Beyond Capital Gains: How Deferred Sales Trusts Address Other Tax Challenges for Retirees

Most investors familiar with Deferred Sales Trusts (DSTs) recognize their power for deferring capital gains tax when selling appreciated assets. However, sophisticated retirement planners understand that DSTs offer solutions to numerous other tax challenges that retirees commonly face. From reducing Net Investment Income Tax exposure to mitigating Required Minimum Distribution impacts, these additional tax advantages can significantly enhance retirement income efficiency.

Deferred Sales Trusts offer retirees tax planning advantages that extend far beyond basic capital gains deferral

The Multi-Dimensional Tax Landscape Facing Retirees

Before exploring specific DST tax advantages, it’s important to understand the complex tax challenges retirees typically encounter:

• Bracket management complexity: Navigating multiple tax brackets across different income types
• Income threshold triggers: Managing income to avoid crossing thresholds that activate additional taxes
• Tax diversity limitations: Over-concentration in specific tax treatment categories
• Timing control constraints: Limited ability to control precisely when income is recognized
• Forced income recognition: Required distributions that may push retirees into higher brackets

Real-world impact: A typical successful retiree might face not just standard income tax rates, but also:

• 3.8% Net Investment Income Tax
• Social Security benefit taxation (up to 85%)
• Medicare premium surcharges (IRMAA)
• State income taxes on retirement distributions
• Alternative Minimum Tax considerations

DST Advantage #1: Net Investment Income Tax Mitigation

The 3.8% Net Investment Income Tax (NIIT) applies to investment income for taxpayers exceeding certain income thresholds ($200,000 for single filers, $250,000 for married filing jointly). This additional tax can significantly impact retirement income efficiency.

How DSTs Address NIIT Challenges

A properly structured DST can help mitigate NIIT exposure through:

1. Income characterization: DST payments consist partially of return of basis (not subject to NIIT)
2. Income timing control: Structuring payments to manage total income relative to NIIT thresholds
3. Income smoothing: Avoiding large single-year income events that trigger NIIT

Practical example: Martha sold an investment property for $1.8 million with a $600,000 basis. Without a DST, her $1.2 million capital gain would have immediately triggered approximately $45,600 in NIIT (3.8% of $1.2 million). By using a DST, she structured payments to keep her annual income below the NIIT threshold, potentially eliminating this tax burden entirely.

Comparative tax calculation:

Potential lifetime savings: $45,600 in NIIT plus time value of deferred taxation

DST Advantage #2: Alternative Minimum Tax Planning

The Alternative Minimum Tax (AMT) was designed to ensure high-income taxpayers pay at least a minimum level of tax. While fewer taxpayers face AMT after recent tax law changes, it remains a concern for many retirees with substantial deductions or specific income types.

How DSTs Help Address AMT Exposure

DSTs provide strategies for AMT management through:

1. Income timing flexibility: Controlling when income is recognized to avoid AMT trigger points
2. Tax preference item management: Reducing certain income categories that receive unfavorable AMT treatment
3. Multi-year planning opportunities: Creating predictable income patterns that facilitate long-term AMT avoidance

Real-world application: Robert anticipated an AMT issue in the year he exercised significant incentive stock options (ISOs). By establishing a DST for other appreciated assets he needed to sell, he structured first-year payments to minimize additional income, helping avoid approximately $32,000 in potential AMT liability.

Tax planning insight: “Using a DST allowed me to precisely calibrate my recognized income during a year when AMT exposure was a significant concern,” Robert explains. “My tax advisor modeled exactly how much DST income I could receive while staying under key AMT thresholds.”

DST Advantage #3: IRMAA Threshold Management

Many retirees are surprised to discover that Medicare premiums aren’t fixed—they increase based on income through Income-Related Monthly Adjustment Amounts (IRMAA). These surcharges can add thousands of dollars annually to healthcare costs when income crosses specific thresholds.

How DSTs Help Control IRMAA Surcharges

A properly structured DST can assist with IRMAA management through:

1. Payment timing control: Structuring distributions to manage Modified Adjusted Gross Income (MAGI)
2. Threshold bracket management: Calibrating income to remain just below IRMAA threshold points
3. Multi-year income leveling: Avoiding income spikes that trigger temporary premium increases

2024 IRMAA Thresholds and Premium Impacts (Married Filing Jointly):

Practical application: James and Patricia had a MAGI of $190,000 from pensions and investments. Selling their rental property portfolio would have generated $900,000 in capital gains, pushing them into much higher IRMAA brackets for years. Their DST was structured to provide $75,000 annually, keeping their total MAGI just below $258,000, saving approximately $2,834 annually in Medicare premiums.

Lifetime IRMAA savings calculation: Over 20 years of retirement, strategically managing IRMAA thresholds through DST payment structuring could save this couple over $56,680 in Medicare premiums alone (not counting the tax deferral benefits).

DST Advantage #4: Social Security Benefit Taxation Reduction

Many retirees don’t realize that Social Security benefits become taxable when “provisional income” (adjusted gross income + tax-exempt interest + 50% of Social Security benefits) exceeds certain thresholds. Up to 85% of benefits can become taxable, creating a significant tax burden.

How DSTs Help Minimize Social Security Taxation

A properly structured DST can help manage Social Security benefit taxation through:

1. Income type diversification: Balancing taxable, tax-deferred, and tax-free income sources
2. Provisional income management: Structuring payments to control the calculation that determines benefit taxation
3. Strategic basis recovery: Front-loading return of basis components that don’t impact provisional income

Social Security Taxation Thresholds (2024):

Real-life implementation: Margaret, a widow receiving $32,000 annually in Social Security benefits, needed additional income from the sale of highly appreciated stock. Rather than triggering immediate capital gains that would push her well above the thresholds, her DST was structured to provide $28,000 annually, keeping a portion of her Social Security benefits non-taxable.

Tax advisor insight: “We strategically designed Margaret’s DST payment schedule to optimize her Social Security tax situation. This approach saves her approximately $3,400 annually compared to taking the capital gain upfront,” explains her financial advisor.

DST Advantage #5: State Income Tax Diversification

State income tax treatment varies dramatically across the United States, with rates ranging from 0% to over 13%. This creates both challenges and opportunities for retirement tax planning.

How DSTs Create State Tax Planning Opportunities

DSTs provide unique state tax planning advantages through:

1. Relocation flexibility: Establishing a DST before selling assets, then potentially moving to a lower-tax state
2. Income timing around residency: Controlling when income is recognized relative to state residency
3. Multi-state planning: Potential to structure more complex arrangements that optimize across state lines

Strategic opportunity: Richard and Elizabeth owned multiple investment properties in California (13.3% top state income tax rate) but planned to retire to Nevada (0% state income tax). By establishing a DST before selling their properties, they deferred recognition of gains until after establishing Nevada residency, potentially saving hundreds of thousands in California state taxes.

Comparative state tax example:

• $2 million capital gain recognized while California resident: $266,000 state tax
• Same gain recognized through DST after establishing Nevada residency: $0 state tax

Planning note: State taxation of trusts and installment sales varies significantly, making professional guidance essential when implementing cross-state strategies.

DST Advantage #6: Required Minimum Distribution Coordination

Required Minimum Distributions (RMDs) from retirement accounts begin at age 73 (as of 2023 legislation) and can create significant tax challenges by forcing income recognition regardless of need.

How DSTs Complement RMD Planning

A properly structured DST can work alongside RMD obligations through:

1. Counter-cyclical payment design: Reducing DST payments during years with larger RMDs
2. Strategic Roth conversion windows: Using early retirement years for Roth conversions before DST payments increase
3. Income source diversification: Creating non-RMD income sources that provide greater timing control

Implementation example: Thomas established his DST at age 68, structuring minimal payments until age 73, when his RMDs would begin. This created a five-year window with lower income, which he used to complete $150,000 annually in Roth conversions at a 24% tax bracket rather than the 32% bracket he would face later. Once RMDs began, his DST payments increased to supplement his income needs.

Strategic benefit calculation:

• Tax savings from Roth conversions at lower brackets: Approximately $60,000
• Future tax-free Roth growth during retirement: Potentially $100,000+
• More balanced tax burden throughout retirement years

DST Advantage #7: Qualified Business Income Deduction Preservation

The Tax Cuts and Jobs Act introduced the Qualified Business Income (QBI) deduction, allowing many business owners to deduct up to 20% of qualified business income. However, this valuable deduction phases out at higher income levels and has specific limitations.

How DSTs Help Maximize QBI Deductions

For business owners in retirement transition, DSTs can help preserve QBI deductions through:

1. Income threshold management: Keeping total income below QBI phase-out thresholds
2. Business sale timing control: Coordinating business interest sales with QBI considerations
3. Income type diversification: Balancing different income categories to optimize deduction availability

2024 QBI Deduction Phase-out Thresholds:

• Single filers: $182,100 – $232,100
• Married filing jointly: $364,200 – $464,200

Real application: Michael partially sold his business interest while retaining a 30% ownership that generated approximately $120,000 in annual QBI. By using a DST for other appreciated assets, he structured payments to keep his total income below the QBI phase-out threshold, preserving his full 20% deduction (worth approximately $24,000 annually).

Financial impact statement: “By managing my DST payments carefully, I’ve been able to preserve my full QBI deduction for the past three years, adding over $70,000 to my after-tax retirement income during this period,” Michael explains.

DST Advantage #8: Estate Tax Basis Step-Up Planning

Estate tax planning represents another area where DSTs offer advantages beyond simple capital gains deferral. The strategy can work alongside basis step-up rules to potentially eliminate capital gains tax entirely for heirs.

How DSTs Complement Estate Tax Planning

A properly structured DST can enhance estate planning through:

1. Selective asset basis management: Strategic decisions about which assets to place in DST versus hold for step-up
2. Generational timing strategies: Holding certain DST installment payments until after death for potential basis treatment advantages
3. Life expectancy considerations: Structuring DST term length with mortality expectations in mind

Strategic approach: For assets unlikely to receive a full step-up at death (such as those in certain trusts), a DST can provide tax deferral benefits that complement broader estate plans.

Estate planning insight: “We structure DSTs differently for clients with estates above exemption thresholds versus those below,” explains estate attorney Jennifer Richards. “For larger estates, we focus on removing appreciation from the estate, while for smaller estates, we may emphasize techniques that maximize potential basis step-up.”

Implementing a Multi-Dimensional DST Tax Strategy: A Comprehensive Approach

To fully leverage these diverse tax advantages, consider this structured approach:

Step 1: Comprehensive Tax Exposure Assessment

Before designing your DST strategy, work with tax professionals to identify your specific tax exposures:

• Projected tax brackets throughout retirement
• Potential NIIT and AMT exposure
• IRMAA threshold proximity
• Social Security taxation calculation
• State tax considerations
• RMD projections
• QBI preservation opportunities
• Estate tax situation

Assessment tool: Create a year-by-year tax projection for the next 10-15 years, identifying specific tax challenges in each period.

Step 2: Strategic DST Payment Structure Design

Design your DST payment schedule specifically to address identified tax challenges:

• Phase-based approach: Different payment levels for different retirement phases
• Threshold management: Payments calibrated to specific tax threshold points
• Complement other income: Structure around pension, Social Security, and RMD schedules
• Flexibility provisions: Build in adjustment options as tax laws and personal situations change

Design example: For clients facing significant RMDs beginning at 73, a common approach includes higher DST payments from 60-72, then reduced payments from 73 onward as RMDs increase.

Step 3: Regular Strategic Review and Adjustment

Tax laws, personal circumstances, and financial markets change, requiring regular review:

• Annual tax planning meetings: Coordinate DST payments with overall tax strategy
• Periodic payment adjustments: Modify schedule as needed and permitted within DST rules
• Tax law change integration: Adapt strategy to evolving tax regulations
• Life transition coordination: Adjust for changes in health, residence, or family situation

Implementation insight: “We review our clients’ DST payment structures annually, making strategic adjustments to ensure ongoing tax efficiency as both personal circumstances and tax laws evolve,” explains tax strategist Michael Rodriguez.

Case Study: The Johnsons’ Comprehensive DST Tax Strategy

To illustrate how these multiple tax advantages can work together, consider this real-world example (with names changed for privacy):

Client profile:

• Robert and Susan Johnson, ages 66 and 64
• $2.8 million in highly appreciated assets (rental properties and stocks)
• $1.6 million in IRAs
• $72,000 combined annual Social Security benefits (beginning age 67)
• Planning relocation from California to Arizona at age 68

Tax challenges identified:

• Potential $560,000 capital gains tax if selling assets outright
• RMDs projected to push them into higher tax brackets after age 73
• IRMAA threshold concerns with projected retirement income
• California state tax exposure on substantial gains
• Social Security benefit taxation mitigation opportunities
• Estate planning objectives for their children

Multi-dimensional DST strategy implemented:

1. Phase 1 (Ages 66-68):
   • Minimal DST payments ($60,000 annually)
   • Primary goal: Create low-income years for $200,000 annual Roth conversions at lower tax brackets
   • State tax strategy: Defer California tax on gains until after establishing Arizona residency
2. Phase 2 (Ages 69-72):
   • Moderate DST payments ($120,000 annually)
   • Calibrated to keep total income just below IRMAA second threshold
   • Continued strategic Roth conversions at optimal tax brackets
   • Social Security timing strategy: Robert claims at 70, Susan at 69
3. Phase 3 (Ages 73-80):
   • Reduced DST payments ($90,000 annually) as RMDs begin
   • Payments structured to manage total income relative to IRMAA thresholds
   • Strategic charitable giving to offset tax impact of larger RMDs
4. Phase 4 (Ages 81+):
   • Increased DST payments ($150,000 annually) for greater spending flexibility
   • Healthcare cost considerations prioritized
   • Estate planning integration with remainder DST principal

Projected tax benefits:

• Capital gains tax deferral: $560,000 initial tax saved
• State income tax savings: Approximately $280,000 by establishing Arizona residency
• IRMAA threshold management: $84,000+ in Medicare premium savings over retirement
• Roth conversion advantages: $90,000 in conversion tax savings plus future tax-free growth
• Social Security tax efficiency: Optimized to reduce taxation of benefits
• Estate planning enhancement: More efficient wealth transfer to children

Total projected tax advantage: The comprehensive strategy is projected to provide over $1 million in total tax benefits compared to traditional approaches, while creating more stable and predictable retirement income.

Common Questions About DST Advanced Tax Planning

“How does the SECURE Act impact DST planning strategies?”

The SECURE Act and SECURE 2.0 changed several retirement planning considerations that relate to DST strategies:

• RMD age changes: With RMD age now 73 (moving to 75 by 2033), there’s a longer window for strategic Roth conversions that DSTs can complement
• Inherited IRA changes: The elimination of stretch IRAs for many beneficiaries makes tax-efficient asset transfers more valuable, potentially enhancing DST