People are often curious — or confused — about trusts, their various options and the role they play in saving on taxes. They’ve heard that it’s wise to have a Trust and that it can help their family save on taxes. Yet, given how frequently these conversations come up in our initial meeting with clients, we’ve decided to give an overview on the main types of trusts and the tax implications associated with them to clear up some common misperceptions. Exciting I know, so buckle up and enjoy the ride…. if after reading you have any additional questions about trusts, taxes, or any other issue related to estate planning, feel free to give us a call.
TWO TYPES OF TRUSTS
There are two primary types of trusts — revocable and irrevocable trusts — and each one comes with different tax consequences.
1| REVOCABLE LIVING TRUST
A Revocable Living Trust (RLT), also known simply as a living trust, is by far the most commonly used type of trust in estate planning. While you are alive, there is absolutely no tax or financial impact on you or your family as a result of creating a living trust.
A living trust is not a separate entity, you will continue to file taxes through your social security number and the trust is tied to you and will flow through your social security number as its tax identifier. However, once you are incapacitated or pass away, a living trust then acts as a separate entity from you for the purpose of avoiding the court process called probate, and this is where the confusion regarding taxes often comes from. But before we explain the tax implications of a living trust, let’s first describe how a living trust works.
A living trust is simply an agreement between three people: a person known as the grantor, who gives assets to a person or entity known as a trustee, to hold those assets for the benefit of a beneficiary(s). In the case of a revocable living trust, the reason there are no tax consequences is because you can revoke the trust agreement or take the assets back from the trustee at any time, for any reason. In fact, while you are alive and well, you can change the terms of the trust, change the trustee, change the beneficiaries, or terminate the trust altogether.
A majority of all people who create a revocable living trust will serve in all three roles, as they will give their property (“grantor”), to themselves to hold and manage (“Trustee”), for their own benefit (“beneficiary”). When creating a revocable living trust, you also name back-up, or “successors,” for each of these roles. That way, when you are alive, but no longer well and cannot manage your own affairs, someone that you have named as a “successor trustee,” can easily step in and take over managing your finances, your property and pay your taxes without having to go to court. When you pass away, your successor trustees can then manage your property for whomever you have named as the beneficiary, or beneficiaries, to receive everything you own once you’re gone.
However, upon your death, a revocable living trust becomes irrevocable, and this is when tax consequences come into play. There’s a lot of confusion about this transition and why a revocable living trust becomes irrevocable, or the tax implications change. If you think about it, during your life you can own property, earn an income and file taxes. Once you die, your trust now owns property and can earn income on that property, but you can no longer file taxes. As a result, your trust effectively becomes the corporation you’ve created to act on your behalf after your gone. That’s why following your death, the trustee you’ve named will step in to take over management of the trust assets and one of the first things they’ll do is to apply for a tax ID number for the trust. At this point, the trust becomes a taxable entity. Any income earned inside of the trust that is not distributed in that year would be subject to income taxes, at the taxable rates of the trust (or at the tax rates of the beneficiaries, if income is distributed to the beneficiaries).
2| IRREVOCABLE TRUSTS
In its simplest form, an irrevocable trust is created when you make a gift to a trustee to hold assets for the benefit of the beneficiary, and you cannot take back the gift you’ve made to that individual.
When you create an irrevocable trust, either during your lifetime or upon your death, the trust is a separate tax-paying entity, and it is either subject to income tax on the earnings of the trust at the rates of the trust, or at the rates of the beneficiaries.
Unlike a revocable living trust, an irrevocable trust is (as the name implies) irrevocable. This means that the trust’s terms cannot be changed, and the trust cannot be terminated once it’s been executed. When you transfer assets into an irrevocable trust, you relinquish all ownership of those assets, and your chosen trustee takes total control of everything in the name of the trust. Because you no longer own the assets held by the trust, those assets are no longer considered part of your estate. If the trust has been properly maintained, the assets held by the trust are also protected from lawsuits, creditors, divorce, serious illness and accidents, and even bankruptcy.
However, as mentioned earlier, irrevocable trusts also come with tax consequences. As of 2024, if an irrevocable trust earns more than $15,200 in income that is not distributed out of the trust in that year, every dollar over that amount is taxed at 37%. This just so happens to be the same percentage as the highest tax bracket for an individual, but you would have to earn $609,350 before paying the same tax rate of 37%. To avoid this high tax rate, in some cases, an irrevocable trust can be prepared so that the tax consequences pass through to the beneficiary and are taxed at their individual income tax rate, which is typically a much lower rate.
A majority of our clients leave their assets to their children and loved ones in this manner. When they pass away, their trust becomes an irrevocable Lifetime Asset Protection Trust for their beneficiaries. When we draft a like this, it can provide the beneficiary with protection from common life events, such as debt collection, divorce, debilitating illness, crippling accidents, lawsuits, and bankruptcy, without being taxed at such a high rate on such little income. It provides the best of both worlds, as it can provide asset protection for the inheritance you’ve left behind, it can allow your beneficiaries to have as much, or as little, control / management over the assets as you would like, but the income can still be taxed at the same rate it would have been if you simply gave their inheritance to them outright as individuals.
If you have a trust and are curious how it’s set up, or the income tax consequences for your loved ones upon your death, we’re happy to conduct a trust review meeting with you. During our trust review process, we will take your trust through a 75-point checklist and translate what it says for you and how those terms will impact your family, your wealth and the tax consequences after you’re gone. If you don’t have a trust, we’ll be happy to take you through our initial strategy session, where we will provide you with a crash course on estate planning and evaluate your options.
THE ESTATE TAX: WHAT IS IT & WHO HAS TO PAY
The estate tax is a tax on the value of a person’s assets at the time of their death. Upon your death, if the total value of your estate is above a certain threshold amount, known as the federal estate tax exemption, the IRS requires your estate to pay a tax, known as the estate tax, before any assets can be passed to your beneficiaries. When I explain this to my clients in our initial meeting, I describe this as a “coupon.” The government gives you a coupon to pass your assets tax free to your loved ones, up to a certain amount (the federal estate tax exemption). Every year this coupon will go up with inflation, but in any given year, politicians can change the amount of your coupon.
In 2024, the federal estate tax exemption is $13.61 million for individuals ($27.22 million for married couples). Simply put, if you die in 2024, and your assets are worth $13.61 million or less, your estate won’t owe any federal estate tax. However, if your estate is worth more than $13.61 million, every dollar more than that will be taxed at a whopping 40% tax rate.
In addition, the state you live in can also have an estate tax, separate and apart from the federal government’s estate tax. Illinois is one of seventeen states that have an estate or inheritance tax. In Illinois, any amount of your estate over $4 million will be taxed at a graduated rate that goes as high as 16% based upon the 2024 tax rates. Eleven states, and the District of Columbia, have an estate tax, while five states have an inheritance tax, where they tax people who live in their state when they receive an inheritance. Currently, Maryland is the only state in the nation that has both an estate tax and an inheritance tax.
By using various estate planning strategies, you can reduce — or even eliminate all together — your estate tax liability. Some of the strategies are simple, but the more money you have, the more complex they’ll need to become by using irrevocable trusts. Regardless of the method and without question, if you can save your family from a massive tax bill, they are well worth it.
If you’d like to learn more, or need to get a plan in place to save your family from a major tax burden, give us a call. We’ll be happy to have an initial 15 minute phone to answer any questions you may have and determine if we may be a good fit to work together. The next step in working with our office is a Family, Wealth & Legacy Strategy Session, where we will go over your assets, family dynamic, the law and what would happen to you and your family based on the various legal options available to you.
THE FUTURE OF ESTATE TAX: 1/1/2026 IS COMING
The current $13.61 million estate tax exemption is set to expire on Jan. 1, 2026, and return to its previous level of $5 million, which when adjusted for inflation is expected to be around $7 million. Over the years, I’ve heard many estate planning attorneys repeat that the 3 Commandments of Estate Planning are: (1) we don’t know when you will die, (2) we don’t know how much money you’ll have when you die, and (3) we don’t know what the estate tax exemption will be when you die. That’s why it’s so important to work with an attorney who takes the time to sit down and explain all of these dense concepts to you in a way that you will understand. Who will develop a long-lasting relationship with you and have processes in place to ensure that you are updated when the law changes and that strategies are put in place to protect your family, regardless of the amount of the estate tax exemption or the size of your assets.
WE’RE HERE FOR YOU
If you are trying to decide whether a revocable living trust, irrevocable trust, Lifetime Asset Protection Trust, or some other estate planning vehicle is the right solution for you and your family, give us a call. We will be happy to help guide you in making that decision, so your estate can provide the maximum benefit for the people you love most, while paying the least amount of taxes possible. Call us today to schedule your visit.
This article is a service of Family Wealth & Legacy Legal Solutions (FWLLS). We do not just draft documents; we ensure you make educated, informed and empowered decisions for yourself and the people you love. That’s why we offer a Family Wealth & Legacy Strategy Session™, during which you will get educated and begin to prepare to avoid life’s most common legal problems and get a plan in place to make the best possible choices for the people you love. You can begin by calling our office today to schedule a Family Wealth & Legacy Strategy Session and mention this article to find out how to get this $750 session at a significantly discounted rate, or even for free.