’s an explanation of the tax implications associated with different types of trusts. Of course, if you need further clarification about trusts, taxes, or any other issue related to estate planning, meet with us for additional guidance.

THE TWO TYPES OF TRUSTS

There are two primary types of trusts — revocable living trusts and irrevocable trusts. Each comes with different tax consequences.

REVOCABLE LIVING TRUST

A revocable living trust, also known simply as a revocable trust, is far more commonly used in estate planning. So long as you are living, there is no significant tax advantage by creating a revocable trust.

A revocable trust uses your Social Security Number as its tax identifier, and this type of trust is not a separate taxable entity from you. In Texas, this type of trust is not even a separate legal entity. However, (if done properly) a revocable trust can help the people you leave behind avoid the court process called probate. This is often where the confusion about the tax advantages of trusts comes from. Before we explain the tax implications of a revocable trust, let's first dive into how a living trust works.

A revocable trust is (at its most basic) an agreement between a person known as the settlor, who gives legal ownership to a person or entity known as a trustee, to use those assets for the benefit of a beneficiary or a set of beneficiaries. The reason there are no tax consequences is because you can revoke the trust or take the assets back from the trustee at any time and for any reason. In fact, so long as you are living, you can change the terms of the trust, change the trustee, change the beneficiaries, or terminate the trust altogether.

The revocable living trust becomes irrevocable if you become incapacitated or when you die. At that point, the trustee you’ve named will step in and take over the management of the trust assets, and one of the first things that your trustee will do is to apply for a tax ID number for the trust. At this point, the trust becomes a taxable entity, and any income earned inside of the trust that is not distributed in that year would be subject to income taxes, at the taxable rates of the trust (or at the tax rates of the beneficiaries, if income is distributed to the beneficiaries).

IRREVOCABLE TRUSTS

An irrevocable trust is created when you make a gift to a trustee to hold assets for the benefit of the beneficiary, and you cannot take back the gift you've made to that individual.

When you create an irrevocable trust, either during your lifetime or at death – through a testamentary trust (a trust that’s created at the time of your death through your will) or through a revocable trust created during your lifetime – the trust is a separate tax-paying entity, and it is either subject to income tax on the earnings of the trust at the rates of the trust or at the rates of the beneficiaries.

Because on its irrevocability, the trust’s terms can’t be changed, and the trust can’t be terminated once it’s created. When you transfer assets into an irrevocable trust, you relinquish all ownership of those assets, and your chosen trustee takes total control of the assets transferred into the name of the trust. Because you no longer own the assets held by the trust, those assets are no longer considered part of your estate, and so long as the trust has been properly maintained, the assets held by the trust are also protected from lawsuits, creditors, divorce, serious illness and accidents, and even bankruptcy.

However, as mentioned earlier, irrevocable trusts also come with tax consequences. As of 2022, the income earned by an irrevocable trust is taxed at the highest individual tax bracket of 37% as soon as the undistributed taxable income reaches more than $13,450. To avoid this high tax rate, in some cases, an irrevocable trust can be prepared so that the tax consequences pass through to the beneficiary and are taxed at his or her individual income tax rates, which are typically lower.

We often set up a trust in this way when creating a Lifetime Asset Protection Trust for a beneficiary. When set up like this, the trust can provide the beneficiary with protection from common life events, such as serious debt, divorce, debilitating illness, crippling accidents, lawsuits, and bankruptcy, without being taxed at such a high rate on such little income.

If you have a trust set up and would like us to review its income tax consequences for your loved ones upon your death, then we’d loved to meet with you.

THE ESTATE TAX: WHAT IT IS & WHO PAYS IT

The estate tax is a tax on the value of a person’s assets at the time of their death. Upon your death, if the total value of your estate is above a certain threshold amount, known as the federal estate tax exemption, the IRS requires your estate to pay a tax, known as the estate tax, before any assets can be passed to your beneficiaries.

As of 2022, the federal estate tax exemption is $12.06 million for individuals ($24.12 million for married couples). Simply put, if you die in 2022, and your assets are worth $12.06 million or less, your estate won't owe any federal estate tax. However, if your estate is worth more than $12.06 million, the amount of your assets that are greater than $12.06 million will be taxed at a whopping 40% tax rate.

You can reduce your estate tax liability—or even eliminate it all together—by using various estate planning strategies. Most of these strategies are fairly complex and involve the use of irrevocable trusts, but such strategies are without question worth it, if you can save your family such a massive tax bill. To learn how to save your family from such a major tax burden, please schedule a time to meet with me.

And please note, we are only speaking about the federal estate tax here. Texas does not currently have any kind of estate or “death” tax.

THE FUTURE ESTATE TAX

The current $12.06 million estate tax exemption is set to expire on Jan. 1, 2026, and return to its previous level of $5 million, which when adjusted for inflation is expected to be around $6.03 million. Here’s one thing we know for sure: We don’t know what the estate tax exemption will be at the time of your death, and we also don’t know what the value of your assets will be at the time of your death. Because of this, when you plan with us, we will ensure that we put in place planning strategies to protect your estate from estate taxes, regardless of the amount of the estate tax exemption or the size of your assets.

WE’RE HERE FOR YOU

If you are trying to decide whether a revocable living trust, irrevocable trust, Lifetime Asset Protection Trust, or some other estate planning vehicle is the right solution for you and your family, meet with us. We will support you in making that decision, so your estate can provide the maximum benefit for the people you love most, while paying the least amount of taxes possible. Call us today to schedule your Family Legacy Planning Session.

This article is a service of The Bushman Law Firm, LLC, and Drew Bushman, serving the Greater Waco area. I don’t just draft documents; I ensure you make informed and empowered decisions about life and death, for yourself and the people you love. That's why I offer a Family Legacy Planning Session, during which you will get more financially organized than you’ve ever been before and make all the best choices for the people you love. You can begin by going to my website, drewbushman.com, today to schedule a consultation call and mention this article to find out how to get your $750 Family Legacy Planning Session at no charge.