Under the New Tax Law, “Bracketing” is the strategy for trusts

Under the 2013 new federal tax law, inaccurately named the American Taxpayer Relief Act, Congress created up to 12 layers of tax rates.  In a recent interview with WSJ Wealth Advisor (http://online.wsj.com/news/articles/SB10001424052702303973704579352510474240396), Bernstein’s Paul Lee discusses the strategy of “income shifting” to save taxes.

Trusts are often used as a vehicle to reduce or eliminate gift and estate tax while bequeathing wealth to children or other beneficiaries, but are subject to taxes on their own earnings, from investments, interest and other forms of income.  Individuals can have as much as $406,750 of ordinary income before the top tax rate applies to them. In contrast, trusts must pay the top rate on any income over $12,150 for 2014. Starting this year, income taxes range as high as 43.4%, with a 3.8% investment surtax applying on top of the new 39.6% top bracket.

Mr. Lee, who is based in New York, has been alerting advisers to the potential benefits of increasing trust distributions in the right circumstances.  He has modelled potential savings to be had from making bigger distributions from a $10 million dynasty trust. Dynasty trusts are created to essentially last forever, benefiting family members for generations to come. Mr. Lee says a $10 million trust that distributed $250,000 to each of four different beneficiaries each year for 30 years would end up 28% wealthier than if the trust made no distributions.

But a trust doesn’t have to be huge for the strategy to work. Shifting more income to beneficiaries of a trust with just $300,000 in it could save a significant amount in taxes, according to Mr. Lee.  Running the numbers quickly in the new year can be important. A trust with $30,000 in taxable income and a single beneficiary with taxable income of $100,000 would owe $32,217 in combined taxes if the trust makes no distribution for 2013, as compared to $29,340 in taxes if it pays out $20,000 to the beneficiary, according to Mr. Maddox. Shifting $20,000 of income out of the trust cuts the amount of tax it owes from $10,923 at a 43.4% marginal tax rate to $2,446 at a 33% marginal rate. The beneficiary would owe more tax–$26,893 as compared to $21,293–but is in the 28% bracket. The combined overall savings from making the distribution would be $2,877.

Trustees need a firm grasp of the different kinds of income inside a trust to use distribution strategies successfully, advisers say. Investment income, interest, dividends and capital gains are all part of the mix. Many trusts allow the trustee to pay out only income, which generally includes interest and dividends. Some give the trustee flexibility to distribute principal, or allocate capital gains to principal.

As long as tiered rates remain under ATRA, bracketing strategies, including income shifting, need to be considered by trustees, to ensure maximum wealth transfer through a trust.