If you want to plan ahead to pass assets down to heirs in a tax-efficient manner, a grantor trust might be the right choice for you. Find out more about what a grantor trust is and how it works, so you can make an informed decision about your finances.
Who is the Grantor of a Trust?
A grantor is a person who creates a trust. They’re often the same person who funds the trust, transferring ownership of assets into the trust. In most cases, the grantor also appoints the person who will manage the trust — known as the trustee. In the case of a grantor trust, the grantor retains certain powers over the assets, earns income from the assets, pays income taxes on the assets and is typically treated as the owner of assets held in the trust.
How Does a Grantor Trust Work?
A grantor trust takes effect during your lifetime. With a revocable trust, the grantor retains control of the assets put into the trust, and is taxed on the income from those assets as well. With irrevocable grantor trusts, the grantor still retains certain powers over trust assets and is responsible for the taxes. This is different from non-grantor irrevocable trusts, where the income is earned by the trust itself.
Because grantors earn the income from trust assets with a grantor trust, the grantor is responsible for any applicable income taxes. Income from a grantor trust is taxed as personal income, rather than trust income and will flow onto the grantor’s personal tax return.
Upon a grantor’s death, the trust becomes a non-grantor irrevocable trust and the trust will then be responsible for the trust’s taxes. Trust documents may also be drafted to allow the grantor to relinquish grantor trust powers at any time, and if that occurs, the trust will be responsible for taxes.
What is the Point of a Grantor Trust?
People set up trusts for a variety of reasons, but some common motives for creating grantor trusts include:
Setting assets up for strategic disbursement to heirs later
Setting assets aside from the taxable estate to avoid potential estate taxes upon your death (since these assets will grow outside of the estate and you will reduce your estate further by paying income taxes on the assets)
Allowing trust assets to grow without the encumbrance of income taxes
Retaining some control of assets during life, even while engaging in this strategic planning
What’s the Difference Between a Grantor and Non-Grantor Trust?
Grantor trusts allow the grantor to retain certain powers over the assets within the trust. During the period the trust is a grantor trust, the grantor is treated as the owner of those assets and responsible for the income taxes on the assets. With a non-grantor irrevocable trust, the trust becomes a wholly separate entity and is treated as the owner of the assets within it, and the trust is responsible for taxes on the income.
Types of Grantor Trusts
Many types of trusts exist, and a financial advisor or estate planning professional can help you understand which types might be fitting for your unique situation. Some common types of grantor trusts include:
Revocable living trusts: A living trust is one created during lifetime, and a revocable trust is one that can be changed over the course of the grantor’s lifetime. These types of trusts are traditionally grantor trusts, where grantors have full ownership and control of assets and are responsible for the taxes.
Qualified personal residence trusts: This is a specific type of trust meant to hold the ownership of a home. The reason to create such a trust is to remove the value of the home from the total estate value to help reduce estate tax burdens for heirs in the future.
Grantor retained annuity trusts: This type of trust creates an annuity payment situation, where income is drawn over a set period of time from the assets put into the trust. Once the annuity terms of the trust are met, the remaining assets go to the beneficiaries.
Intentionally defective grantor trusts: This is another type of trust that allows the grantor to pay income taxes on the irrevocable trust assets so that the trust assets can grow without the drag of both income and estate taxes. These assets are removed from the grantor’s estate and are able to grow outside of the grantor’s taxable estate (avoiding potential estate taxes). The grantor is treated as the owner of the assets for income tax purposes, but not for estate tax purposes.
Which Trust Is Right for You?
Choosing which trust is right for you can be a complex decision. You should consider your financial situation now and what you think it might be in the future. You should also factor in your wealth-building and management goals, as well as what type of legacy you want to leave behind for those you love. Finally, consider talking with a financial advisor or estate planning professional to understand which types of trusts are most likely to meet your needs and help you reach your goals.
Our Take
Setting up a trust can give you a powerful legal and financial tool with many benefits. However, choosing the wrong trust or structuring it the wrong way can leave you with financial regrets in future years. Take time to understand your options and work with experienced professionals to set up trusts that are right for you.