fbpx

Learn how to reduce your income and estate tax, fast.

Get our tips on big-picture strategy and actionable tactics for startup equity, small businesses, crypto, real estate, and more.

JOIN 1,000+ FOUNDERS, EMPLOYEES, AND INVESTORS WHO TRUST VALUR

Questions About Trusts & State Income Tax: Part 1

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? 

In this post we are addressing the first of these questions. (See this post for question two.)

Won’t I just have to pay state income tax when I get the money out of 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 is not subject to income tax

About Valur

We built a platform to give everyone access to the tax and wealth building tools of the ultra-rich like Mark Zuckerberg and Phil Knight. We make it simple and seamless for our customers to take advantage of these hard to access tax advantaged structures so you can build your wealth more efficiently at less than half the cost of competitors. From picking the best strategy to taking care of all the setup and ongoing overhead, we make it easy and have helped create more than $500m in wealth for our customers. Schedule a time to chat with our team and learn more about how we can help you!