Trusts that Avoid State Income Tax

One of the advantages of using trusts in your estate plan is tax mitigation. While trusts are well-known to help reduce estate taxes, they are also becoming increasingly more common for income tax savings. 

Can you avoid state income tax with a trust? Yes you can. 

Make Use of ING trusts

Clients are using tax strategies for trusts in response to states raising income tax rates, like the Millionaires Tax in Massachusetts. They are turning to their advisors to learn how tax planning with incomplete gift non-grantor trusts (“ING” trusts) can be effective. ING trusts help those who want to save income taxes, but do not have the luxury of leaving their highly taxed state for a state with lower or even no income tax at all.

ING trusts are irrevocable trusts structured as non-grantor trusts for income tax purposes.  Internal Revenue Code sections 671-677 provides the powers that, if drafted into a trust document, will cause the trust’s income to be taxed to the grantor (creator) of the trust personally, thereby making it a grantor-type trust. However, if those powers are noticeably absent, then the trust will be treated as a separate taxpaying entity for tax reporting purposes. This means the trust will file its own tax return and pay its own taxes. The income will be removed from the taxing authorities of the grantor’s home state by administering this so-called non-grantor type trust in a state with no state income tax.

INGs can be set up as either complete or incomplete gift trusts depending on the desire for estate tax savings as well. But the potential for significant savings on state income taxes in each year of the trust is what has drawn interest from residents of high-income taxed states. One trade-off, however, of employing the ING trust strategy is that non-grantor trusts are subject to federal income tax at the highest rate of 37% in 2023, once the trust has earned around $14,000 of income.

Contrast that with a married individual filing jointly, who wouldn’t hit this bracket until earnings exceed $693,750. If a grantor of an ING trust is not already in the highest federal tax bracket personally, they will need to consider the tradeoff. A grantor trust will keep them at their lower federal tax rate, but still subject them to state income tax. The alternative is a non-grantor trust that will push them, or more specifically their trust, to the highest federal rate, but will eliminate the state tax altogether.

Real-World Case Study

Jack is married to Cindy and they have a brokerage account currently worth $20M and $1M of taxable income annually. This results in a $304,550 federal income tax and $90,000 state tax. Since they are already in the highest tax bracket federally, Jack and Cindy established an ING trust under the laws of New Hampshire*, a state with no state income tax. They funded the trust with the taxable investment account thereby removing it from taxation in their home state of Massachusetts. 

This non-grantor trust will pay the same amount of federal tax. But by being situated in New Hampshire, the strategy will save Jack and Cindy $90,000 in state income tax going forward.

*Ask about our ability to assist clients in NH where we are admitted to practice and act as a trustee

How do you know whether you are a candidate for ING Trust leverage to avoid state income tax? Read our article, Income Tax Planning for High-Income Tax States.