Now is the time to begin looking at ways to minimize your 2018 income tax bill. Everyone should consider the “timing” of their deductions and, if possible, income. Depending on your circumstances, it might make sense to prepay some expenses for 2019, so you include them on your 2018 tax return. These expenses may include state estimated tax payments, expenses related to your investment real estate or small business.
Using Charitable Remainder Trusts To Reduce Your Income Tax
Some folks may be familiar with Charitable Remainder Trusts (CRTs) as an estate tax reduction technique; typically, you’d receive an income stream for years and then your gift to the trust passes to your most beloved charity. CRTs are also effective in reducing income taxes under the right circumstances.
Aside from being able to take a limited income tax deduction over five years for the value of the property transferred into a CRT, a CRT can be used to reduce your income tax bill as follows:
- Avoiding a Large Capital Gain. If you anticipate recognizing a large capital gain on an appreciated asset, such as the sale of your business or valuable stock you purchased years ago, you can transfer the asset into a CRT which then sells it. You will not recognize any capital gain on the sale. In addition, payment of the annual distribution is only taxed when you receive it, which spreads income over a number of years.
- Shifting Income to the Next Generation. If you will not need the income from an income-producing asset, you can provide an income stream for your children by transferring the property into a CRT and making your children the current beneficiaries. This shifts the taxable income down to the next generation.
- Planning for Retirement Income. A Net Income With Makeup Charitable Remainder Trust (NIMCRUT) can be used to invest for tax-deferred growth while you are still working and do not need investment income. After you retire, the CRT assets can be invested to replace your lost income.
- Combining Life Insurance. A CRT combined with a significant life insurance policy, often owned by an life insurance trust is a dynamic duo. The income stream pays for a life insurance policy, taxes are reduced, and the insurance replaces the value of the asset donated to charity. This strategy is a win/win for all.
Strategies for Reducing the Taxable Income of Irrevocable Trusts
Under federal income tax laws, irrevocable, non-grantor trusts (such as Bypass Trusts and Dynasty Trusts) are subject to highly compressed income tax brackets. In 2018, the top 37% tax rate kicks in at only $12,500 of trust income. In addition, trusts in the top tax bracket are subject to the 20% long-term capital gains rate and the 3.8% surtax.
As part of their fiduciary responsibilities, Trustees of this type of trust must evaluate ways to reduce the trust’s annual income. After taking into consideration the terms of the trust agreement, the tax status and ongoing needs of the trust beneficiaries, and applicable state law, income-reducing strategies Trustees should consider include:
- Distributing trust income to beneficiaries so that it is taxed in their lower tax bracket.
- Making in-kind distributions of low basis trust assets to beneficiaries.
- Invoking the 65-day rule and distributing trust income to beneficiaries by March 6, 2019, which will allow the trust to deduct the income as a 2018 distribution.
- Exploring options to permit capital gains to pass to beneficiaries instead of being taxed inside of the trust, such as reforming or decanting the trust to broaden the Trustee’s discretion to allocate between trust income and principal.
- Shifting trust investments to minimize taxable income and gains.
- Terminating small, uneconomic trusts.
Planning to minimize income taxes is a balancing act. Your needs and the needs of other beneficiaries must be carefully weighed against the overall tax savings. In addition, income, gains, losses, and tax brackets must be reviewed annually since the expenses of the individual or trust beneficiary will change from year to year.