When you come into money for any reason, you expect the taxman to be expecting a share, so you would naturally apply this dynamic to inheritance transfers. Generally speaking, inheritances are not subject to regular income taxes because an estate is accumulated after taxes have been paid.
However, there is a shade of grey when it comes to distributions of assets that are held by living trust, and we will explain the details in this post after we provide a general overview.
Living Trust Benefits
The revocable living trust is a very effective estate planning tool that can be a better choice than a simple will as your estate plan centerpiece. When you have this type of trust, you would be the trustee while you are living, so your ability to access your assets would not change in any way.
Streamlined Estate Administration
Since the trust would be the owner of all or most of the assets that comprise the estate, the administration process would be streamlined. The successor trustee that you name in the trust declaration would enter a turnkey situation that would benefit the heirs.
Another positive when it comes to the administration phase is the avoidance of probate. This is a costly and time-consuming legal process that would enter the picture if you facilitate asset transfers through the terms of a will.
You can include spendthrift protections when you have a living trust if this is a source of concern.
The trust would become irrevocable after your passing, and the beneficiaries would not have access to the principal. Creditors of the beneficiaries would “step into their shoes,” so they would not be able to reach the principal either.
They could go after assets that have been distributed, but to account for this, you can instruct the trustee to distribute limited assets on an incremental basis. This would also limit the beneficiary’s ability to spend lavishly.
A significant percentage of elders become unable to handle their own affairs at some point due to cognitive impairment. To account for this, you can name a disability trustee that would assume the role if it ever becomes necessary.
Income Taxes on Trust Distributions
Now that we have explained some of the benefits that living trusts provide, we can focus on the point of this post. The principal or corpus that is held in a living trust is not subject to further taxation since the decedent paid taxes before they accumulated this remainder.
Beneficiaries of a living trust do not have to report distributions of the principal. However, distributions of the trust’s earnings are subject to taxation, and the trust itself would be required to pay taxes on undistributed income that is generated by the principal.
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We got into this area of the law because we want to help people pass along suitable legacies to their loved ones. A lot of folks harbor misconceptions that can yield negative consequences, so we place an emphasis on education.
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If you have already learned enough to know that it is time for you to work with an attorney to put an estate plan in place, we are here to help. You can send us a message to request a consultation appointment, and we can be reached by phone at 585-374-5210.