Setting up a trust as a legal entity can help protect your assets from creditors and help your family avoid probate when you die. While trusts can provide you with some benefits, they are not a tax-free entity. In some cases, taxes still have to be paid when money is distributed.
When a trust is used as an estate planning tool and the person who originally set up the trust dies, the assets inside can be passed on to a beneficiary. If you receive assets from the trust such as cash, real estate or securities, you will generally not have to pay income taxes on these amounts. If the inheritance is very large and it is above the estate tax exemption, you could have to pay estate taxes on the amount.
Taxes on Income
Some trusts are set up to provide regular payments to the beneficiaries. If you receive income that has been created from investments in the trust, you will have to pay taxes on the amount you receive. This could require you to pay capital gains taxes if stock was sold to generate the money. Someone has to pay money on the earnings of the trust and if the money is distributed to you in the same year that it is earned, that burden falls on you.
When money in a trust is used to buy investments, the trust could be gaining value even though no one is actually using the investments. If the trust earns an income, it will have to pay taxes to the Internal Revenue Service. The amount of money that must be paid will be based on the trust tax rates that are set up by the IRS. These rates are different from the rates for individuals and businesses.
When it comes to taking regular distributions from a trust, take your marginal tax rates into consideration. If you can request a certain distribution from the trust, you might want to take a distribution that would allow your annual income to fall below the next marginal tax bracket. This way, you do not have to pay a higher rate of taxes on part of your income for the year. To make this possible, you will have to make a request to the trustee if the provisions of the trust allow it.