For years, clients have created trusts as an effective way to pass assets to the next generation. There are a lot of benefits to trusts, including the ability to attach strings to how your beneficiaries use the assets you leave for them. There are also some potential downsides.
Perhaps the biggest downside to a trust is the exorbitantly high income tax rate they must endure.
In 2013, when trust income exceeds approximately $12,000, the trust becomes subject to the highest possible tax bracket of 39.6 percent. Add to that the 3.8 percent Medicare surtax, scheduled to take effect this year, and trusts become subject to federal income taxation of 43.4 percent.
Depending on what state your trust is domiciled in, you can also add state income tax to the pile. In New York, the highest tax rate for your trust could approach 8 percent.
All-in-all, 50 percent of your trust’s income could be eroded, needlessly, by ineffective tax mitigation strategies. Not only are you losing up to 50 percent of the income, but you’re foregoing all of the potential future compounded income that could have been earned on the tax liability.
What can you do?
If properly drafted and administered, you could utilize a deferred annuity to give the trustee more control over when and how the trust’s income will be taxed.
Annuities are granted tax-deferred status. This means that gains within the annuity are not taxed until they are withdrawn. Because the gains are tax-deferred, they can be used for additional compound growth. This can be a great way to magnify the impact of your legacy on the next generation.
Properly funding and administering your trust is of the utmost importance to be sure your trust-owned annuity maintains its tax-deferred status. For example, if the beneficiary of your trust is another trust (referred to as a non-natural person), its qualification under IRC 72(u) could be lost.
Many annuity companies also offer minimum death benefit guarantees on their contracts. These guarantees vary by company, but are often a death benefit equal to the higher of:
A return of premium (adjusted for any withdrawals);
The contract value.
This means that you can help eliminate down-side market exposure, because your heirs will receive at least what you contributed to the annuity (adjusted for withdrawals), but they’ll still be participating in the potential upside of the markets.
There are other tax-deferred, or even tax-free funding options, like life insurance, which could help make your trust more efficient, so be sure to work with your independent financial advisor, accountant and trusted estate planning attorney to craft a plan which best meets your needs.
Stephen Kyne is a Partner at Sterling Manor Financial, LLC in Saratoga Springs. Securities and investment advisory services are offered solely through Cadaret, Grant & Co., Inc. Member FINRA/SIPC. Sterling Manor Financial and Cadaret, Grant are separate entities.
