If you’ve been estate planning, you’ve probably come across the idea of setting up a trust. Trusts are flexible and diverse legal entities that you can use to achieve various estate planning goals, including reducing your estate tax burden.

A critical — and often overlooked — consideration when selecting a trust for a particular purpose is the trust’s tax treatment. Tax planning is one of the most critical aspects of financial planning, and this can be especially true when it comes to trusts. Each type of trust offers different tax advantages and potential drawbacks, and the tax implications of each trust class vary. Depending on your unique financial situation and specific goals, different types of trusts may be more or less appropriate.

REVIEWING THE BASICS

Before we dive into the tax advantages of different types of trusts, let’s review how trusts work in general. Trusts are legal entities that hold assets for a particular purpose or specific beneficiary, often managed by a third party. There are three leading “players” when it comes to a trust:

1. The grantor is the person who creates the trust.
2. The beneficiary is the person or entity who receives the trust’s assets in some form after sufficient conditions are met.
3. The trustee is the person or entity responsible for managing the trust, both during the grantor’s lifetime and afterward.

Trusts can also be boiled down to one of two primary classes: irrevocable and revocable. The terms of an irrevocable trust cannot be amended or otherwise altered after the trust is established, while revocable trusts can be changed or even terminated down the road. Other, more specific types of trusts offer differentiated benefits, but they all fall under one of these two umbrellas.

TAX ADVANTAGE MACHINES

Generally, irrevocable trusts provide three primary tax advantages. And while the irreversibility of their terms may seem like a downside, this feature of irrevocable trusts enables their primary tax benefit.

Advantage #1: reduction of estate size: As you relinquish control of the assets you load into the trust, they are essentially removed from your estate for tax purposes. Suppose your estate is larger than the current federal estate tax exemption of $12.92 million. In that case, an adequately designed irrevocable trust will reduce the amount of your estate that the government takes upon your passing. This arrangement can simultaneously shield these assets from creditors.

Revocable trusts miss out on these estate tax-shielding benefits. Because the grantor still controls the assets in a revocable trust, they are considered a taxable part of their estate. Additionally, income generated by the assets within a revocable trust is passed through and ultimately reported on the grantor’s tax return, unlike what generally happens to income from an irrevocable trust.

Advantage #2: beneficial income tax treatment: Another primary tax advantage of irrevocable trusts is that they can be used to shift income to beneficiaries in lower tax brackets. Income from irrevocable trusts is taxed at the trust level instead of the grantor’s. This can be advantageous if the trust’s beneficiaries are in lower tax brackets than the grantor, as they may be able to pay a lower tax rate on the income generated by the trust’s assets.

Advantage #3: gift tax exclusion: Each year, every individual in the U.S. can give a specified amount to any other person or entity and not pay tax on that gift, known as the gift tax exclusion. In 2023, the gift tax exclusion is $17,000. The grantor of an irrevocable trust can effectively use their gift tax exclusion to “gift” assets to the trust and reduce their taxable estate simultaneously.

As an important note, the annual gift tax exclusion applies separately to each individual. The grantor can make multiple tax-free gifts in a single year, as long as they are designated for different beneficiaries.

GRANTOR-RETAINED ANNUITY TRUST

In addition to their general benefits, specific types of irrevocable trusts provide unique tax advantages. For example, a grantor-retained annuity trust (GRAT) has several tax benefits for estate planning. A GRAT allows an individual to transfer assets out of their estate while still receiving a stream of income from those assets — and then avoid taxes on any possible appreciation.

Here’s how it works. The grantor first loads assets into the trust in a lump sum. Then, they name the length of time the trust will last (the term) and specify a percentage of the trust to be paid out to them each year (the annuity). After the trust’s term expires, any remaining funds not paid out through the annuity will pass to the GRAT’s named beneficiary.

The tax treatment of a GRAT is a little complicated, but if structured correctly, it can provide massive tax benefits. When you load assets into the trust, the IRS calculates an expected appreciation rate of those assets and projects their value at the end of the trust’s term. After the trust expires, any amount that the assets appreciated over that projected value passes to the trust’s beneficiaries, gift tax-free. For this reason, it’s a smart tax move to load the trust with assets you think may greatly appreciate. A GRAT’s typical “goal” is for the entire original value of the trust to be paid back to you through the annuity while leaving the appreciation of the assets to your beneficiaries without incurring gift tax.

BENEFITS OF AN IRREVOCABLE TRUST

If you own a life insurance policy at the time of your passing, the death benefits from that policy will be included as part of your estate for tax purposes. However, if you use an irrevocable life insurance trust, those benefits can be distributed to your beneficiaries without incurring estate tax liabilities.

Although the federal estate tax exemption is currently very high at $12.92 million in 2023, 12 states impose estate taxes with exemptions much lower than the federal exemption. For individuals in these states, or those with an estate larger than the federal exemption, using an irrevocable life insurance trust can be a direct way to avoid estate taxes on behalf of your beneficiaries. Of course, keep in mind that this is an irrevocable trust — once the terms are established, there’s no altering them.

Scott Brown is a financial adviser with Wealth Enhancement Group. Read the original version of this article on the Wealth Enhancement website here.