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Questions About Trusts & State Income Tax

A trust can’t help someone avoid paying federal income tax. However, shifting assets into a trust in a tax free state is a way that many people minimize their state income taxes. Trusts in tax free states are often used by people that live in states with high state income taxes and have: (a) a large asset income portfolio; and/or, (b) an asset they expect will have a significant appreciation event.

Many people hear about using trusts in tax free states to minimize their tax burden and immediately have two questions: (1) won’t I just have to pay state income tax when I get the money out of the trust; and, (2) how is it legal to avoid state income taxes by moving my assets into a trust in a state with no income tax when I am still living in a high income tax state? 

Will You Have to Pay State Income Tax When Getting the Money Off the Trust?

AKA Is this just tax deferral

The answer to this question depends on whether the distribution is from the trust’s principal or from appreciation/interest. Distributions from a trust’s principal balance are generally not subject to income tax because it’s assumed that principal was already taxed. 

In some states (California, for example), there is something called a “throwback rule” that allows the state to tax the appreciation/interest when they are distributed from the trust to the beneficiary. Even for residents of states with a throwback rule, having appreciating assets in a trust in a tax free state can still be advantageous. First, it allows for the deferral of state taxes. This deferral provides an opportunity to reinvest in the principal and/or take distributions over a number of years to strategically lower effective tax rates. Second, if the beneficiary moves to a state without a throwback rule before taking the distribution they can avoid the state income tax entirely.

In states without a throwback rule (New York and New Jersey, for example), the gain from appreciation/interest (outside of dividends) on the assets in the trust shift to principal after the trust pays its taxes. Once the gain has converted from interest to principal it can be distributed to the beneficiary as a distribution of principal, which again – according to Investopedia – is not subject to income tax. 

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