First and foremost, understand how taxes will impact the distributions you receive—before they’re paid.
Alyssa Zebrowsky, Wealth Advisor
Trusts are commonly used wealth planning vehicles. Yet many beneficiaries don’t anticipate how the structure of their trusts may impact their entire financial pictures, from what they spend and how they invest to meeting their expectations and making future plans.
Moreover, because trusts do not have to conform to a single structure, beneficiaries of multiple trusts may well want to think carefully about how, when and in what order they receive distributions—and if the distributions they receive might impact their non-trust resources.
The devil’s in the details
Irrevocable trust distributions can vary from being completely tax free to being taxable at the highest marginal tax rates, and in some cases, can be even higher. Therefore, understanding the tax implications is critically important—which is why we focus on irrevocable trusts in the discussion below. In contrast, distributions from revocable trusts are not taxable to the beneficiary.
Grantors, too, should examine whether or not the characteristics of the trust(s) they have created are benefiting—or likely to benefit—their heirs (and their decision making) to the degree originally intended.
Your J.P. Morgan team, along with your estate planning attorney, can help you gather and assess the information you need. This article can help you get started1.
How irrevocable trusts work
There are three distinct components to consider:
First, understand how the trust operates
Among the questions to have answered:
- Are you a current or future beneficiary? That is, will you receive distributions of income or principal now—or later, when the current beneficiaries’ interest terminates?
- Who is the trustee? Does the trustee have authority over investments and distributions? Or, is there a third party whose authority on investments and/or distributions supersedes that of the trustee?
Next, determine the tax characteristics
As a beneficiary, there are several key things you will want to know:
- Is the trust a grantor trust for income tax purposes? If so, the grantor is responsible for paying U.S. and state income taxes owed by the trust, and the beneficiaries will not owe income taxes on distributions they receive from the trust. Even so, for estate tax purposes, the assets in an irrevocable grantor trust may be considered outside of the grantor’s estate and therefore not subject to estate taxes at the grantor’s death.
- Is the trust a non-grantor trust for income tax purposes? Then keep in mind, the trust is the taxpayer for any trust income not distributed to a beneficiary (i.e., accumulated income), and may be taxed in several jurisdictions: the state in which the trustee resides, in the state in which the grantor resided when the trust was created, and/or in the state in which a trust beneficiary resides.
As an example: A non-grantor trust established in Delaware by a Florida resident has four beneficiaries who live in Colorado, California, Illinois and Florida, respectively. Because California taxes the accumulated income of trusts that have a California resident beneficiary, the income is subject to California state income tax. However, this income is not subject to tax in Delaware, Colorado, Illinois or Florida.
- Are the trust assets exempt from generation-skipping transfer (GST)2 taxes?
- At your death, will the trust assets be subject to estate taxes?
Lastly, understand the distribution provisions
- Does the trustee have discretion under the trust agreement to distribute cash or other assets to the beneficiary(ies), or are certain distributions mandatory? If you are the beneficiary of a trust that makes mandatory distributions, you likely will have a predictable income stream from that trust—and can plan accordingly (though investment decisions and investment returns can affect distribution amounts).
Conversely, if the trustee has complete discretion over distribution timing and amounts, you may not have a predictable income stream, making planning more difficult.
How a trust works may affect your goals
Your relationship to a trust (grantor, beneficiary) can enhance your lifestyle and allow you to fund long-term goals, such as paying for a child’s college education or making charitable gifts. Consider:
- Grantor—If you are the grantor of an irrevocable grantor trust, then you will need to pay the taxes due on trust income from your own assets—rather than from assets held in the trust—and to plan accordingly for this expense. Financial modeling can help determine whether this additional expense is sustainable without compromising your other goals.
- Beneficiary—When trusts make (at a minimum) annual mandatory distributions, beneficiaries can reasonably expect a reliable stream of income. However, this may not be the case if distributions are made solely at the discretion of the trust’s trustees. In such instances: If you don’t need discretionary distributions to accomplish your goals, you may want to inform the trustee of this fact. The trustee may then invest those assets with a longer time horizon in mind, since the remainder beneficiaries will ultimately receive these assets years into the future. (All else being equal, remainder beneficiaries stand to inherit more from a trust that does not currently make distributions and whose assets are invested with long-term growth as its primary investment goal.)
Case study: Trust distribution strategy
In this example, a widower with his own assets is also the beneficiary of several trusts that were funded upon the death of his spouse. Taken together, the accounts hold $25 million in investable assets—to which the widower has varying levels of access:
Withdrawal strategy: Minimize taxes
To minimize future transfer and income taxes to the extent possible, the widower worked with his advisors to implement a strategy for his spending, investing and gifting:
- Spending order—The plan is to first draw from the accounts that are subject to his estate taxes to meet his spending needs, and then from accounts that are exempt from estate taxes, as follows: Required Minimum Distributions (RMD) from his IRA; individual brokerage account and Marital GST Non-Exempt Trust; additional IRA withdrawals; Bypass GST Non-Exempt Trust; Bypass GST Exempt Trust.
- Asset allocation—The overall allocation of the $25 million in investable assets is 60% are in equities; 40% in fixed income. The assets that will be spent first are more conservatively invested than those that will be spent last, meaning most of the fixed income investments are held in the brokerage account and Marital Trust. The equities are in the Bypass Trusts.
- Treatment of charitable gifts—As part of his own estate plan, the widower plans to use funds from his retirement account (IRA) and personal assets, along with funds from trusts subject to the most estate taxes,6 to make charitable gifts. He will not make donations using funds in his GST-exempt funds.
We can help
We understand that trusts can be complex, with many considerations to take into account. Your J.P. Morgan team, along with our Wealth Advisors, Wealth Strategists and Trust Officers, can work with you and your tax advisors to create a distribution strategy that both meets both your day-to-day spending needs and your longer-term estate plans.
1For the purposes of this discussion, we assume that the trust, grantor and beneficiaries are all U.S. entities or individuals. The outcomes may vary for foreign trusts, grantors and/or beneficiaries.
2The GST exemption is the same amount as the U.S. estate and gift tax exclusion: currently, $12.06 million and twice that for couples. However, these amounts are scheduled to be cut roughly in half when the current legislation expires at the end of 2025, unless Congress acts otherwise. In 2022, the GST tax rate is 40%.
3The Marital Trust holds assets passing to the widower from his spouse’s estate in excess of the amount that could pass free of estate tax. The assets will be includable in the widower’s estate at his death.
4The GST Non-Exempt Trust is subject to the GST when distributed to a grandchild or more remote descendant.
5The Bypass Trust—sometimes referred to as a Family Trust or Credit Shelter Trust—received the amount that could pass free of estate tax upon the death of the spouse. It is not includable in the widower’s gross estate upon his passing, and therefore will not be subject to estate tax. The GST Exempt Trust is not subject to the generation-skipping transfer tax, and thus can pass from generation to generation with no additional estate, gift or generation-skipping tax liability.
6The widow can use the trust assets as long as she has a power of appointment that includes charitable beneficiaries.