If you’re a financial advisor, you probably understand the importance of trusts in estate planning. They provide control, protection, and flexibility when it comes to transferring wealth. But there’s a part of the story that doesn’t get enough attention—how trusts are taxed.
And the truth might surprise you.
In 2024, an irrevocable trust reaches the top federal income tax bracket of 37% at just $15,201 in taxable income. Compare that to a married couple filing jointly, who don’t hit that same rate until they earn over $731,200.
That’s a massive difference—and it’s a trap many well-meaning families fall into without realizing it.
Why Are Trusts Taxed So Aggressively?
The IRS treats a non-grantor trust (one that is its own taxpayer) as a separate entity for income tax purposes. Unless the trust distributes its income to beneficiaries, it pays income tax itself—and does so on a highly compressed bracket schedule.
Here are the 2024 federal income tax brackets for trusts:
- 10% on income up to $3,100
- 24% on income between $3,101 and $11,150
- 35% on income between $11,151 and $15,200
- 37% on income over $15,200
That means just a modest amount of retained income can push a trust into the highest tax bracket.
If the trust holds dividend-producing assets, interest-bearing accounts, or rental real estate, it may easily exceed that threshold. The result? The trust ends up paying more in taxes than necessary—money that could have gone to beneficiaries.
The Role of DNI: A Key Planning Tool
Here’s where smart planning can make a big difference. The concept of Distributable Net Income (DNI) allows a trust to pass income through to the beneficiaries, along with the tax burden. That’s often a good thing—because the beneficiary is usually in a much lower bracket.
The trust gets a deduction for distributed income, and the beneficiary reports that income on their personal tax return. But the amount that can be passed through is limited to the trust’s DNI, which requires careful calculation and proper drafting of the trust agreement.
If a trust is set up as an accumulation trust and doesn’t require distributions, or if the trustee isn’t actively managing distributions with tax planning in mind, the result is often unnecessary tax drag.
What Financial Advisors Should Watch For
This isn’t just a legal issue—it’s a wealth management issue. Financial advisors should be aware of the tax treatment of trusts and how it impacts the overall plan.
Here are a few practical questions to ask:
- Is the trust required to distribute income annually?
- Does the trustee understand the importance of DNI and tax brackets?
- Can income-producing assets be repositioned outside the trust?
- Would a distribution this year reduce overall tax liability?
- Is the trust structured in a way that allows for strategic flexibility?
These conversations often reveal opportunities to reduce tax liability, align investments with the client’s estate plan, or revise an outdated trust.
Not All Trusts Are Created Equal
Some trusts were drafted years ago, when tax rules were different. Others were never intended to hold income-producing assets, but over time, they’ve accumulated significant investment portfolios.
In some cases, it may make sense to revisit the trust structure entirely—through decanting, trust modification, or even creating new entities to better serve the family’s goals.
Bottom Line
Trusts are an essential part of many estate plans. But if no one is watching the income tax treatment, they can quietly become one of the most inefficient vehicles in a client’s portfolio.
Financial advisors who understand how to navigate these tax rules—and collaborate with estate planning attorneys when needed—can add tremendous value for their clients.
If you or your clients have questions about how a trust is being taxed, let’s talk. A simple review might uncover opportunities to reduce taxes and better align the plan with the family’s goals.
This article is not legal advice. To apply these concepts to your or your client’s specific situation, consult an experienced estate planning attorney.
