Friday, September 2, 2016
Michael Kitces recently published an Article entitled, Minimizing the Income Tax Bite of a Bypass Trust, (July 27, 2016). Provided below is a summary of the Article:
The bypass trust is a popular estate planning strategy used to reduce a couple’s exposure to estate taxes, by leaving the assets of the first spouse to die not to the surviving spouse, but to a trust for his/her beneficiary instead. If the surviving spouse doesn’t inherit the assets directly, they’re not subject to future estate taxes when the second spouse ultimately passes away.
However, while the bypass trust is effective for saving on estate taxes, it’s not very favorable for income tax planning, given that trusts reach a top 39.6% tax bracket (plus the 3.8% Medicare surtax on net investment income) at “just” $12,400 of taxable income. And at that threshold, long-term capital gains (and qualified dividends) are subject to a whopping 20% + 3.8% = 23.8% tax rate as well. Plus state income taxes to boot (if applicable).
Fortunately, though, the tax rules for bypass trusts (and other “non-grantor” trusts) allow trusts that distribute their income to beneficiaries to distribute the tax consequences to the beneficiaries as well – allowing those beneficiaries to claim the income on their own personal tax returns (and be subject to their far more favorable individual tax brackets) while the trust claims a “Distributable Net Income” (DNI) deduction to avoid any double taxation.
Of course, the caveat to passing through income from a trust to the beneficiary is that while distributing the income to the beneficiary may minimize income taxes, it just compounds the estate tax problem the bypass trust was designed to avoid (by pushing the income back into the spouse’s taxable estate). However, given the significant rise in the Federal estate tax exemption over the past 15 years – from “just” $1M in 2001 to $5.45M today – many bypass trusts are actually no longer necessary. Which means it has suddenly become a far more effective strategy to start deliberately making income distributions from a(n existing) bypass trust to the beneficiary, who may no longer face any estate taxes, but can materially reduce the family’s income tax exposure in the process!
Special thanks to Jim Hillhouse (Professional Legal Marketing (PLM, Inc.)) for bringing this article to my attention.