Before we look at the question that serves as the title of this post, we should explain some things about living trusts. First, you should understand the fact that you do not lose direct personal control of assets that you convey into a living trust.
A living trust is revocable, so you can dissolve the trust at any time, and you would be the trustee while you are alive and well. Technically, the trust would be the owner of property that you transfer to it, but you would hold the reins of the trust.
For example, if you were to make the trust the owner of your checking account, you could use it as usual. You could also put your home into a trust, and you would retain the same rights and responsibilities of home ownership.
Streamlined Estate Administration
If you use a will to record your final wishes, it would be admitted to probate and the court would supervise during the administration process.
Probate is time-consuming, and no inheritances are distributed while the estate is being probated. Expenses accumulate, and people with prying eyes can obtain probate records.
In addition to the procedural side of the equation, the executor of the estate has to identify assets that are not consolidated in one place.
The situation is very different when a living trust is used. As we have stated, you would act as the trustee while you are living, and you would name a successor trustee to succeed you when the time comes.
After your passing, the trustee would distribute assets to the beneficiaries in accordance with your wishes, and the probate court would not be involved.
Spendthrift Protections
You do not have to leave direct, lump sum inheritances when you establish a living trust, and you can include a layer of asset protection.
After your death, the trust would become irrevocable, and the beneficiary would not have access to the principal. They would receive distributions in accordance with the instructions that you recorded in the trust declaration.
The beneficiary’s creditors would step into the shoes of the beneficiary. They would not be able to go after the principal if the beneficiary runs into financial trouble. However, assets that have been distributed to the beneficiary would be fair game.
With the above in mind, you can direct the trustee to distribute a certain amount each month, so the beneficiary is never in possession with large sums of money for very long. You could allow for distributions of portions of the principal when the beneficiary reaches certain age plateaus.
This is a demonstration of one way to proceed, but the choice is yours, and that freedom is one of the major benefits that these trusts provide.
Taxes on Distributions
Now we can close it out with the answer to the tax question. The IRS works with the assumption that assets in your living trust were still in your possession after you paid taxes all of your life. An additional tax on a beneficiary would not be fair, because it would be an instance of double taxation.
For this reason, distributions of the principal are not taxable, but the beneficiary would have to report interest income that they receive. The trust itself would have to pay taxes on undistributed interest income.
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