- The 3.8% net investment income tax applies to certain trusts and estates.
- Given the lower income thresholds for reaching higher tax brackets in a trust, it is possible that income or capital gains retained by the trust will be taxed at higher rates than if the income or gains were distributed to beneficiaries.
- The Columbia Management Learning Center is dedicating a series of blog articles to this important and timely “Navigating the New Tax Regime” topic.
The 3.8% net investment income tax (NIIT) does not just apply to the individual investor. It also applies to certain trusts, and as with individuals, the 3.8% surtax is in addition to ordinary income and/or capital gains taxes owed by the trust.
Determining if and when the NIIT may apply in the case of a trust is complex. This article is not meant to be a comprehensive discourse, but rather a high-level overview of where the tax may apply to a trust. Financial advisors and investors should consult qualified tax and legal professionals for their specific circumstances.
In general, a trust can be taxed in a like manner to individuals. Most tax principles that apply to individuals also apply to trusts and estates as a separate entity. Trusts can earn taxable and tax-exempt income, (for instance tax-exempt income from municipal securities would not be subject to taxation in a trust), and they are eligible to deduct certain expenses. They are also allowed a small exemption amount. The amount depends on the type of trust, but they are not eligible for a standard deduction.
One key difference between trust and individual taxation is the “compression” of income tax brackets applied to a trust compared to an individual. In other words, trust income tax brackets of 15%, 25%, 28%, 33% and 39.6% are reached at a far lower income amount than individual income tax brackets. The same compression is true for reaching the highest general long-term capital gains rate of 20%.
In general, trust income (in the form of interest, dividends, ordinary income and capital gains) retained by the trust is taxable to the trust. Distributed income, to the extent it is not a return of trust principal, is taxable to the beneficiary who receives the distribution. The exceptions are:
- A charitable remainder trust due to the charity’s tax-exempt status — in this case, the retained income is not taxed, but the beneficial distributions are generally taxable to the beneficiary
- A grantor who has retained an interest in the trust (e.g., the right to revoke the trust or to control beneficial distributions) either directly or through a “power holder” — in this case, trust income is taxable to the grantor or the power holder
For estates and applicable trusts, the NIIT is applied to the lesser of:
- Undistributed net investment income (the trust’s net investment income which is not distributed to the beneficiary)
- The excess of adjusted gross income over the amount at which the highest income bracket begins (which for 2015 is $12,300)
- The Campbell Family Trust is an irrevocable non-grantor trust that has net investment income of $51,000 for 2013.
- The trustee has made no distributions to the beneficiaries for the tax year.
- Assume that the trust’s AGI is also $51,000 for 2013.
- Consequently, $38,700 of income will be subject to the 3.8% NIIT. This is the lessor of undistributed net investment income ($51,000) or AGI over $12,300 ($51,000 – $12,300 = $38,700).
Given the lower income thresholds for reaching higher tax brackets in a trust, it is possible that income or capital gains retained by the trust will be taxed at higher rates than if the income or gains were distributed to beneficiaries. For example, a trust will reach the highest general long-term capital gains rate of 20% if the undistributed taxable income exceeds $12,300, while if the beneficiary is a single tax filer, she would not reach that long-term capital gains rate until she exceeded $413,200 in taxable income in 2015.
2015 estate and trust income tax brackets
For this purpose we are discussing trusts that are separate taxpayers. The income on some trusts, like revocable or living trusts, is taxed to the individual who set up the trust, so the NIIT would apply to the person and not the trust. Trusts, funds or accounts that are exempt from the NIIT, include charities and retirement plans charitable remainder trusts, Archer medical savings accounts, health savings accounts (HSAs), qualified tuition programs, and Coverdell education savings accounts.
Next in this series:
- Asset allocation and asset location: How both contribute to after-tax return
- Asset location: Its role in after-tax return and retirement planning
What you may have missed:
- Strategies for business owners to reduce net investment income tax
- Retirement plan design for the new tax regime
- Maximizing workplace retirement plans to reduce or eliminate the net investment income tax, including our “Power of the workplace” podcast
- What is the net investment income tax?
- The three tax thresholds of the new tax regime, including our “Navigating the new tax regime” podcast
This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Management does not provide tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.