Trusts can be used to accomplish many financial planning goals: They can shelter investments from taxes and creditors, set aside funds for college tuition and charity, or protect an estate from a spendthrift family member.
Trusts are important estate planning tools, but many investors – even the wealthiest – avoid thinking about their own mortality and what will happen to their investments and property when they die.
“Trusts can be a difficult topic,” said Catherine McBreen. “The issue requires an investor to think about loved ones in terms of his or her own passing. Emotions can add a layer of complication to financial decisions about how to most efficiently protect and appropriately transfer wealth. Considerations range from ‘Who will get the family china?’ to ‘How can I leave a lasting legacy for my favorite charity?’ ”
Even the most sophisticated investor can be daunted by the technicalities surrounding estate taxes and trust law, and the sheer number of trust types can be overwhelming. In the end, all trusts embody a simple concept. According to www.livingtrustnetwork.com,
“In a general sense, a trust is nothing more than an arrangement whereby one person agrees to hold property for the benefit of another.”
Every trust has a grantor who creates a trust, a trustee who manages the trust, principal –money or assets – to fund the trust, and a beneficiary who will ultimately receive a benefit from the trust. All trusts contain these basic components, and they are classified in terms of whether they are “living” or “testamentary,” said livingtrustnetwork.com.
A living trust takes effect during a grantor’s lifetime, while a testamentary trust is created when a grantor dies and his or her last will and testament goes into effect. Living trusts avoid probate if properly funded during a grantor’s lifetime. Testamentary trusts, which are subject to probate, are public documents.
Trusts are further broken down into “revocable” and “irrevocable.” As part of a will, a testamentary trust is revocable until the grantor’s death, when it becomes irrevocable. A living trust can be either revocable or irrevocable with different tax consequences for each scenario. The grantor of a revocable living trust retains control over the assets held in trust and is treated as the owner of the property for tax purposes, said livingtrustnetwork.com.
“An irrevocable trust is a different story,” livingtrustnetwork.com said. “If you transfer some or all of your property to an irrevocable living trust, you are giving up all your rights to that property.” Irrevocably living trusts are commonly used to reduce federal estate taxes, but the transfer is considered a gift, and is subject to gift taxes based on the value of the asset at the time it was transferred to the estate. An increase in value will not be subject to estate or gift taxes.
Many trusts are established to take advantage of different income or estate tax benefits, and are classified by the purpose they serve. Wealthy investors often establish several trusts, each to accomplish a specific financial goal. According to Spectrem research, 9 percent of investors with a net worth of $25 million or more have six or more trusts.
Livingtrustnetwork.com provides the following description of some of the common trust types:
• A/B Trusts split into two distinct trusts upon the death of the grantor: a Credit Shelter Trust (or By-Pass Trust) and a Marital Trust. The first is designed to hold the amount sheltered from federal estate tax, while the second holds the remainder of the property sheltered from estate tax by the marital deduction. The scheme reduces the estate tax liability of a married couple.
• Asset Protection Trusts are designed to protect assets from the claims of creditors.
• Charitable Trusts benefit one or more charities. If established according to federal tax laws, a charitable trust entitles a grantor to deduct a portion of the contribution as a current charitable income tax deduction.
• Charitable Split-Interest Trusts have both charitable and non-charitable beneficiaries. The trusts can be set up in a number of ways to establish the primary or lead interest as either the charitable or the non-charitable beneficiary.
• Life Insurance Trusts are irrevocable trusts designed to hold the life insurance of a grantor or other person. Its purpose is to exclude the policy payment from federal estate taxes. A Crummey Trust is a life insurance trust that allows a grantor to exempt life insurance premiums from federal gift taxes.
• Special Needs Trusts are established to benefit a person who is receiving government benefits. The trust provides a source of funds without disqualifying the beneficiary from receiving government benefits.
• Spendthrift Trusts allow a trustee to avoid make distributions to a beneficiary if the trustee fears the beneficiary would waste the money, or the money would go to a creditor.
• Qualified Personal Residence Trusts are designed to reduce federal estate taxes on a grantor’s personal residence. The QPRT allows the grantor to transfer his residence to a trust, and still continue living in it.
• Dynasty Trusts are designed to last forever, with generation after generation receiving distributions.
Once a household decides to create a trust as part of overall financial, estate and retirement plans, the grantor must then decide who to appoint as trustee. Households commonly select the grantor or another family member to “self-trustee” and avoid the management costs charged by a corporate trustee.
“Most households will still choose a family member to act as trustee, but that’s not always the best idea,” said McBreen. “Few families fully understand the duties and responsibilities of a trustee and place an overwhelming burden on a family trustee.
“Family conflicts can make managing a trust even more difficult,” McBreen said, “A family member acting as trustee may lack the emotional detachment necessary to make sound financial decisions.”
More than 90 percent of investors with $1 million to $5 million who have established trusts act as their own trustee, while 87 percent of investors with $5 million to $25 million self trustee. Less than half of investors with $25 million or more ask a family member to serve as trustee.
Wills work hand-in-hand with trusts to efficiently preserve and pass down wealth, More than half of American adults – 55 percent – have not written a will even though they will have little control over what happens to their wealth or minor children when they die, according to a December survey by the consumer website FindLaw.com.