Taxes on Trust Accounts

Question: A friend has trust funds for each of her children’s college education. Each trust is currently about $200k. The elder child is a high school sophomore and the trust is currently 70% equities. Should that number be reduced even though the capital-gains taxes may be quite high?

Answer: The taxation of income retained by trusts is rather vicious. Starting at only $12,400 in 2016, the trust moves into the highest tax bracket and is subject to the Obamacare surtax as well. This means an effective federal long-term capital-gains rate of 23.8% (and likely state taxes as well) on income not distributed to beneficiaries. Unfortunately, capital gains are generally not distributable to the beneficiary (where it is typically taxed at 15% or less).

I would first suggest that your friend find out if the provisions of the trust permit special distributions of long-term capital gains to the beneficiaries. Assuming they do not, a reasonable goal is to immediately take advantage of the lower brackets by bringing the capital gains to $12,400 this year, and to the inflation-adjusted limit in each of the next few years, which both reduces the exposure to equities and reduces taxation to a more reasonable 15% federal level. It may be possible to justify larger special distributions to the beneficiaries beginning in the first year of college, as long as funds are spent in the same calendar year as the distributions for purposes stated in the trust agreement, but that is for the attorney who created the trust to advise.

As for the larger question, the money invested for a high school sophomore, if the goal is to finance a bachelor’s degree in college, will be spent over the period beginning with the date the student enters college and ending with graduation. The midpoint of that spending period is (hopefully) the end of the second year of college, which is presumably between 4 and 5 years from the current date. This is the average time frame for the investments, which would certainly suggest a gradual move toward investments that preserve rather than grow assets. Shifting that $12,400 each year (adjusted for inflation) in the direction of cash equivalents makes some sense.

I have to punt on the precise percentage that belongs in equities. It depends on the rest of your friend’s family portfolio, on the willingness to use alternative sources in the event of an extreme event, on emotions during bear markets (a major problem for do-it-yourself investors), and on how diversified the equity portion is. (If it is all in one stock I’d be inclined to damn the tax torpedoes and go full speed ahead on risk reduction.)

A 529 plan would have been a far better tool for college savings than a trust, since it would have allowed changes on a tax-free basis, as well as ultimately producing tax-free income so long as the money was spent on qualified college expenses. If the trust doesn’t have to be emptied for college, of course, it might be possible to terminate it and distribute the assets in-kind to the beneficiaries, allowing them to pay the taxes at their own, presumably lower, rates after selling them personally. But there is a lot more to trusts than tax law, and the feelings of the trustee about the ability of beneficiaries to responsibly handle assets once they have control cannot be overlooked, especially with beneficiaries who are still teenagers.