Inheritance Tax and Trust Funds

By: Stephanie Faris | Updated September 08, 2018

You can’t earn money in America without paying taxes on it. This usually includes money you inherit, but things get a little more complicated when that inheritance is part of a trust. There are ways your loved ones can pass money on to you without handing over a big tax burden. The key is in the type of trust they set up. However, there are downsides to avoiding that tax burden that may negate any financial benefits they bring your loved ones.

Tip

An irrevocable trust fund can offer a tax shelter, but recipients will be required to pay gift taxes if the amount gifted exceeds the estate tax exemption.

Trust Fund Taxes

If you choose to set up a trust fund, your heirs will be responsible for paying taxes when they receive the assets in the fund. They’ll only pay taxes on any gains the trust fund has earned since you put the money in, though. In other words, when your trustee hands the funds over to your beneficiaries, the amount that you put in, also known as the principal, won’t be taxed, since that was money you initially put in.

For those inheriting money from an estate, it’s important to know how taxes will work. When the trustee hands the funds over to the beneficiaries, that trustee reports the income the trust earned on the tax return filed on behalf of the trust. The trustee will then issue a Form K-1, which tells the beneficiary how much of the money was interest and how much was principal. That directs the recipient on how much earnings to report at tax time.

Revocable Trust Fund Taxes

When you’re ready to move your money into a trust for your loved ones, you’ll be given two major choices: revocable or irrevocable trust. On the surface, revocable trusts sound like the best idea, since you can change, or “revoke,” them at any time after you’ve put them in place. If you want to change the beneficiaries or completely withdraw the trust and keep your funds, you can do so. Revocable trusts also have the benefit of bypassing probate when you die, which means your money won’t be tied up in court proceedings for months while everything is worked out.

One major drawback to a revocable trust, however, is its taxability. Since you’re still the owner of the trust while you’re living, you’re responsible for paying taxes on any money you make on those funds. After your death, the trust will be assigned a separate tax ID number and be required to file an annual tax return using Form 1041 each year. Beneficiaries can take out the initial money you set aside tax-free, but taxes will be due on any income those funds earned. As long as the money remains in the trust, though, the trust itself is required to continue to pay taxes on any money earned.

Irrevocable Trust Fund Taxes

An alternative to revocable trusts is an irrevocable trust, which remains fixed from the day you put it in place. This means you can’t easily revoke or change it. This can be intimidating at first since it requires a full commitment, but there are some positives to an irrevocable trust. One is that it offers greater legal protection against creditors. Once the funds are placed into the trust, the trust takes over ownership, so anyone coming after you for money would have a difficult time getting to the assets you’ve set aside for your heirs. You’ll also find that by having a large chunk of your finances in an irrevocable trust, you’ll be able to protect it if you ever have a mandatory depletion of your assets, for instance, if you need to rely on Medicare at some point in your later years. You can also take control over how the funds are distributed.

But the tax savings are perhaps the biggest benefit of an irrevocable trust. As people age, they’ll often find ways to pass gifts on to their children and other heirs to avoid it counting toward their taxable estate when they die. By putting the funds into this type of trust, you can set the money aside and direct it to distribute to your heirs at specific times. You may choose to issue $10,000 per year to each child, for instance, or set up an irrevocable trust to release to your grandchild upon college graduation.

Gift and Estate Tax Exemptions

The key to the taxability of an inheritance trust fund is in the estate tax exemption the IRS grants each taxpayer. Under the Tax Cuts and Jobs Act, you’re now allowed up to $11.18 million in tax-exempt gifts to heirs. For a couple, this means you can shield a $22.36 million estate. For most people, this is more than sufficient, so setting up a trust to hand all of your assets over to your heirs when you die is probably no big deal. For that reason, irrevocable trusts are primarily popular with those who are on the wealthier side.

It’s important to note, though, that gifts to your heirs while you’re still alive can affect the $11.18 million gift limit you have on your estate. Currently, you can give up to $15,000 per year per recipient. If you’re married, your spouse can also give $15,000 per year per recipient. But the $11.18 million exclusion counts for your entire lifetime, so the gifts you gave when you were in your 40s, 50s, 60s and so on will count toward that $11.18 million when you die and leave your estate to your survivors. It’s also important to note that the $11.18 million amount was only put in place for the 2018-2025 tax years. Unless something changes, the estate tax exemption will revert back to the $5.49 million it was at before the new law, adjusted for inflation.

Life Insurance Trusts and Taxes

Although irrevocable trusts may be free from estate taxes, one type of inheritance tax trust that may be an exception is a life insurance trust. Often life insurance policies are set up so that their owners can make changes while they’re alive. If your life insurance policy allows you to change beneficiaries or coverages, it could be included in your estate when you die even if it was set up as an irrevocable trust.

If you already have a life insurance policy in place, you may be able to transfer it to an irrevocable life insurance trust for estate planning purposes. But if you die within three years of transferring the policy, the tax benefits will be lost. That means your life insurance policy will remain part of your estate and possibly push you over the exemption amount.

Trust Inheritance Taxes and Living Trusts

Often people choose to set up a trust long before their death. In doing so, they’re able to ensure the money is there for their heirs if something happens. However, there are other benefits to a living trust, including avoiding probate and saving the costs associated with having your assets dragged through the court system.

One area where living trusts can help you is if you’re married. You can set up a joint living trust that will cut down on probate costs if one of you outlives the other. However, there are disadvantages to a joint trust, particularly when it comes to managing it after death. The assets will need to be divided once one spouse dies, so it will be important to ensure that things are clearly delineated to avoid issues. It can also become problematic when it comes to trying to pay taxes on the part of the trust that remains for the surviving spouse. Legal help may be necessary to properly shelter the part of the estate that remains from a huge tax burden.

Physical Assets and Taxes

When you deal with an inheritance tax and trusts, you’ll probably initially think of assets you pass on in the form of cash. But you likely own plenty of assets that are material items. This includes your home and everything in it, as well as high-value property like jewelry and automobiles. All of these items will be passed on to your heirs when you die. The good news is, you can include all of these items in your trust fund to avoid having them locked into the probate process for months after your death.

For tax purposes, your physical assets will work the same way the money you place in a trust works. If they gain value, your heirs will pay capital gains tax on the amount they appreciated since you originally bought them. However, if your heirs end up selling the items for less than you paid for it, they’ll be able to claim the loss on their taxes, as they would with any other property in the estate that lost value over time. Since heirs may have to sell items in the trust fund to pay the taxes on them, they’ll need to research how much they’ll owe if they proceed.

Appointing a Trustee

Every trust fund needs a trustee to administer the distribution of assets after your death. Although you can appoint one of your beneficiaries as a trustee, this isn’t advised. A third party can come in and make sure your wishes are carried out without having an emotional involvement. The person you choose as a trustee needs to understand that he may be called upon on an ongoing basis to file taxes on behalf of the trust and work out any disputes that arise.

Your trustee should also be aware that she has every right to employ professional help if necessary. Funds from the trust can be used for legal assistance or an accountant to help work things out. There are attorneys who specialize in estate issues, and such a professional can help trustees navigate the murky waters that come with straightening out assets.

Filing Trust Taxes

The trustee will also need to know how to report distributions on behalf of the trust fund. The fund will be issued an employer identification number, which is similar to a Social Security number. This number will be input on Form 1041, which is used to report any gains or losses on the original money put in the estate, as well as employment taxes paid to household workers employed by the estate.

Although it may sound overwhelming, a trustee may not have to deal with paying taxes if the funds are distributed to beneficiaries before they earn any income. In many cases, funds will simply remain in the trust until they’re distributed, having gained no value during that time. If no income has been produced, the trustee will also not have to deal with Form 1041, which is only necessary if the trust earns a gross annual income of $600 or more. The calendar year for an estate runs from the date the decedent dies to Dec. 31.

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About the Author

Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.

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