People often have questions about how taxes can impact inheritances, and we are going to look at taxation on living trusts in this post. But first, we will provide a general overview so you understand some of the benefits that these trusts provide.
Simple, Efficient Estate Administration
One of the most commonly held estate planning misperceptions is the notion that wills are very simple, and trusts are extremely complicated.
The verbiage and the underlying principles that are associated with a trust may be a bit more complicated, but the practical administration process is another matter.
When a will is used as an asset transfer vehicle, it is admitted to probate, and the executor that is named in the document acts as the administrator. It will take nine months to a year or so for the process to run its course in most cases, and no inheritances are distributed until the estate has been closed by the court.
Probate expenses shave down the value of the estate before it is distributed to the heirs, and anyone that wants to access probate records can obtain all the details.
On the other hand, if you use a revocable living trust as your primary vehicle of asset transfer, the trustee would distribute assets outside of probate. The court would not supervise the distributions, so the administration process would be simplified
Plus, the trust would own all or most of the assets that comprise the estate. This is another benefit that helps to facilitate a streamlined estate administration process.
Flexibility and Control
You would be the trustee if you establish a living trust, so you would directly control the assets in the trust. Along the way, you can change the terms and alter the beneficiary and successor trustee designations as you see fit.
Many people become unable to make sound decisions at some point in time due to cognitive impairment. To account for this, you can name a disability trustee to assume the role if it ever becomes necessary.
Asset Protection and Spendthrift Safeguards
You may have concerns if you are going to be leaving an inheritance to someone with free spending habits that tends to accumulate a lot of debt. When you have a living trust, you can include a spendthrift clause that would provide asset protection.
The trust would become irrevocable after your death, and the beneficiary would not be able to reach the assets. Their creditors would also be held at bay, so the resources in the trust would be protected.
In the trust declaration, you provide instructions for the trustee with regard to the way you want the assets to be distributed to the beneficiary. For example, you can provide a certain fixed amount each month. This is one possibility, but you would have total control over the nature of the distributions.
Taxes on Living Trust Income
Now that we have provided a basic overview, we can get to the point. Generally speaking, inheritances are not considered to be taxable income, because the decedent already paid their taxes. This applies to distributions of the principal that is held by a living trust.
However, ongoing interest has never been taxed, so distributions of the trust’s earnings would be subject to regular income taxes. The trust itself would have to pay taxes on undistributed interest income.
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