A trust is a legal entity that holds money and assets for future distribution or management. For example, you might create a trust for your children’s college education, putting money into it which they can withdraw when they go to school. Or you might put the family home into a trust, creating a legal entity that will own the property potentially indefinitely to ensure that it will always stay in the family. The intersection of trusts and taxes can be complicated, but working with a financial advisor can help you clarify relevant issues so you can make good decisions.
What Is a Trust?
There are three main kinds of trusts:
- Simple Trust: This is the most basic and common. It holds assets and distributes all of the income that it makes off those assets to the trust’s beneficiaries. It does not distribute any of its principal.
- Complex Trust: Generally defined as “not a simple trust,” this trust is considered complex if it distributes less than all of its earned income in a year; if it distributes any of its principal; or if it makes distributions to charities as well as named beneficiaries.
- Grantor Trust: This trust is managed by the individual who established it. They exert a potentially high degree of control over the trust’s assets depending on how the trust was established.
With a grantor trust, the individual who established the trust pays all related taxes on the trust’s funds. Simple and complex trusts, however, have to directly pay taxes on all income, assets and tax events.
Trusts pay federal, state and (when applicable) local taxes. However, this article will only address federal tax rates and exemptions, as the specific rates and regulations surrounding state trust taxation is beyond the scope of this article.
2023 Ordinary Income Trust Tax Rates
In 2023, the federal government taxes trust income at four levels. These tax levels also apply to all income generated by estates. Below is a breakdown of these rates and brackets:
- $0 – $2,900: 10%
- $2,901 – $10,550: 24%
- $10,551 – $14,450: 35%
- $14,451+: 37%
The standard rules apply to these four tax brackets. So, for example, if a trust earns $10,000 in income during 2023, it would pay the following taxes:
- 10% of $2,900 (all earnings between $0 – $2,900) = $290
- 24% of $7,099 (all earnings between $2,901 – $10,000) = $1,703.76
- Total Taxes = $1,993.76
2023 Long-Term Capital Gains Trust Tax Rates
Short-term capital gains (from assets held 12 months or less) and non-qualified dividends are taxed according to ordinary income tax rates. Qualified dividends and capital gains on assets held for more than 12 months are taxed at a lower rate called the long-term capital gains rate. For trusts, there are three long-term capital gains brackets:
- $0 – $3,000: 0%
- $3,001 – $14,649: 15%
- $14,650+: 20%
Once again, these tax brackets also apply to all income generated by estates.
Most trusts generate a majority of their income through investments, but this is not a hard and fast rule. Many manage assets such as buildings and property, for example. Any income generated by rents or rental fees from these assets would be classified as ordinary income, not capital gains.
Primary Tax Deductions for Trusts
Here are four categories of primary deductions that concern trusts.
Contributions and Gifts
The contributions made into a trust are generally not subject to income taxes. The person making this contribution has already paid taxes on the money, so the IRS considers this double taxation. By and large the trust only pays taxes on income it generates from money and assets it holds.
The beneficiary of a trust may have to pay taxes on money that he or she receives. Generally speaking, beneficiaries must pay taxes on any distributions they receive that the trust paid from income that it earned in the current tax year. A beneficiary does not have to pay taxes on any distributions that the trust makes from its principal balance. This is to avoid double taxation. Any money in the trust’s principal has already been taxed. Any money that the trust earns and distributes in the same year, it does not pay taxes on.
When both could apply, distributions from a trust are considered to be first from the current year’s income (and so the beneficiary has to pay taxes on that money) and then from the principal. However, in some cases a beneficiary can still avoid paying any taxes if he or she has received less from the trust than lifetime gift tax exemption. In 2023, that is set at $12.92 million for individuals and $25.84 million for couples.
Trustee and Tax Preparation Fees
The trust may deduct reasonable fees for trustee management and tax preparation. However, the trust may only deduct these fees based on the proportion of income that is taxable. For example, say that a trust received $20,000 worth of income in a given year. However, only $10,000 of that income was subject to taxes. The trust could then deduct half of its management and accounting fees.
A trust may typically deduct any cash donations made to charity. Since this is a deduction it is nonrefundable, meaning that a trust cannot deduct more in donations than it earned in taxable income.
Income Distribution Deduction
Trusts which make distributions to beneficiaries can separate their income into two segments for tax purposes: the income which the trust keeps for itself, and the income which the trust distributes. The portion of the trust’s income which it distributes is known as the distributable net income, or DNI. Trusts do not have to pay taxes on the portion of their income which they distribute to beneficiaries in the same calendar year as it was earned. (This is because beneficiaries pay taxes on this income.) Any income that the trust does not distribute in the same year that it is earned is taxed and then added to the trust’s principal.
The DNI is calculated as the trust’s total taxable income, less its capital gains, plus any applicable tax exemption. So:
DNI = Total Taxable Income – Total Capital Gains + Applicable Exemptions
Remember, total capital gains is the sum total of all capital gains offset by any capital losses. A trust can then deduct from its income taxes the amount of any distributions it makes to qualified beneficiaries up to the total DNI.
Trusts pay taxes on ordinary income and long-term capital gains. While their rates have changed slightly in 2023, they remain largely comparable to previous years.
Estate Planning Tips
- Building an estate plan on your own can be difficult, but a financial advisor can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted 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.
- Having a will is a great first step to taking care of your family and assets after you’re gone. However, there are many more things that you can include in a comprehensive estate plan. To learn more, check out SmartAsset’s guide to estate planning vs. wills.
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