There are a lot of benefits of trusts, but there also are some disadvantages. NJ 101.5’s recent post, “The disadvantages to trusts,” discusses some of the things you should know before moving forward.
Trusts can save on estate taxes but are typically subject to higher income tax rates than those of an individual taxpayer once the “grantor” (i.e., trustmaker) dies. Trusts have to pay income taxes on the income they generate by the assets they hold. Such irrevocable trusts hit the top bracket at a very low income threshold: $12,400 of taxable income in 2016. The top income tax bracket for an individual doesn’t happen until his or her income exceeds $415,050. Also, the additional 3.8% net investment income tax applies at low thresholds.
So, when a trust is being used for estate tax planning purposes, it’s smart to measure the estate tax efficiency of the trust versus the potential income tax inefficiencies of the trust.
These tax rules are in effect when the trust pays its own taxes. However, in some situations, a trust will be a “grantor trust,” which means that the grantor of the trust is still treated as the owner of the trust’s assets for income tax purposes. As a result, since the income of the trust is taxed to the grantor, these lower tax thresholds usually don’t apply.
Aside from the gory details of taxes, remember that the use of trusts for tax or asset protection purposes typically means you give away absolute control over the trust assets—that would apply if the assets were owned by the grantor or the beneficiaries.
A trustee is designated for the trust to conduct investment and distribution decisions. This trustee is, in many instances, a family member and (when properly drafted) the beneficiary of the trust—neither the grantor nor the beneficiary will have the level of access either would have enjoyed had the assets been owned outright and outside of a trust.
There are ways to avoid surrendering absolute control while keeping the protective components of a trust. The rules are complex, so leave the drafting of a trust to a knowledgeable trust and estate attorney.
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Reference: NJ 101.5 (August 3, 2016) “The disadvantages to trusts”