Grantor vs Non-Grantor Trust: Which One Is Better for You?

When setting up a trust, you'll face an important decision: should you create a grantor trust or a non-grantor trust? If you're not sure what the difference is between a grantor vs non-grantor trust, here's everything you need to know.

A grantor trust treats you as the owner for tax purposes - you pay taxes on trust income using your personal tax return. A non-grantor trust operates as a separate taxpayer, filing its own return and paying its own taxes.

Some people benefit from the simplicity and tax advantages of grantor trusts. Others need the tax separation that comes with non-grantor trusts. Here's how to choose the right option for your situation.

What Is a Grantor Trust?

A grantor trust gives you significant control over trust assets while treating you as the owner for income tax purposes. You can change beneficiaries, or even cancel the trust entirely if your circumstances change. This is why many people use this type of trust for their estate planning.

The IRS considers the trust's income part of your personal income - you report all trust earnings on your individual tax return and pay taxes at your personal tax rates.

You'll also have to file Form 1041 if your trust earns $600 or more in income or if it has a non-resident alien as a beneficiary.

Grantor trusts come in many forms. Revocable living trusts automatically qualify as grantor trusts. Many irrevocable trusts also receive grantor trust treatment if you keep certain powers, like the right to substitute trust assets or add beneficiaries.

So, both revocable and irrevocable trusts can potentially be grantor trusts.

Related Article | What Is a Grantor Retained Annuity Trust?

Does a Grantor Trust Have to File a Tax Return?

A grantor trust must file an informational tax return showing its income and expenses. However, instead of calculating taxes, the return simply notes that you'll report all income on your personal tax return.

The trust provides you with a statement showing what income to include on your individual income tax return.

Do Beneficiaries Pay Taxes on Grantor Trust Distributions?

Typically, no. While the trust exists as a grantor trust, beneficiaries don't pay taxes on distributions.

Since you pay all the taxes on trust income, beneficiaries receive their distributions tax-free. This can be a significant estate tax advantage if you want to maximize the value of gifts to your family members.

Why Would You Want a Grantor Trust?

Grantor trusts come with two main advantages.

First, paying the trust's taxes essentially allows you to give extra money to your beneficiaries tax-free. Your tax payments reduce your taxable estate without counting as gifts.

Second, grantor trust status lets you sell assets to the trust without triggering capital gains tax, which makes them a valuable tool for estate tax planning.

What Are the Cons of Grantor Trust?

The main disadvantage is your obligation to pay taxes on trust income that you don't personally receive. This can become problematic if the trust generates a lot of income.

Moreover, grantor trust status might prevent you from qualifying for certain income-based programs or benefits since all trust income appears on your tax return.

Related Article | Intentionally Defective Grantor Trust

How Do You Tell If a Trust Is a Grantor Trust?

A trust typically qualifies as a grantor trust if the grantor retains certain powers over it. These powers include the right to:

Change beneficiaries
Borrow from the trust without adequate security
Substitute trust assets with assets of equal value
Use trust income to pay life insurance premiums on your life
Revoke the trust entirely

All revocable trusts automatically count as grantor trusts. Irrevocable trusts must specifically include one or more of these powers to qualify.

What Is a Non-Grantor Trust?

A non-grantor trust operates as a separate taxpayer from you.

When you create this type of trust, you give up specific control and benefits that would make it a grantor trust, such as the power to change beneficiaries, the right to borrow from the trust, the ability to substitute assets, or the power to use trust income for your benefit.

You also can't serve as the trustee or maintain any significant control over trust assets.

As a result, a non-grantor trust will be paying income tax independently from you and receive its own tax identification number from the IRS. For example, if the trust earns $50,000 in rental income from a property, that income appears on the trust's tax return, not yours.

Who Pays Taxes on a Non-Grantor Trust?

Either the trust or its beneficiaries pay taxes on non-grantor trust income.

Generally speaking, the trust pays taxes on any income it retains. When the trust distributes income to beneficiaries, they pay taxes on their distributions. The trust can deduct these distributions, effectively passing the tax obligation to the beneficiaries who often have lower income tax liability than the trust.

What Is an Example of a Non-Grantor Trust?

A common example is a trust that you create for your adult children where an independent trustee manages the assets.

For example, let's assume that the trust holds an investment portfolio that generates $100,000 in yearly income. If the trustee distributes $60,000 to beneficiaries (your adult children), they pay taxes on that amount. The trust's income taxes will cover the remaining $40,000.

Why Would You Want a Non-Grantor Trust?

Non-grantor trusts help reduce overall family taxes by splitting income among multiple taxpayers. They work particularly well when your beneficiaries fall in lower tax brackets than you. These trusts also keep trust income off your personal tax return.

What Are the Cons of a Grantor Trust?

The main drawbacks are higher trust tax rates and loss of control.

Trusts reach the highest tax bracket (37% in 2024) at just $15,200 of retained income. There's also typically a 3.8% net investment income tax charged by the IRS.

You also must give up significant control over the trust to achieve non-grantor status. This means you can't serve as the trustee, change trust beneficiaries, direct trust investments, approve distributions, use trust property personally, or borrow from the trust. You'll have to appoint an independent trustee to make these decisions without your input.

Can a Spouse Be a Beneficiary of a Non-Grantor Trust?

Yes, your spouse can be a beneficiary, but there are certain rules that you should be aware of. Typically, your spouse can't be the only beneficiary, and you can't maintain control over distributions to your spouse. Basically, any spouse-related powers must be limited to avoid grantor trust status.

Related Article | Spousal Lifetime Access Trust

What Is the Difference Between a Grantor and a Non-Grantor Trust?

When it comes to grantor and non-grantor trusts, there are three main differences: tax implications, control, and administration.

Tax Consequences: A grantor trust's income appears on your personal tax return and you pay all taxes at your individual rates. A non-grantor trust files its own return and pays its own taxes, with income either taxed to the trust or passed through to beneficiaries.
Control: With a grantor trust, you can maintain significant powers like changing beneficiaries, substituting assets, or even closing down the trust. With a non-grantor trust, you have to give up these powers. An independent trustee will be making all of the decisions about investments and distributions.
Administration: Grantor trusts typically have easier administration because all tax reporting flows through your personal return. Non-grantor trusts need separate tax ID numbers, their own tax returns, and more complex accounting to track income and distributions.

Your choice between these trusts depends on your goals.

Grantor trusts keep the taxable income on your return but allow you to reduce your grantor's taxable estate by paying the trust's taxes.

Non-grantor trusts offer tax benefits by splitting income among multiple taxpayers but require you to give up control to achieve these advantages.

Related Article | At What Net Worth Do I Need a Trust?

Non-Grantor Trust vs Irrevocable Trust

Non-grantor trust and irrevocable trust are two different aspects of trust creation. An irrevocable trust simply means you can't change or cancel the trust after creating it. A non-grantor trust refers to how the trust pays taxes.

Most non-grantor trusts are irrevocable, but not all irrevocable trusts are non-grantor trusts. For example, an irrevocable life insurance trust can be structured as either a grantor or non-grantor trust, depending on what powers you retain.

Grantor Trust vs Non-Grantor Trust: Which One Is Right for You?

Ultimately, the answer to this question depends on your financial situation and goals. It's important to work with a qualified advisor to figure out the best course of action for you.

But generally speaking, choose a grantor trust if:

You can afford to pay taxes on trust income and want to reduce your estate. Paying $50,000 in annual trust taxes essentially gives your beneficiaries an extra $50,000 gift tax-free.
You want maximum flexibility to change trust terms or beneficiaries. This works well for young families whose needs might change as children grow.
You want to sell appreciated assets without triggering capital gains tax. For example, selling $2 million of stock with $1.5 million in gains to your grantor trust generates no immediate tax.

On the other hand, choose a non-grantor trust if:

Your beneficiaries are in lower tax brackets than you. A trust earning $100,000 yearly can distribute this income to beneficiaries in the 24% bracket instead of paying your 37% rate.
You need to qualify for income-based programs or benefits. Moving a $500,000 investment portfolio to a non-grantor trust keeps its income off your tax return.

Overall, non-grantor trusts require more independence from you but potentially come with better tax-planning opportunities. An experienced attorney or advisor can help you decide which option is the best for you.

FAQs

Is an Irrevocable Trust a Grantor or Non-Grantor Trust?

An irrevocable trust can be either a grantor or non-grantor trust. The irrevocable status only means you can't change or cancel the trust. The grantor/non-grantor status depends on what powers you keep. For example, if you retain the right to substitute assets or add beneficiaries, your irrevocable trust becomes a grantor trust despite being irrevocable.

Is a Revocable Trust a Grantor or Non-Grantor Trust?

All revocable trusts are grantor trusts. Since you can change or cancel a revocable trust anytime, the IRS always treats you as the owner for tax purposes. Revocable trusts can't qualify as non-grantor trusts because you maintain too much control over trust assets.

Does a Grantor Trust Become a Non-Grantor Trust When the Grantor Dies?

Yes. After your death, the trust automatically becomes a non-grantor trust because you can no longer be the owner for tax purposes. The trust then starts filing its own tax returns and paying its own taxes. Your death may also trigger other changes in trust administration depending on the trust's terms.

What Type of Trust Avoids All Taxes?

No trust completely avoids all taxes. Different trusts can reduce specific types of taxes. For example, charitable trusts reduce income taxes through deductions. Irrevocable life insurance trusts avoid estate taxes on death benefits. Grantor trusts help avoid capital gains taxes on asset sales. A qualified advisor can help you match the right trust structure to your specific tax concern.

What Is the Best Trust for Tax Purposes?

It depends on which taxes you want to minimize. For example, you can use non-grantor trusts to shift income to beneficiaries in lower tax brackets. With grantor trusts, the trust's income will flow to your personal income tax return.

The Bottom Line

It can be difficult to choose between a grantor vs non-grantor trust because both types of trusts offer certain benefits.

Grantor trusts are simple and flexible, but they keep income taxes on your personal return. Non-grantor trusts require you to give up control, but there are opportunities for potential tax savings. Ultimately, it's essential to work with a qualified advisor or attorney to set up the best trust for your purposes.