Estate taxes are a form of transfer tax that affects the very wealthy. For multimillionaire households, avoiding the estate tax is a significant issue. One tool that households can use to try to minimize their estate tax liability is the trust. However, it’s important to understand that this is a limited, and fairly specific, tool. Here’s what you need to know.
For help with your estate plan, consider working with a financial advisor.
What Is The Estate Tax?
The estate tax is a transfer tax like income or capital gains taxes. It triggers when someone receives wealth or assets that they didn’t have before. In this case, the estate tax triggers when someone receives assets from a deceased benefactor.
The estate tax only apply to estates worth more than the IRS’ cap, and the IRS adjusts this cap each year to account for inflation. In 2023, the estate tax only applies to estates worth more than $12.92 million for individuals and $25.84 million for married couples.
As with all tax brackets, the estate tax applies only to assets above the cap. For example, on an estate worth $13,020,000, the IRS would only collect taxes on $100,000.
This is an important distinction and one that people often get wrong. Similar to income taxes, assets above the estate tax cap have no impact on the assets below the cap. If your estate is worth $12.92 million, you will pay no taxes on that money. If your estate is worth $15 million, you will pay no taxes on the first $12.92 million. The only question is whether your estate pays taxes on the assets above that cap.
The major difference between estate tax and most transfer taxes is that it is born by the payer, not the recipient. If you die and leave a multimillion-dollar estate to your heirs, the estate itself would pay any taxes owed to the IRS. Your heirs would then receive the remaining, post-tax assets.
Estate tax rates are comparable to income taxes, with brackets that scale from 18% at the lowest to 40% at the highest.
Revocable Trusts Cannot Avoid Estate Taxes
As a threshold matter, one of the most common forms of trust is the revocable, or “living,” trust. This is a third-party trust that you set up during your life, and which you maintain control over. You can move assets in and out of the trust, oversee its investments, change its beneficiaries and more.
There are many uses for a revocable trust, particularly when it comes to helping your estate avoid probate issues. Estate tax relief is not one of them. Under ordinary circumstances, passing your assets through a revocable trust will not shield them from estate taxes in any way.
Irrevocable Trusts Can Remove Assets From Your Estate
The second most common form of trust is known as irrevocable trust. As its name suggests, when you make an irrevocable trust you sign over control of the included assets. You name who will benefit from the trust, how its assets will be managed and distributed, and what assets you initially are including.
You are then free to contribute additional assets over time. However, once you establish the trust, you cannot change its terms without a court order. You also cannot withdraw or directly access the assets you have contributed to it.
The downside to this is that you lose direct control over your assets. You can name yourself as a beneficiary, which allows you to receive and use anything based on the terms of the trust, but this isn’t the same thing as owning those assets directly.
The advantage to this is that you remove these assets from your estate. Once you put something in an irrevocable trust it legally belongs to the trust, not to you. Assets in an irrevocable trust do not contribute to the overall value of your estate which, for a particularly large estate, can shield those assets from potential estate taxes.
But that doesn’t mean the assets in an irrevocable trust are shielded from taxes altogether. Instead, the assets in an irrevocable trust are taxed at different rates depending on their status. In most cases this means either the trust itself pays income tax on undistributed gains, or a trust’s beneficiary pays income taxes on money they receive from that trust.
Residence Trusts Can Shield Real Property
A residence trust is another form of irrevocable trust because only irrevocable trusts can shield assets from estate taxes. Here, you put property such as a home into the trust’s name. You then list yourself and your heirs as the beneficiaries to the trust, allowing you to continue using the house and letting them do so after you die. The result is that the trust owns the property but you and your heirs can use it.
The advantage here is that there is no asset to tax. Even though you and your heirs can continue living in the home, you don’t own it so it can’t contribute to your estate for tax purposes. This is particularly useful for people who are house-rich.
Intentionally Defective Grantor Trusts and Stepped Up Stocks
Finally, one of the most popular forms of trust for estate tax planning is known as the intentionally defective grantor trust.
One of the biggest downsides to transferring assets through an irrevocable trust is that it still involves some degree of tax liability. Even though you shield those assets from estate taxes, your heirs or the trust itself will still pay taxes. Typically this comes in the form of income taxes which either the trust pays or your heirs pay when they receive distributions.
You can mitigate that through the use of an intentionally defective grantor trust, or IDGT. This is an irrevocable trust into which you place assets, again shielding them from estate taxes. However, you maintain responsibility for paying taxes on the trust’s assets. This allows the trust to grow tax-free over time since you pay its taxes.
Bottom Line
For every high-net-worth households, estate planning will involve some taxes. By using trusts, you can structure your way out of and around some of that liability. And by setting up trusts to hold various assets, you can potentially reduce your overall estate tax liability. Trusts can work under the right circumstances and for the right assets, but they require a lot of planning.
Tips for Planning Your Estate
To maximize the legacy you leave to your heirs, you’ll need a comprehensive financial plan and investing strategy. A financial advisor can help you with both. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
It’s never pleasant to think about, but there may come a time when you’re unable to make decisions for yourself. For these scenarios, a living will or another form of the advance directive can help ensure your family knows your wishes.
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