Estate taxes are often the central focus of an estate plan because they can prove to be the heaviest drag on a legacy. A common approach is to create trusts to capture and leverage an individual’s estate tax exemptions. While this tactic can move the plan two steps forward, accelerated trust income tax brackets are often waiting to drag it two steps backwards. The internal taxation of trusts can limit their efficiency, and estate planners should think about taking a leaf from the playbooks of protection and retirement income planning, especially when the goal of the trust is to accumulate and protect trust capital and provide an income to the trust beneficiary that he can’t outlive.
Long-Term Impact
When taking clients through the estate-planning process, it’s important to discuss the long-term impact of trusts that the client may implement today. The income taxation of trusts is an important factor in assessing what that impact will be. When an individual establishes a grantor trust, he continues to pay the tax on any income generated by the trust investments. But a trust with a deceased grantor, such as a credit shelter trust or a funded irrevocable life insurance trust, will be taxed as non-grantor trusts, meaning that the trust is a tax-paying entity, subject to the compressed trust income tax brackets. Those brackets can have a striking impact. In 2015, an individual won’t reach the top tax bracket until he has $413,200 in income. However, trusts reach that same bracket level at a mere $12,300 of income. Clients taking advantage of this type of trust for estate tax savings may be leaving their survivors an income tax problem.
Dealing With Internal Trust Taxation
There are several ways to deal with this burdensome internal trust taxation:
1) Terminating the trust at the grantor’s death, 2) Distributing all the income out to trust beneficiaries and allowing them to pay the taxes at their individual rates, or 3) Simply reinvesting inside the trust and absorbing the additional income taxation.
Any of the three options may be sensible when the trustee takes into account the many possible dictates of the trust agreement, the needs of the beneficiaries for regular income or liquidity, how vulnerable they may be to attempted attachment by creditors, the trust’s risk tolerance and its time horizon.
Annuities Owned By Trusts
In addition to the three options outlined above, there’s a fourth potential option. Clients and financial professionals recognize that tax-deferred annuity products are important retirement income vehicles, and these are a popular choice among clients looking for tax-deferred growth and income when their working years are over. Annuities have inherent strengths that can provide value in many spheres.
In general, the internal growth of a non-qualified annuity is income tax-deferred. Generally, the owner of the annuity pays ordinary income tax on gain only when it’s distributed from the annuity contract. This tax deferral feature alone can make annuities a logical choice to be owned by a trust. It can provide a trustee with the freedom to select growth oriented sub-accounts inside the annuity without incurring a heavy income tax drag. There’s also a wide variety of annuities available that have a comprehensive menu of options.
As noted, the choices facing estate-planning professionals often involve trade-offs, and admittedly, an annuity can have its drawbacks. To derive the benefits of tax deferral, the owner gives up the ability to treat any of the growth as a capital gain. Instead, the gain on an annuity is taxed as ordinary income. With a few exceptions, there’s a 10 percent penalty on gains withdrawn before age 59½. And, unlike capital assets such as real estate, stocks or bonds, there’s no step-up in cost basis at the owner’s death. When the asset is passed to an heir, so is the built-in income tax liability in the form of Income in respect of a decedent (IRD). At present, the Internal Revenue Service allows for a beneficiary to stretch out the withdrawals on an inherited annuity contract, but the beneficiary must still begin receiving distributions in the year following the annuitant’s death. Finally, it’s important to note that annuities tend to have higher fees than other financial products and that additional riders ensuring certain rates of return or return of capital will also come with a cost and impede the overall rate of return. These are all factors a trustee must balance against the potential advantages of owning an annuity.
Despite some of the hurdles, a trust owning an annuity can present a unique opportunity simply because trusts can be established to have at least two generations of beneficiaries. Taking advantage of the longer life expectancies of younger beneficiaries can result in substantial tax deferral. If the trustee names a member of the younger generation as the annuitant on a contract, it may be possible to defer distributions across two generations or more, reducing the impact of both ongoing trust income taxation and IRD at the death of the older beneficiary.
Example: A Funded Credit Shelter Trust
The opportunity is perhaps best illustrated through an example of a credit shelter trust (CST) created to preserve the decedent’s federal estate tax exemption, when a step-up in cost basis at the surviving spouse’s demise isn’t a concern. The trust has two classes of beneficiaries: (1) the surviving spouse is the income beneficiary, and (2) the grantor’s children are the remainder beneficiaries. For a variety of reasons, the spouse may prefer not to receive income from the trust. He may simply not need it or may expect to be in a lower tax bracket after retirement and prefer to defer the income until then. The spouse may also wish to leave a larger balance of funds to the remainder beneficiaries.
If the trust holds capital assets, the trustee can always distribute the trust income to the spouse if he needs it, but this example assumes that the spouse prefers to allow the income to be accumulated in the trust. In that case, the account will be subject to capital gains, ordinary income tax and the 3.8 percent Medicare surtax.
To the extent a trust agreement gives the trustee the discretion to withhold or accumulate income, if the trust owns an annuity, the trustee will have control over its income distributions. The trustee also has flexibility to exchange and rebalance the annuity’s sub-account allocations without triggering any income or capital gains tax, which allows for the trustee to make adjustments over time and respond to changes in the market.
Now consider the effect if the trustee names one of the trust’s remainder beneficiaries as the annuitant. The surviving spouse is still the primary beneficiary of the trust and can therefore receive distributions necessary. If the spouse doesn’t require the income, the annuity’s value will grow for the next generation. When the surviving spouse eventually passes away, if the annuity carrier allows the trustee to distribute the contract to the annuitant in kind, there will be no taxable event at that time and no disruption in the tax deferral. Keep in mind that the availability of this option will depend on the policy of the issuing company and the terms of the contract.
When the annuity is passed in kind to the annuitant, if he doesn’t need immediate access to the funds, those monies can continue to grow tax deferred. This creates potential for two generations of tax-deferred growth. If the average tax-deferred rate of return, net of fees, were 3.4 percent, the annuity would grow to $3,809,039 over the two generations .1 In a taxable trust account, subject to a top tax rate of 39.6 percent plus the 3.8 percent Medicare surtax, it could take as much as a 6 percent rate of return to achieve the same result. At five percent, the tax-deferred funds would grow to $7,039,989,2 and at six percent to $10,285,718.3
While the potential tax deferred growth is compelling, clients must be made aware that the beneficiaries will be facing ordinary income tax on the gain in excess of the initial contribution of $1 million. However, they may elect a non-qualified stretch option, allowing them to take distributions over their life expectancy rather than as a lump sum. Again, if the beneficiary doesn’t need the income, he may decide to take only the required minimum distributions. That means that a third generation could enjoy tax deferral on a large portion of the funds. With 20 more years to grow, the impact could be even more substantial.
Consider Full Range of Choices
Of course, there are countless types of trusts, and they all pose different planning issues, so there should never be a one-size-fits-all choice or a default funding vehicle. Ultimately, a trustee with fiduciary duties should marshal the available resources—competent tax, legal and investment advice, as well as his independent judgment—in deciding what’s permissible and prudent. Financial professionals can best help their clients make successful decisions by considering the full range of choices and by including income taxation as one of the risks to assess in the decision-making process. This is particularly relevant when the individuals involved care about passing a legacy on to future generations. The most potent leverage comes when the structure and the funding are in balance and meet the clients’ goals.
Endnotes
1. $1 million compounded at 3.4 percent over 40 years equals $3,809,039.
2. $1 million compounded at 5 percent over 40 years equals $7,039,989.
3.$1 million compounded at 6 percent over 40 years equals $10,285,718.
The views expressed herein are those of the authors and do not necessarily reflect the views of MetLife and/or any of its affiliates.