This Valentine’s Day – Think… Trust Income Tax Savings!


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This Valentine’s Day – Think… Trust Income Tax Savings!

This Valentine’s Day – Think… Trust Income Tax Savings!

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Trusts typically have the highest marginal tax rates in the U.S. tax system, but money can be saved with good tax planning and thoughtful timing. A very big day of tax-saving opportunity is coming up, and the holiday I use to remind myself to take advantage of it every year happens to be Valentine’s Day.

March 6, 2022 is the deadline to make distributions to beneficiaries under the “65-day rule” to avoid the much higher trust income tax rate, and if you want to take advantage of it, you should start as soon as possible. It is often advantageous to tax individual beneficiaries as much as possible. The 65-day rule can help with this. (Note that this article applies to non-grantors, usually irrevocable trusts, subject to income tax.)

How the 65 Day Rule Works

Many times, when we look back on our lives, we wish we could “live it all over again.” This is covered by Section 663(b) of the Internal Revenue Code (“IRC”). IRC Section 663(b) simply states that distributions from a trust or estate within the first 65 days of a tax year can be effective on the last day of the previous tax year. For example, a trustee’s distribution of trust income to beneficiaries no later than March 6, 2022 can be deemed to have been made on the last day of 2021 for income tax purposes.

Why do we care? The main advantage is the unique (and often overlooked) opportunity to save on income tax. Trusts, estates or individuals all pay income at progressive rates, with a maximum rate of 37%. For 2021, the individual top tax rate will only be triggered if married taxpayers earn more than $628,300 or single taxpayers earn more than $523,600 (the 2022 limits are $647,850 and $539,900, respectively). However, for trusts or estates, in 2021, the top marginal tax rate will be triggered when income is just over $13,050 (it’s just $13,450 in 2022). To put salt in the wound, an additional Medicare surcharge of 3.8% may also apply to trusts or estates, resulting in an effective marginal tax rate of 40.8%.

There is a way to avoid high trust tax rates, though. Non-grantor trusts are taxed on retained earnings at the end of the year. Trusts can use the income distribution deduction, so income distributed to beneficiaries is deducted from the trust’s taxable income. This effectively shifts the tax liability for income from high-tax trusts to individual beneficiaries, who have a much lower marginal tax rate.

This tax saving can buy a lot of roses for your loved ones.

Problems solved by the 65-day rule

The problem with this tax-efficient strategy of distributing trust income to beneficiaries is that it is difficult to execute before the end of the year. This is because the trustee usually does not know the amount of the income until after December 31st. The 65-day rule gives trustees more time, which improves their ability to plan and distribute income.

For example, a trust with $100,000 in income will owe $40,800 in federal income tax. If that income is distributed from the trust to the beneficiary by the end of the year, then the beneficiary will be taxed at the beneficiary’s lower personal tax rate! If this were the sole income of the single, unmarried beneficiary, the tax would be $18,021, a savings of $22,779. (This calculation is based on 2021 tax rates.)

Note that an irrevocable election must be submitted to distribute the previous year’s income tax payment (but unfortunately without any income tax withholding) to beneficiaries. Elections are usually made on IRS Form 1041-7 and the Trust Income Tax Return (IRS Form 1041). If you have not yet prepared a trust tax return, you can file a 1041-7 separately, or if you do, you must file a Form 1047 by March 8, 2024.

Proper planning of trust income can save you a lot of tax every year. So…for Valentine’s Day this year, also mark your calendars for the March 6, 2022 deadline and think “tax savings!”

This article was written and expresses the views of our staff consultants rather than Kiplinger editors. You can check advisor records with the SEC or FINRA.

Founder of Goralka Law Firm

John M. Goralka, founder of The Goralka Law Firm, helps business owners, real estate owners, by better protecting their assets, minimizing income and estate taxes, and addressing confusion and transitions to preserve, protect and enhance their estates and successful families realize their dreams of enlightenment. John is one of the few California attorneys certified as a California Bar Tax and Estate Planning, Trust and Probate Specialist.

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