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Revocable Living Trust & Taxes: A Comprehensive Guide

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Revocable living trusts are one of the most popular tools people use to manage the distribution of their assets regarding estate planning. 

October 12, 2023
Author: NCH

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A Revocable Living Trust allows you, the creator, to amend it anytime you want. You can change or cancel its terms without anyone’s consent. It’s an excellent instrument you can use for estate planning.

But what about taxes? If you’re wondering how revocable living trusts are taxed, you’ve come to the right place. 

In this blog, we’ll explore the tax implications of a revocable living trust and how it will affect your beneficiaries in the long run. 

Basics of A Revocable Living Trust

A Revocable Living Trust (RLT) is a legal document that outlines how your assets are handled when you pass away. It allows you, the grantor, to name a trustee who will manage your assets for the benefit of your beneficiaries. 

Establishing an RLT is relatively easy. You only have to write an agreement appointing a trustee to manage and administer your assets. Your trustee could be a relative, a spouse, a bank, or a trust company. 

Once you’ve established a trustee, you can place all your assets into the trust. 

Revocable Vs. Irrevocable Living Trust

What distinguishes a revocable living trust from an irrevocable one is its amenability. An irrevocable living trust cannot be amended once it’s established. If you want to change a certain term in the trust, you’ll have to get the approval of the trustee and the beneficiaries before you can alter it.

On the other hand, RLTs can be modified anytime you wish. You can change or cancel the trust whenever you want to. This allows you to maintain control of your assets and who receives them. 

Advantages of A Revocable Living Trust

Aside from being amendable, there are plenty of benefits to an RLT. 

Protects Your Interest

RLTs protect your interests by providing your relatives with a guide on how you want your assets to be managed should you become incapacitated. 

Your living trust will only be considered valid if it was created when you were of sound mind to agree to its terms.

Prevents Probate

Probate is the legal process of transferring your assets upon your passing. Through this process, your assets will be reviewed by a probate court, which decides how your holding will be divided and distributed among your assets. 

Probates are time-consuming and expensive. Thankfully, trusts aren’t subjected to probate. If you have established an RLT before your death, your assets will automatically be transferred to your beneficiaries. 

Protects Your Privacy

Aside from being time-consuming and expensive, probates are also public proceedings. Once your will undergoes probate, it becomes part of the public record, allowing other people to access it whenever they want to. 

But by skipping this process entirely, you’ll be able to keep the details of your trust under wraps.

Allows For Continuity

Under an RLT, your assets will continue to grow for years without disruption. RLTs also eliminate the risk of selling your properties since they’re not required to undergo probate. 

How Are Revocable Living Trusts Taxed?

Most living trusts are required to file a federal return if they make at least $600 in annual income. However, there are certain exemptions to this rule. 

For instance, revocable living trusts are not taxed throughout their grantor’s lifetime. The Internal Revenue Service will treat your RLTs as grantor trusts while you’re still alive. As a result, you must include any income or capital gain your trust generates in your tax returns. 

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Once you pass away, your RLT will become an irrevocable living trust. The IRS will then tax your trust for any profit or capital gains it gains from its holdings. Your trustee will have to file an annual federal income tax return using Form 1041. 

Trust Distributions

A revocable living trust makes two types of distributions: principal and income distribution. 

Principal distribution refers to the money beneficiaries will receive from the trust’s balance. Some examples of this include stocks, bonds, and real estate properties. 

This disbursement is not taxable since the IRS typically assumes it was already taxed before it was even placed into your trust.

On the other hand, income distributions are the profit your assets generate over time, like interest, dividends, etc. Interest distributions are taxable income, which your trust has to pay. 

Since tax rates for revocable living trusts are high, most trustees will distribute the interest income to their beneficiaries. The distribution will then be taxed depending on the individual tax rate of the beneficiary who received it. 

Once your trustee makes an income distribution to your beneficiaries, they can deduct it from your trust’s Form 1040. They must also issue a K-1 Form to the IRS, explaining how much of the distributions are considered principal and income. 

The IRS will then forward the document to your beneficiary, informing them of how much income taxes they’ll have to pay for the distribution. 

This approach is an excellent tool for lessening the tax burden of your RLTs. However, it’s only applicable if your RLT is considered a simple trust. 

A simple trust has three qualities:

  • Requires mandatory distributions of all income generated during the taxable year. 
  • Prohibits the disbursement of its principal.
  • Prohibits distributions. 

If your RLT doesn’t have these characteristics, it will be considered a complex trust. The tax burden will be divided between your beneficiaries and the trust itself. 

Contact A Revocable Living Trust Attorney Today

Revocable living trusts are an excellent tool for effective estate planning. They can help you avoid probate courts and protect your interest from those who may want to challenge your wishes.

However, understanding the tax implications of a revocable living trust can be challenging. If you need help planning for the future, look no further than NCH. 

NCH specializes in effective estate planning. Our experienced team is here to guide you as you create your living trust. We’ll help you minimize tax liabilities and guarantee a bright future for your loved ones.

To learn more about our services, visit our website here or call us at 1-800-508-1729.

DISCLAIMER: The above material has been prepared for informational purposes only, containing opinions of the provider, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.

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