Tax-Smart Trust and Estate Planning: Through the Years
Working Through Evolving Tax Implications
Going through the process of estate planning often raises many questions – one of the most common being, “What are the tax ramifications of this plan?”
The answer to that question varies based on many factors that are likely unique to your situation, like your state of residence, your overall net worth and the complexity of your circumstances. And along with that, each of those factors may grow more complicated as you get older and your estate and family grows.
To illustrate, let’s consider Mr. and Mrs. Smith as they sit down to discuss estate planning with their attorney at various stages of their lives:
The Young Professional Stage
We first meet Mr. and Mrs. Smith as young professionals, both working and beginning to grow their assets. They sit down with their attorney to start the estate planning process after the birth of their first child. Their concerns, at this point, mainly focus on ensuring that their child is taken care of, should anything happen to the two of them. Their attorney explains that they will need powers of attorney and basic wills that lay out who will take care of their child if they become incapacitated or pass away. The attorney also recommends that their wills create a trust for their child, should both of them pass away while the child is still young. When Mr. and Mrs. Smith ask what the tax ramifications are for putting this plan in place, the attorney explains that none of the planning will impact their personal taxes – because while Mr. and Mrs. Smith’s estate is growing at a healthy rate, they are just at the beginning of their asset-gathering journey.
That said, the attorney still explains the potential for federal estate tax implications and state estate or inheritance taxes in the future. In 2025, the federal estate tax exemption is $13.99 million, meaning an individual can shelter up to that amount before incurring federal estate taxes – and married couples can functionally combine their amounts, via portability, for an exemption of almost $28 million. Additionally, there are some states that impose their own estate taxes (sometimes called inheritance taxes). In some jurisdictions, there may be an exemption amount, but in other states every dollar is taxed. The attorney explains that while this is unlikely to be a concern based on the Smiths’ current financial situation, it could be relevant in due time.
Lastly, the attorney explains how a potential trust for their child could incur taxes. When the child receives distributions from the trust, either from the income created by the investments or from cash created by selling an asset, the tax implications (income or capital gains or losses) are reported on the child’s personal taxes. However, for any undistributed income or capital gains or losses, the trust will file its own tax return (Form 1041) and pay the taxes.
The Family and Career Building Stage
We next meet Mr. and Mrs. Smith about 10 years later. They now have a couple of kids and have started their own business, which is very successful. They have also purchased a vacation home and their estate has grown considerably. Given all of this, they sit back down with their attorney to discuss updating their estate plan. The first recommendation of their attorney is to create revocable trusts, in which their taxable assets and vacation home can be re-titled. Again, Mr. and Mrs. Smith inquire about the tax ramifications. The attorney explains that a revocable trust does not have its own tax ID number, but rather uses the couple’s respective Social Security numbers. Therefore, all the tax-related events in the revocable trust are reported on their own personal taxes, making it no different than holding the assets in their personal names (from a tax perspective). The attorney, taking notice of the success of their business and the increase in their net worth, then reminds them about federal estate taxes and lets them know that there may be reason, in the future, to make a plan to help alleviate future estate taxes.
Finally, Mr. and Mrs. Smith mention that they have been thinking about gifting money to their kids and are wondering about the tax implications. The attorney lets them know that in 2025, any person can give any other person up to $19,000 tax-free (this is known as the annual gift tax exclusion). And much like portability for estate taxes, married couples can give an individual twice that amount. If Mr. and Mrs. Smith want to make gifts that are larger than that exclusion, they must file a gift tax return (Form 709). Any amount over the annual exclusion will have tax applied, which can either be paid at the time of filing the tax form or can be applied to their lifetime estate tax exemption ($13.99 million). For example, if Mrs. Smith gave one of the kids $100,000, the excess $81,000 ($100,000 minus the $19,000 annual exclusion) would reduce her lifetime exemption by the same amount, dollar for dollar.
The Pre-Retirement Stage
A few years later, Mr. and Mrs. Smith sit down with their attorney again. Their business has continued to grow substantially, and their net worth now sits well above the federal estate tax exemption. They want to discuss wealth transfer techniques to hopefully reduce future estate taxes. The attorney discusses two ideas: Irrevocable trusts for their children where they can make significant gifts utilizing their estate tax exemption, and a Spousal Lifetime Access Trust (SLAT) where one spouse can gift a large amount into a trust for the other spouse. Again, Mr. and Mrs. Smith want to understand the tax ramifications of these options. The attorney explains that for most clients in this net worth range, these trusts would be grantor trusts, which means that while they are irrevocable trusts, they are “defective” in regard to income taxation. Because of this, all of the income and capital gains taxes would be reflected in Mr. and Mrs. Smith’s personal taxes. Since the trust would not pay the taxes, it could grow at a greater rate. Additionally, if Mr. and Mrs. Smith used their non-trust assets to pay the taxes, they could decrease their taxable estate and further limit the steep estate tax that could be applied at their passing.
As seen through Mr. and Mrs. Smith’s story, tax situations can change vastly over the years depending on your financial circumstances and goals. And while the couple was able to apply effective trust taxation principles to each life stage, there are many more options that could be available to them – which could be beneficial for you, too.
To analyze the trust and tax strategies that could work best for your situation, reach out to your tax professional and Baird Financial Advisor.
Baird Trust Company (“Baird Trust”), a Kentucky state chartered trust company, is owned by Baird Financial Corporation (“BFC”). It is affiliated with Robert W. Baird & Co. Incorporated (“Baird”), (an SEC-registered broker-dealer and investment advisor), and other operating businesses owned by BFC. The information offered is provided to you for informational purposes only. Neither Baird nor Baird Trust is a legal or tax services provider and you are strongly encouraged to seek the advice of the appropriate professional advisors before taking any action. The information reflected on this page is subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor. Investors should not make any investment decisions based solely on this information. Past performance is not a guarantee of future results. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor or a member of your Baird Trust team before taking action.
