A trust is a common legal structure for transferring assets to beneficiaries upon your death. Depending upon the type of trust used, such as an irrevocable trust, it can enable your estate to avoid probate and reduce tax liabilities. Let’s briefly explore trusts and the tax obligations placed upon your beneficiaries.
What is a Trust?
As a fiduciary arrangement, a trust holds and distributes assets to beneficiaries at the time of your death. In most cases, trusts are established as part of an estate plan; with the intention of reducing estate and inheritance taxes as well as avoiding probate. The term probate means the legal court process of distributing assets upon your death. A trust also enables your beneficiaries to gain access to the assets more expeditiously than through a will. As the creator of the trust, or grantor, you’ll establish when and how your assets are passed down.
Estate Planning and Beneficiaries
An estate plan is a collection of documents that protect your assets and personal property; which identifies your executor and clearly addresses how you want such items passed to beneficiaries. Your beneficiaries include anyone who receives money, personal effects, or other assets from the estate. As always, HereToday recommends you upload all estate planning documentation to your HereToday Vault. If you don’t have an account yet, sign up for a FREE HereToday plan now.
Revocable Trusts and Irrevocable Trusts
Estate planning typically utilizes one of two trust options: 1) revocable trusts and 2) irrevocable trusts. A revocable trust can be changed or closed at any time during your lifetime. There are no tax-planning benefits with a revocable trust. Conversely, an irrevocable trust cannot be amended or closed once it has been opened without the consent of your beneficiaries. As the grantor, you transfer all ownership of assets into the trust; which legally removes all of ownership rights to the assets and the trust. Should you utilize an irrevocable trust, your assets will not be considered part of the taxable estate; therefore it reduces the tax liability at the time of your death.
Beneficiaries and Paying Taxes on Trust Income
Your beneficiaries will pay taxes on the distributions they receive from the trust’s income, but not on allocations from the trust’s principal. The Internal Revenue Service (IRS) assumes that funds added to your trust have already been taxed; however, accumulated interest generated from the trust will be taxed as income. In fact, your trust is required to pay taxes on all interest income it holds and not distributed past the end of each year.
When your trust makes a distribution to a beneficiary, it deducts the funds allocated on the trust’s tax return; additionally the trust will issue your beneficiary an IRS Schedule K-1 (Form 1041). A K-1 outlines the distribution’s interest income versus principal; based upon this information, determines how much the beneficiary is obligated to claim as taxable income. HereToday recommends you consult an accountant to determine taxes, including applicable taxable capital gains to either the trust or beneficiaries.
Disclaimer. HereToday is not a legal or accounting service. This content should not be taken as legal or accounting advice. Before drafting any legal or accounting document, please consult an attorney or accountant.