This Valentine’s Day – Think … Trust Income Tax Savings!

Valentine’s Day is synonymous with hearts and flowers, but for those with non-grantor trusts, there’s another symbol that could be associated with it: dollar signs.

Two dogs "smile." One wears a headband with red hearts, and the other has red heart-shaped glasses on.
(Image credit: Getty Images)

Trusts typically have the highest marginal tax rates in the United States tax system, but there are ways to save through good tax planning and thoughtful timing. One very important date for a tax-saving opportunity is fast approaching, and the holiday I use to remind myself to look into capitalizing on it every year happens to be Valentine’s Day.

March 6, 2022, is the deadline to make distributions to beneficiaries under the “65-day rule” to avoid the much higher trust income tax rates, and if you want to take advantage of it, you should get started soon. It is generally advantageous to have trust income taxed to the individual beneficiaries whenever possible. And the 65-day rule can help with that. (Note that this article pertains to those with non-grantor, typically irrevocable trusts that are subject to income tax.)

How the 65-Day Rule Works

Many times when we think back on our lives, we wish we had a “do over.” Internal Revenue Code (“IRC”) section 663 (b) provides just that. IRC section 663 (b) simply provides that a distribution from a trust or an estate within the first 65 days of the tax year can be made effective as of the last day of the preceding tax year. For example, a distribution of trust income by the trustee to a beneficiary made as late as March 6, 2022, can be treated for income tax purposes as if it had been made on the last day of 2021.

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Why do we care? The primary advantage is a unique (and often overlooked) opportunity for income tax savings. A trust, an estate or an individual all pay income under graduated rates up to a maximum rate of 37%. For 2021 this top rate for individuals is triggered only when incomes surpass $628,300 for married taxpayers, or $523,600 for singles (for 2022 the limits are $647,850 and $539,900 respectively). For a trust or an estate, however, for 2021 the top marginal tax rate is triggered with any income above just $13,050 (for 2022 it is just $13,450). To throw salt on the wound, an additional 3.8% Medicare surtax may also apply to a trust or an estate, creating an effective marginal tax rate of 40.8%.

There’s a way to avoid that high trust tax rate, though. Non-grantor trusts are taxed on retained income at the year end. Trusts can use an income distribution deduction, so income distributed to a beneficiary is deducted from the trust’s taxable income. This effectively passes the tax liability for the income from the highly taxed trust to the individual beneficiary, who is taxed at a much lower marginal rate.

This tax saving can buy a lot of roses for your loved ones.

The Problem the 65-Day Rule Solves

The problem with this tax-savings strategy of distributing income from the trust to the beneficiary is it’s tough to execute before the end of the year. That’s because trustees often do not even know the amount of the income until after Dec. 31. The 65-day rule gives trustees more time, allowing a greater ability to plan and allocate income.

For example, a trust with $100,000 of income would owe $40,800 in federal income tax. If that income was distributed to the beneficiary from the trust before year end, then the beneficiary would get to pay tax at the beneficiary’s lower individual rate! If that was the only income received by the single, unmarried, beneficiary, then the tax would be $18,021, a savings of $22,779. (This calculation is based upon 2021 tax rates.)

Note that an irrevocable election must be filed to allocate income tax payments (but unfortunately not any income tax withholding) to the beneficiaries for the prior year. The election is typically made on IRS Form 1041-7 with the trust income tax return (IRS Form 1041). If the trust tax return is not yet prepared, then, 1041-7 may be filed alone, if filed alone, then form 1047 must be filed by March 8 2024.

Proper planning for trust income can provide a substantial tax savings each year. So … for Valentine’s Day this year, also mark your calendar for the March 6, 2022, deadline, and think “Tax Savings!”

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

John M. Goralka
Founder, The Goralka Law Firm

Founder of The Goralka Law Firm (opens in new tab), John M. Goralka assists business owners, real estate owners and successful families to achieve their enlightened dreams by better protecting their assets, minimizing income and estate tax and resolving messes and transitions to preserve, protect and enhance their legacy. John is one of few California attorneys certified as a Specialist by the State Bar of California Board of Legal Specialization in both Taxation and Estate Planning, Trust and Probate.