Top 5 Ways to Reduce Income Tax owed from an Irrevocable Trust
Now that we’re in the middle of tax season, you’re likely gathering all tax documents and getting ready to file. If you are affiliated with an irrevocable trust or estate – either as the owner or a beneficiary – it’s crucial you understand your role and how that will affect your taxes this year.
When assets are held in an irrevocable trust or estate, a fiduciary tax return must be filed on behalf of the entity managing those assets. Fiduciary tax return and Form 1041 will be used interchangeably from here onwards. A 1041 reports the income, deductions, and distributions of an irrevocable trust or estate. The irrevocable trust or estate itself is taxed separately from the beneficiaries.
If you are the beneficiary of an irrevocable trust or estate and you received a K-1 reporting income earned from it (income can include interest, dividends, rental income, capital gains, etc.), you will report that on your regular 1040 because you must pay taxes on distributions you receive.
So, when does the entity need to file a fiduciary tax return? Most file every year, as it’s necessary when over $600 of income is generated, if the entity is a complex irrevocable trust, or if it has multiple beneficiaries. A simple irrevocable trust only needs a return if it generates more income than was distributed to beneficiaries.
To be considered a simple irrevocable trust, the irrevocable trust must annually distribute income to beneficiaries but not distribute the principal or make charitable distributions. A complex irrevocable trust must either: retain some income rather than distributing it all; distribute principal to the beneficiaries; distribute funds to charitable organizations.
Because irrevocable trusts and estates are subject to some of the highest income tax rates, tax planning and strategy are important when dealing with them. Below are five strategies that can help reduce the tax bill for an irrevocable trust or estate.
Distribute Income to Beneficiaries
Once distributed, beneficiaries pay the taxes on that income, not the entity itself.
Deductions for Irrevocable trust Expenses
Irrevocable trusts and estates can deduct some expenses paid in managing the irrevocable trust, including fees associated with investment management, legal and accounting concerns, and administration. This reduces taxable income, lowering the overall tax liability.
Charitable Deductions
By making donations to qualified charitable organizations, irrevocable trusts can reduce their income tax obligations. [Charitable Deduction Limits: At the federal level, charitable deductions are limited to 60% of your Adjusted Gross Income (AGI). In California, deductions are limited to 50% of your AGI; in Idaho, charitable deductions are limited to 60% of your AGI].
Tax-Exempt Investments
Interest income from municipal bonds is exempt from federal income tax and from some state/local taxes. (At the state level, interest for residents in California and Idaho is tax-exempt). Investing in tax-exempt bonds or other tax-advantaged investment vehicles can help reduce taxable income.
Strategize the Timing of Income and Deductions
By deferring income (e.g. deferring rent or interest income) or accelerating deductions into the next year, irrevocable trusts and estates can manage tax obligations.
We’ve discussed strategies for how the fiduciary can lessen their tax bill. But what if you are the beneficiary and your inherited assets generate sizable income? As mentioned above, if an irrevocable trust generates income, that can be distributed to you (and then, the tax burden falls to you). The taxable amount will vary depending on your personal income tax rates.
So, how can I reduce my taxes as the beneficiary who was distributed income from an irrevocable trust or estate?
Offset it with Tax-Deductible Expenses
Another way to reduce your tax bill is to offset it with tax-deductible expenses, such as charitable deductions or itemized deductions. Whether or not you’re able to claim itemized deductions depends on a few factors but if applicable, itemized deductions include costs like mortgage interest, property taxes, medical expenses, and educational expenses.
Capital Gains Tax Treatment
If the income you receive comes from capital gains, you can take advantage of their preferential tax rates. As long as the irrevocable trust held the assets for more than one year before distributing them to you, the capital gains should be taxed at preferential rates (0%, 15%, or 20%, depending on your income level). (Note - if you want to sell your inherited assets, you should consider waiting a year to ensure capital gains are taxed at the lower rates).
Capital Loss Carryovers
Opposite of capital gains are capital losses, which are assets that decrease in value between when you inherit them and when you sell them. If your losses are more than your gains, you can deduct up to $3,000 from your income. Losses over $3,000 can be carried over and used to offset gains in future years.
Income Splitting
Lastly, if you're in a high tax bracket, you may want to split your income. Income splitting is when you gift income (or assets that produce income) to a family member in a lower tax bracket. Once gifted, the assets are taxed at the recipient's lower tax rate. However, be mindful of gift tax limits ($18,000 per recipient in 2024) and generation-skipping transfer taxes.
Whether you are the fiduciary responsible for an irrevocable trust/estate or a beneficiary of that entity, any income earned from assets within it will increase your tax bill. Ways to lessen that bill differ on your relation to the entity but can include distributing the income, taking advantage of deductions, and offsetting it with other tax-advantaged investments.
As always, we recommend working with a tax professional who understands both tax strategies and wealth management.
Author: Rob Cucchiaro, CFP®, CRPC, AAMS
Questions discussed in this article:
Q: When do I need to file a fiduciary tax return?
Q: What is the difference between a simple and complex irrevocable trust?
Q: If I have a simple irrevocable trust, does the income from it count as taxable income?
Q: How much income can I earn from an irrevocable trust without paying taxes in Idaho?
Q: How much income can I earn from an irrevocable trust without paying taxes in California?
Q: How much income can I earn from an estate without paying taxes in Idaho?
Q: How much income can I earn from an estate without paying taxes in California?
Q: What are the top 5 ways to reduce income tax owed from an irrevocable trust or estate?
Q: What are the top 5 ways to reduce income tax owed from an irrevocable trust or estate, as the owner of it?
Q: What are the top 4 ways to reduce income tax owed from an irrevocable trust or estate as a beneficiary?