Trusts, both revocable and irrevocable, can be a great planning tool for all sorts of circumstances, particularly now with the ability to create very flexible trusts. One type of irrevocable trust is called a grantor trust – sometimes referred to as an intentionally defective grantor trust (IDGT) – and it offers potential tax-savings opportunities under the right circumstances.
Irrevocable Trusts are typically used for making gifts and are generally structured one of two ways for income tax purposes: (1) as a trust whose grantor (creator) pays the taxes on behalf of the trust while he or she is alive (a grantor trust); or (2) as a trust that pays its own taxes (a non-grantor trust).
In the case of an irrevocable grantor trust, because the grantor pays the taxes on behalf of the trust, the trust’s principal is not drawn down by tax payments, including those for both taxable income and capital gains. Absorbing the tax liability for the trust is often viewed as a tax-free gift by the grantor that does not count against the grantor’s annual or lifetime gift tax exclusion. For example, Julia sets up a grantor trust and contributes $1 million to the trust. The trust has $50,000 in taxable income. The $50,000 of taxable income is taxed on Julia’s personal income tax return. Julia pays the tax owed on the $50,000 of income from her own funds, not diminishing the trust’s assets. When Julia pays the tax owed on the $50,000 of income, she is effectively making an additional gift to the trust.
As noted in the previous paragraph, covering the trust’s tax bills is commonly considered by estate planners as a tax-free gift, though individual circumstances may vary. When the grantor pays the trust’s tax bills, doing so will also reduce Julia’s estate for estate tax purposes, thus reducing estate taxes at her passing if any are due.
In the case of an irrevocable non-grantor trust, the trust pays its own taxes using trust tax rates. The effective trust tax rate on income and capital gains is typically higher because the trust does not have to generate much income or capital gains in order to reach the top tax bracket. For example, that $50,000 of taxable income generated by Julia’s irrevocable trust reaches the highest tax bracket at only $15,650 (in 2025), whereas an individual doesn’t reach that 37% bracket until they have over $626,350 of taxable income. There is therefore greater tax efficiency when the grantor pays taxes on behalf of the trust because the tax bill on the same amount of trust income will be lower if listed on a personal return. However, if at any point it is no longer desirable for the grantor to pay the taxes on behalf of the trust, the grantor has a one-time power to “turn off” the grantor trust status, resulting in the trust paying its own taxes going forward. This power is permanent and irrevocable, so once the grantor has exercised it, the trust cannot go back to being a grantor trust.
In summary, grantor trusts offer several benefits:
- They hold assets that avoid withdrawals for tax bills because the grantor pays those bills, typically at lower effective tax rates.
- With no tax bills to pay, grantor trusts retain more assets for long-term growth.
- Since they are irrevocable and exist outside of the grantor’s estate, they enable the grantor to reduce the size of their estate by covering the trust’s taxes.
- Finally, as irrevocable trusts, they provide creditor protection to both the grantor and the beneficiaries.
As trust planning continues to evolve, the flexibility and tax efficiency of structures like grantor trusts offer meaningful opportunities for individuals and families. For those exploring how trusts might support their long-term goals, learning more about the options available—and how they might align with personal circumstances—can be a valuable next step.
Grantor trusts may not be suitable for all investors and they involve legal and tax complexities that should be evaluated with professional guidance.
