How to Invest an Estate to Minimize Income Taxes
Not all estate investments are created equal, and certainly not in their treatment by Congress and the Internal Revenue Code (IRC). There are many types of investments, such as wages, rental income, deferred retirement income, royalties, interest, and short-term capital gains that are taxed at the highest applicable rate of the taxpayer (in 2013, that could be as high as 39.6 percent).
And then there are other types of income, including qualified dividends and long-term capital gains that may only be taxed at 0, 15, and 20 percent. Still other sorts of income, namely tax-exempt interest, remain untaxable in the hands of the estate or trust and the beneficiary.
If you’re dealing with an estate or trust that has substantial assets, you may want to consider crafting an investment portfolio for it that takes into consideration not only the tax consequences of these investments to the estate or trust but also to the beneficiaries.
On the other hand, if a different beneficiary is already in a high tax bracket because of income from other sources, the trust or estate may want to invest in tax-exempt bonds or low-dividend paying stocks. Your beneficiary doesn’t need more income to add to his or her return, and the trust or estate only requires enough to pay the ongoing administration expenses without dipping into the assets.
Be aware and careful of state tax consequences. State tax laws don’t always align with federal tax laws, and the results can be startling for you, as executor or trustee, and for your beneficiary. The best result is one that works for everyone’s federal and state returns, so take your state laws into consideration when making investment decisions.
How to limit the fiduciary’s income taxes
Every new year begins with a little uncertainty as to what the year will bring financially. You could lose a job, obtain a higher-paying job, or even win the lottery. Fortunately, the financial future of estates and trusts is more predictable because the pool of assets in an estate or trust is usually known, which means fewer variables are at play.
Of course, there will always be outliers, like a stock market that either rises high or falls precipitously, or a retirement account that’s discovered hiding behind the sofa cushions. But for the most part, after you marshal the assets, you should have a pretty good idea of what you have to work with.
From there, it’s a reasonably easy matter to decide how to invest it. If you know that distributions equaling at least the total taxable income will be made to the beneficiaries, the only income you have to be concerned with paying tax on is capital gains, which are taxed at lower rates than ordinary income. You may want to look at ways to invest that will produce less current income.
A trust or estate hits the highest tax bracket at a very low level of income ($11,950 in 2013, adjusted annually for inflation). After it reaches that mark, every dollar earned above that mark (other than capital gains, tax-exempt income, and qualified dividends) gets taxed at the highest rate.
Then again, you may not have much of a choice about how you invest the estate or trust’s income. Many trusts and estates hold ownership interest in closely held businesses or real estate that have been in the family for years and which can’t be easily sold. In these cases, your opportunities for planning rest solely on any other assets held in the trust or estate.
How to protect the beneficiary
The fact is that trusts and estates often don’t make distributions regularly, but rather shift large sums infrequently to the beneficiaries. The beneficiary, who may be working a regular job, is used to having taxes withheld at work and has always received an annual tax refund.
But along comes the money from the estate or trust and the income that it carries out on the estate’s or trust’s Schedule K-1, and not only is there now a large additional amount of taxable income, but that income has pushed the beneficiary into a higher tax bracket.
Instead of receiving a refund, the beneficiary now has a large tax bill and no cash because the distribution he or she received is long gone, spent on a new car, a home, or to pay off credit card bills.
Be sure to plan ahead with your beneficiary to make clear that any distributions made to him or her may be partially taxable and that he or she will be responsible for the tax. It’s often helpful for you to prepare a quick calculation to see how large an amount of income the beneficiary will have to declare, and then let the beneficiary know.
Sometimes, it’s possible for you, as executor, trustee, or administrator, to pay estimated taxes on behalf of the beneficiary; that way, the worst of the taxes should be paid before the beneficiary’s tax return is ever prepared, and any balance due will be small.
But, even if you can’t, or don’t, pay the estimated taxes on the beneficiary’s behalf, there are investment strategies you can use to lessen the tax impact. If your beneficiary is a resident of one state and you’re investing in tax-exempt bonds, make sure that they’re the obligations of that state and no other.
Doing so makes the income tax exempt, both for federal and state purposes, to the beneficiary. Or if you’re at a point of terminating an estate or trust and passing the actual assets out to the beneficiary, you can elect to pay the capital gains tax at the fiduciary level; the property then passes to the beneficiary or remainderman with the new and improved, taxes already paid, basis.