What’s one of the best ways to immediately improve the performance of your client’s trust portfolio? Locate it in a state that exempts the trust from state income tax.
Not all states are created equal when it comes to income taxes. Most states impose a tax on accumulated trust income ranging from 3% to more than 12%. But there are seven states that do not. They are:
- South Dakota
A trust governed under the law of a state that does not impose income tax can improve investment performance by more than 100 basis points a year simply by eliminating the drag from the state tax.
In most states, resident trusts are taxable on accumulated ordinary income and capital gains. The key to avoiding the tax is locating a trust in one of these no tax states. In some states this may be difficult, if not impossible. In others, it is as simple as naming a trustee in one of the states listed above.
The strategy applies to trusts that are irrevocable at a later date and existing irrevocable trusts that are being taxed by your client’s (the grantor’s) home state.
Advisors Can Retain The Relationship
An important question for families and advisors considering a state free of trust income tax is whether the family’s existing team of trusted advisors (attorneys, investment advisors, etc.) can continue to serve. The answer is yes. That's beneficial for all, particularly for the client, who wants to retain the continuity of the advisor team.
The way to keep a client’s advisor team in place when moving to a state that treats trust income favorably is through the bifurcated trust model.
Under a bifurcated trust, instead of one party making all the decisions, the parties agree to separate investment management and trust administration. The trustee performs all important functions necessary to carry out the terms of the governing trust agreement. The family investment advisor is given the power to manage the trust assets.
Advisors that have clients who have relocated, but are still paying trust income tax to their former home state should have their client consult with a CPA or attorney. It may be possible to minimize or avoid the taxes.
Choose A Trust Company That Gives You Flexibility
An effective approach to executing the no-income tax trust strategy is working with a trust company that can manage trusts in at least one of these states.
A national trust company has legal authority to administer the trust document in every state across the country, including the seven income-tax free states. If the trust company does not have a national charter or is not authorized to administer trusts in a no-tax state, it won’t be possible to benefit from the tax advantages.
It’s important to know before considering a move to a no-tax state whether the trust company has the legal authority to administer a trust in that state.
In addition to fees, taxes on trust accounts deliver a big hit to a beneficiaries trust income. Recommending a move to no-income tax state can be one of the most valuable pieces of advice an advisor can give a client.
Jim Combs is CEO of National Advisors Trust, is an independent, nationally chartered trust company owned by 137 RIA shareholders and has $9 billion in assets under administration.