“If someone does thorough estate planning, especially with living trusts, doesn’t that pretty much eliminate the need to hire professional help after death?” If you think so, today’s article is intended to burst your bubble.
Your estate plan (whether will or living trust) appoints a Representative who has to administer your taxable estate. The estate includes
your living trust, IRAs and other assets even if they don’t go through probate. When you die, administering your estate takes time: collecting the assets, determining the values, liquidating unwanted stuff, paying final expenses and debts, and transferring the assets to the right beneficiaries. During this time, taxable income is received, such as rent, interest and IRA distributions.
To minimize the income taxes and satisfy the IRS on your behalf, the Representative’s diligence will assure that your family avoids paying too much, too soon, or too late.
Tax bracket and tax year
An individual taxpayer is not in the top federal tax bracket (43.4%) until they make over $413,000 per year. But, for estates (and trusts) that top rate applies to income exceeding $12,300. Income (rent, etc.) received during administration is income to your estate. Of every estate income dollar over $12,300, 48.4% is lost to income tax when you add Illinois’ 5% income tax.
The estate gets an income tax deduction, however, for income that is distributed to beneficiaries. When that occurs, the distributed income ends up being taxed at the beneficiary’s usually-lower individual tax rate.
When should the tax year end? Probate estates can select a fiscal year ending on the last day of any of the eleven months following the month of death. Living trusts use a calendar year ending December 31 unless the Representative files a “645 election” to cause the trust to be treated just like a probate estate. If the Representative plays the cards correctly, the estate (whether probate estate or living trust) can have its first tax year end on the last day of any one of the eleven months following death.
How much does it matter?
Imagine that Paul, retired farmer married to Sue, dies on September 2, 2015. They have been accustomed to annual income of about $160,000 in rent, interest and IRA distributions. Paul’s living trust creates a Family Trust
, from which income can be distributed to Sue if she needs it, otherwise it can accumulate in the trust or be distributed to their children. Between his death and December 31, about $100,000 of their usual income comes to his trust. Sue and their three adult children are each in the 25% marginal tax bracket.
Here is where professional advice is going to help maximize the benefits to the family.
If Paul’s Representative fails to distribute the $100,000 to Sue or their children in time, it is taxed to the trust instead of the beneficiaries. That failure increases the taxes to be paid by about $20,000.
If the Representative fails to make the 645 election, the income taxes on the $100,000 will be due (from the beneficiaries who receive the income, or the trust if the income was not distributed) by April 15, 2016. If the election is made, which can extend the tax year to August 31, 2016, tax on the $100,000 can be delayed. If the trust pays the tax because the income is not distributed to the family, the tax will be due December 15, 2016. If the income is distributed to the family, they won’t have to pay the income taxes until April 15, 2017. If Sue doesn’t need the income and it is distributed to the children, this might make the most sense.
But what if the $100,000 (or most of it) is going to be distributed to Sue to maintain her accustomed standard of living? If the distribution of $100,000 is delayed into 2016, then instead of having $160,000 of personal income to report for 2015, Sue’s would drop to $60,000 even though she can file as married filing jointly. Her taxes would drop dramatically, but when she gets the $100,000 in early 2016, plus all of the $160,000 of their usual rent, interest and IRA distributions, and files as a single, she will soar into a much higher bracket. It may be better to take the $100,000 as a distribution from the trust in 2015, to avoid a spike into a higher personal tax bracket in 2016.
Get the picture? Find trustworthy estate planning professionals now. Build a lifelong relationship. Then they and your Representative can press forward cooperatively to maximize all benefits of your plan for your family.
© 2015 Curt W. Ferguson, all rights reserved. Attorney Samuel Collins contributed to this article, which appeared in the March 2015 issue of the Prairie Farmer® magazine.