Many taxpayers understand—at least in a general way—how individual tax returns work.
Someone earns or receives income. The taxpayer gets some deductions. Often including a big “standard deduction” that means someone doesn’t pay income taxes on the first $12,000 or $24,000 of income.
And then the tax rates paid? A familiar set of percentages. Often percentages that mean someone pays a top tax rate of 12, 22, or 24 percent on the last dollars they earn.
In comparison, trust tax returns work very differently. Fiduciaries, and even beneficiaries, need to keep those differences in mind both to minimize taxes and not be blindsided.
Steeply Progressive Income Tax Rate Schedules
A first thing to take note of, for example? Trust income tax brackets ratchet up very quickly.
To pay the top tax rate on a 1040 tax return in 2020, for example, a taxpayer often needs to earn several hundred thousand dollars of taxable income.
Note: In 2020, the top individual tax rate of 37 percent kicks in at $518,410 for taxpayers using the single and head of household filing status. For married taxpayers, the top individual tax rate of 37 percent kicks in at $622,051.
In comparison, a trust pays the top income tax rate in 2020 once its income reaches $12,951. That top rate equals 37 percent on ordinary income (like interest income on bonds and short-term capital gains).
Often 20 Percent Capital Gains and Ordinary Dividends Tax Rates
The tax rate on long-term capital gains and qualified dividends also quickly reaches the top tax bracket.
Individuals often pay a 0 percent or 15 percent long-term capital gains tax rate. They only pay the top 20 percent long-term capital gains or qualified dividends tax rate when their taxable income gets pretty high. Like several hundred thousand dollars of taxable income. (In 2020, for example, married taxpayers filing together (so, “jointly”) move into the top capital gains tax bracket at $496,600, a single taxpayer at $441,450, and a head of household taxpayer at $469,050.) And that top rate equals 20 percent on qualified dividends and long-term capital gains.
A trust? A trust pays the top 20 capital gains and qualified dividends tax rate once its income exceeds $13,150.
Meet the Net Investment Income Tax
And one other tax most taxpayers don’t yet have familiarity with, but which most trusts will encounter: The net investment income tax, also known as “NIIT” or the “Obamacare tax.”
Trusts pay the 3.8 percent net investment income tax once trust investment income (or modified adjusted gross income) exceeds $12,950.
These relatively low thresholds at which top income tax rates, top long-term capital gains tax rates, and net investment income tax kick in? They mean trusts want to avoid realization of income when at all possible.
Tax efficient passive investment strategies make a lot more sense a lot sooner for a trust than for an individual. Active investment strategies that accelerate realization of income? The economics get harder to justify. Even harder than usual.
Trusts Get a Distribution Deduction
Something else to know. If a trust earns but then distributes income to its beneficiaries? That distribution becomes a deduction on the trust tax return. And that distribution in effect moves the income onto the beneficiary’s return.
Note: Some trusts are required to make these distributions. Others, in contrast, get a choice.
In any case, that relocation often saves big amounts of tax—and for a simple-to-understand reason.
By making distributions to beneficiaries, a fiduciary moves income from a 1041 trust tax return where the money gets taxed at those high tax rates to a 1040 individual tax return where the money often gets taxed at a lower tax rate.
In almost all cases, moving the income from the 1041 trust tax return to the 1040 individual tax return drops the tax rate to 15 percent. And the move zeroes out the net investment income tax.
Nondeductible Spending by Trust Particularly Expensive
One final, awkward point to raise.
You’ve read in the earlier paragraphs that trusts pay very high tax rates on the income they earn. You’ve also read here that trusts often want to minimize their realized taxable income.
One other important fact to know is that the amounts a trust pays investment advisors do not count as tax deductions on the trust tax return. (They don’t count as tax deductions on an individual’s 1040 tax return either, by the way.)
This reality can create a conflict with some investment advisors. Say, for example, that active investment manager charges a $24,000 investment advisory fee to advise a trust on its $2,000,000 investment account.
In this situation, the investment advisor may need to generate $32,000 of investment income just to pay the fees. How can this even be? Well, the trust needs to earn at least $32,000 of income to pay $8,000-ish of taxes and then still have $24,000 leftover for investment advisor fees.
The actionable insight here? If the fiduciary can comfortably employ a passive investment strategy—like investing in one of the Vanguard Group’s Life Strategy funds—the trust saves not just the advisor fees ($24,000 in this example). But the trust also avoids needing pay steep taxes (roughly $8,000 in this example) on the income intentionally realized to pay those fees.