Real Question from a Federal Employee
When it comes to estate planning, most federal employees focus on ensuring their loved ones are taken care of and their assets are distributed according to their wishes. However, many overlook a crucial detail that could cost their heirs a significant portion of their inheritance: how trusts are taxed.
If a trust is set up incorrectly, it could face tax rates as high as 40%, meaning nearly half of your estate could end up going to the IRS instead of your family. Let’s explore how this happens and what you can do to avoid it.
Why Trusts Are Taxed So Heavily
Trusts can be a powerful estate planning tool. They help control how and when your assets are distributed and can protect beneficiaries from mismanaging their inheritance. However, the IRS taxes trusts at some of the highest income tax rates, and those rates apply much sooner than most people realize.
For individual filers, the top federal tax rate (around 37–40%) applies once income exceeds roughly $600,000 to $700,000.
But for trusts, that same top rate kicks in at around $10,000 of income.
That means any ordinary income generated by the trust – such as distributions from your TSP, IRA, dividends, rental income, or capital gains – could be taxed at the maximum rate almost immediately. If your trust holds a tax-deferred asset like a TSP or IRA, this could create a massive and unexpected tax bill.
Estate Tax vs. Income Tax: Two Different Problems
When most estate planning attorneys draft trusts, they focus primarily on estate taxes, the so-called “death tax” that applies when you pass away. Estate taxes depend on the total value of your estate and, in some states, can be substantial.
However, what many plans overlook are income taxes – the taxes your trust will pay on income it generates after your death.
If your trust becomes irrevocable (which happens when you pass away) and it’s not structured correctly, any income it earns can be taxed at those high trust tax rates.
The Problem with Boilerplate Trusts
Many estate planning documents are created using boilerplate templates —documents that are one-size-fits-all and don’t account for the unique financial situations of federal employees. These trusts often lack “pass-through” provisions, which are critical for managing tax-deferred accounts like TSPs or IRAs.
Without these provisions, your entire TSP or IRA balance could be forced out of the tax-deferred account upon your death and taxed immediately at the trust rate, roughly 40% or more, plus possible state income taxes.
That’s why it’s so important to ensure your trust is drafted with income tax planning in mind, not just estate planning.
A Better Way: Passing Assets to Your Children
Instead of naming a trust as the direct beneficiary of your TSP or IRA, some federal employees choose to name their children as the beneficiaries. In that case, the children can generally withdraw the funds over 10 years and pay taxes at their own individual rates, which are typically lower than trust tax rates.
There’s also a hybrid solution: with the right trust language, you can structure your plan so your TSP or IRA passes through the trust to your beneficiaries, allowing them to use that 10-year withdrawal window, while still keeping the legal protections a trust provides.
This approach allows you to “have your cake and eat it too” – protecting your heirs while minimizing unnecessary taxes.
The Bottom Line: Coordination Is Key. To avoid this costly mistake, it’s essential to have a financial planner who understands federal benefits and works alongside your estate planning attorney. Together, they can review your trust documents to ensure your tax-deferred accounts, like your TSP, IRAs, or 401(k)s, are handled correctly.
Poorly structured trusts can turn a well-intentioned estate plan into a massive tax bill. Proper planning ensures your assets go where you want them to go — to your family, not the IRS.
If you’re a federal employee or retiree with questions about your estate plan, tax-deferred accounts, or how your TSP fits into your legacy, take time to review your plan with a qualified professional.
ABOUT THE AUTHOR
Micah Shilanski, CFP®, is a distinguished financial planner known for his deep commitment to providing exceptional advisory services to his clients. As the founder of Plan Your Federal Retirement, Micah has dedicated his career to helping federal employees understand and optimize their benefits to ensure a secure and prosperous retirement. His expertise is widely recognized in the industry, making him a sought-after speaker and educator on financial planning and retirement strategies.
Micah’s approach is client-centered, focusing on creating personalized strategies that address each individual’s unique needs. His work emphasizes the importance of comprehensive planning, incorporating aspects of tax strategy, investment management, and risk assessment to guide clients toward achieving their financial goals.Micah Shilanski 00:04
Do you know that trusts could be taxed up to 40% and if you set them up incorrectly in your estate planning, virtually half of your estate goes to the IRS? Well, if you didn’t, then stay tuned for this FERS Federal Fact Check. Hi, I’m Micah Shilanski, with Plan Your Federal Retirement. Today we have a really good question that comes in. I know I say everyone is really good. I look at a lot of questions, and I really appreciate you guys taking the time and submitting these. But it’s also one that kind of pulls on the heartstrings, and it’s talking about a widow. And so let’s hear from Amy. Amy says I’m a widow, and I own an inherited TSP from my husband. Currently, I’ve listed our living trust is a primary beneficiary for the TSP. From what I gathered recently, the trust is taxed at the highest rate, around 40% if this is true, would it be better designate my kids as primary beneficiaries instead of the trust? Does this 40% plus or minus tax rate apply to IRAs 401Ks as well, if the trust is the beneficiary. Thank you for your time. Amy, thank you so much for your questions and my condolences for your loss. So as we’re talking about this, the basic concept of what you’re saying is true, but like most of my answers, it depends right? A lot of things inside of here you are correct. A trust is taxed at one of the highest tax rates. Not only that. It gets there really, really fast. I don’t have the current brackets in my head, so go with me in concept. But for individual filers, whether it’s, you know, say, married filing joint you’re going to hit the top marginal income once you make, like, over 600 $700,000 in income, a trust hits the top marginal income, around 40% when you get like, $10,000 of income. So not only is it taxed at the higher rate, you hit it really, really quickly. So what’s subject to this tax? This is going to be depends. So I’m going to give you the surface level answer, and I’m going to give you the advanced planning answer. So make sure you’re staying tuned for that. The surface level answer is, any type of ordinary income generated by the trust is taxed at that so yes, IRA distributions are taxed at it, dividends and interest are going to be taxed at it. Potentially, capital gains, depending on how it’s set up, could be taxed at it. Rental income could be taxed at that rate. So all being taxed at a really high rate. Here’s the depends answer. Depends on how your trust is set up. The vast majority of estate planning attorneys, and I am sorry, I’m going to throw them all over the bus right here. The vast majority of them are only thinking about estate taxes when they create your estate plan. They are not thinking about income taxes, which a revocable trust, which, when you pass away, then becomes an irrevocable trust. Once that becomes an irrevocable trust, the taxes that trust has to pay are paid at an income tax level. So you got to be looking at both of those things, not only estate taxes, especially depending on what state you live in, estate taxes could be substantial. Those are death taxes. When you die, the government says, Great, how much money do you own? Give me half, right is it’s a big deal. The second part is an income tax anything that generates it in ordinary income, like an IRA or tsp distribution. So the challenge is the way most trusts are drafted, when I first read them from attorneys that don’t really understand income tax planning, they draft the trust that has no pass through provisions. It’s also why I say I’m not attorney right? Not legal advice. None of that stuff. You guys know this by now, but they draft without any pass through provisions. And what happens is, when you die, the trust cannot hold a tax deferred asset. It then pulls everything out, and now that entire TSP is taxed at the trust rate, which is 40 plus percent, right? Plus potentially state income taxes, etc, are going to be there. You have that 40 plus percent going to go to the IRS. If you left it to the kids, this isn’t the sole answer. If you left it to the kids, then they could take that money out over 10 years and be taxed at their tax bracket. There’s a hybrid option, if the language in the trust, and I can’t suggest any language, because I’m not an estate planning attorney, if there’s language in the trust that allows these pass through provisions, you can have a living trust. My wife and I have we have a living trust because we’re alive right now, when both my wife and I pass away, our IRAs go inside of this trust and it’s passed through to the kids, they still get that 10 year of stretch for that 10 year period in time, and it’s going to be taxed at their income tax rates, not at the trust rate. So you can have your cake and eat it too, but it must be drafted correctly. And this is where a really good financial planner is going to come in and work with your estate planning attorney and read this and work with them. And I got to say, the vast majority of these documents that I read from someone who doesn’t just do estate planning. They do estate planning and everything else. They’re using a boilerplate trust that does not meet these rules. So be very, very careful with this. Amy, want to make sure your assets from you and your husband, that you accumulate over time goes to the kids the way you want to, not half to aunt IRS. So this is really important as we go through this. If you have questions about your federal benefits as we’re working through these things, make sure you jump on our website. Plan-your- federal-retirement.com to get more information, to make sure you’re going on the right path. Untill next time, happy planning!