How do we minimize tax impact on distributions from an inherited trust?

[chaskavitch]

So, my husband and his sister are beneficiaries on a trust from their grandfather (via their late father) worth ~$500,000 right now.  It is invested through JP Morgan in "an aggressive growth model".  Unfortunately for us, the trust was written so that no one receives their full balance from the trust until the youngest beneficiary, DH's sister, turns 30 (she's currently 22), which adds 7 years until we can do what we want with the money.  We have, however, been informed that we are "in a position to periodically request income distributions" if we'd like to request the net income from the trust.

What we're really trying to figure out is what our best options for minimizing taxes and maximizing returns is, and I feel like I have a LOT of questions.  Our own taxes make sense, but the trust just adds another layer of complexity I'm not comfortable with yet. 

We asked the trust officer we're in contact with if taxes on capital gains and dividends are paid by the trust, and if they are, if we still have to pay taxes on the distributions.  The trust officer says that the trust does pay taxes on all income, but that we are also taxed on our distributions, which seems wrong on a macro level, since we'd essentially be paying tax twice on the same money.  The internet, after a minute or two of Googling, gives a lot of information about distribution deductions for the trust taxes, and the possibility of tax-exempt interest, etc., but after reading a bit, I'm not really any more clear about our specific questions.   

The estimated annual income for the trust is $11,000.  I'm not sure if that is before or after fees, but that much income puts them in the 33% tax bracket.  So, my main questions are:

1) If we have them reinvest the income rather than put it in a money market fund or distribute it, is it still taxed, or are the taxes deferred until the income is in cash? 

2) Are we being taxed that 33% no matter what we do? 

3) If we do request distributions, are we taxed at our nominal tax rate, or at the tax rate for dividends and short/long term capital gains?

We'd obviously prefer to have the money under our control, so we can put it in Vanguard and pay 0.05% in fees, instead of >1%.  I'm assuming that regardless, our best option is to take the distributions, but like I said, we're just trying to figure out the tax situation and minimize what we're paying if at all possible.  Does anyone have any answers/suggestions? 

[Goldielocks]

My understanding is this:

  Income earned in a given year can be retained in the trust, or passed to you as follows.

1) Income retained in the trust needs to be taxed at the trust levels.  For a testamentary trust (created upon a death), the trust may be taxed at individual tax return rates, starting at the lowest tax bracket.

2)  Income can be passed to you, to be taxed in the beneficiaries hands -- without being taxed inside the trust, first.  You lose the lower tax rate that the trust provides, on the first $11k, however.

3)  Income can be initially taxed by the trust, then passed tax free to the beneficiaries.

Therefore, having the first portion of income taxed within the trust, using the lowest tax bracket is a very good idea.  Looks like the advisor has set this up for maximum tax efficiency and growth for you, but little annual income stream now.

You, on the other hand, may have two goals for the trust:
A - Maximize the income per year you receive by directing JP Morgan to reinvest in  income funds that do not erode the capital to free up more annual distributions over the next 8 years.  This will reduce your future payout due to less growth, but increase your distributions now.

B- Be tax efficient -- have the first income taxed at the trust's marginal rate of 15% bracket, then distribute the rest.  If anyone is not earning any other income, you can shelter the first amount with your personal exemptions, otherwise, you will be paying at your marginal interest rate.

Note, with several beneficiaries, making the distributions tax efficient may not work for everyone at the same time, if some people have high incomes, others low, and the entire amount needs to be distributed equally each year.  If many of you have high incomes, sheltering it as capital gains (high growth, low income funds) is likely recommended, versus distributing extra income out over the next 8 years.

On the other hand, maybe a large capital distribution in a single year would be likewise not recommended if too large per person and pushes everyone into high tax brackets that year.   If this is the case, your advisor should distribute it to the group over a period of several years.


nb -- this is based on Canadian tax, but I find it generally similar in principle across many western countries.

[DevoCPA]

1. The income is still taxed

2. You are taxed at the tax bracket for a form 1041, they are similar to the tax bracket for individuals, but you reach the highest  tax bracket much quicker.

3. You will receive a K-1 and taxed on your form 1040 based on the type of income received. Ordinary, capital gains, etc...