Trusts have been used for centuries to protect assets and ensure they get to the right heir(s) at the right time. A trust can be a very valuable part of your estate plan – if used correctly. However, not every person needs one.
This post will take a look at what a trust is, the major types of trusts, the reasons to have a trust and important questions for you to answer before creating one. As this topic is very complex, this is only meant as an overview to introduce important concepts.
Each person’s situation is unique, so I would strongly encourage you to speak with a knowledgeable estate planning attorney to determine if a trust is appropriate for you.
What is a Trust?
Trusts have varying purposes and structures that can become quite complicated. At its most basic level, a trust is a legal document that outlines how and when you will transfer assets to your heirs/charitable organizations.
There are a few key terms that need to be defined before we move forward:
Grantor – the person establishing the trust
Trustee – the person/institution who is legally responsible for overseeing the operation of the trust.
Corpus – the asset(s) that are placed in the trust
A trust is either established while the Grantor is alive or language is inserted in their Will to create the trust upon their passing (called a testamentary trust).
Trusts used to be a fairly common estate planning tool, but the increase in the estate tax exemption (in 2022 you need to have more than $12.060 million per person to pay any federal estate tax) has caused them to be used less frequently. However, there are many different problems that trusts are used to fix, and their use continues to evolve over time.
Revocable vs Irrevocable
When considering establishing a trust, the first question that needs to be answered is whether it will be a revocable or irrevocable trust.
A revocable trust can be changed by the Grantor while they are alive (as long as they are competent). A common type of revocable trust is a Living Trust, that is normally used to avoid probate. Generally, the income from the investments will be reported on the Grantor’s tax return. The Grantor retains direct control of the assets, and they are not shielded from lawsuits.
An irrevocable trust cannot be changed (or not changed easily) once it is established. Generally, it will require a separate bank account, tax return etc from the Grantor’s. The Grantor also loses direct control over whatever assets are in the trust, and they are not counted as part of their estate when they die (if certain conditions are met). They can still serve as the Trustee, but decisions are made in the interest of the trust, not the Grantor’s finances.
Major Types of Trusts
There are many different types of trusts, and each have a different purpose. Below are a few different categories of trusts with a common example for each:
Special Needs Trust (SNT) – is used to provide additional funds for a disabled individual in a way that will not disqualify them from receiving public assistance benefits.
Irrevocable Life Insurance Trust (ILIT) – a trust that holds a life insurance policy(ies) that will pay proceeds directly to your heirs so they can pay any estate/inheritance taxes owed after you pass away.
Charitable Remainder Unitrust (CRUT) – the Grantor gives assets to an irrevocable trust (receiving an immediate tax deduction) and will receive income (a percentage of the trust value set by the IRS) every year for the rest of their lives. When they die, the assets left in the trust go to charity.
Reasons For A Trust
There are many reasons people establish trusts. Here are a few:
Avoid Probate & Publicity
Assets in a trust do not go through the probate process – which is the public process of settling an estate. The trust allows assets to be transferred privately and more cheaply as probate fees do not apply.
Irrevocable trust assets are protected in the event of a lawsuit. If the Grantor is sued, the trust assets would not be at risk (assuming terms of the trust are followed).
Provide for Others
For parents of children with special needs, it may be important that they structure their estate plan to enable their child to continue to receive public assistance benefits.
There are times that the next generation is not equipped to handle receiving wealth right away. A trust can establish a schedule or milestones the child must reach to access the funds.
When people have a vacation home or a large amount of assets, trusts can be used to reduce or eliminate the Federal estate tax (also called the death tax). This maximizes the amount that can be provided to the next generation.
Though trusts can be beneficial in certain circumstances, there are several downsides to trusts to be aware of:
1. Higher Taxes
Tax rates on trusts are much higher for lower levels of income. In 2022, a married couple filing jointly needs $647,850 in taxable income to be in the 37% tax bracket. A trust only needs $13,451 in income to be in the same bracket. If the trust produces a lot of income, this could get expensive.
2. Greater Complexity
A trust has a document that outlines the operations of the trust (called a trust document). This will detail who makes decisions, who has access to the money, when they have access to it, and how the funds can be invested. These directions must be followed to keep the trust in compliance with how it was established.
3. Need A Qualified Trustee
Each trust has at least one Trustee – this can be the Grantor, family member, friend or a bank/professional Trustee. The Trustee serves as a fiduciary, meaning they are legally responsible for implementing the terms of the trust for the benefit of the beneficiaries. They can be held personally liable if they violate their fiduciary responsibility.
Many times Grantors, their family and friends do not feel comfortable serving as a Trustee, so a professional Trustee is hired to serve in this capacity.
4. Loss of Control
Depending on the type of trust, the Grantor may lose complete control of the assets put into the trust. The Trustee is responsible for managing the Trust corpus for the benefit of the future beneficiaries, not the Grantor. Once the trust is funded, the Grantor may disagree with the Trustee’s decision, but may not have any power to change it.
5. Can Be Expensive
Establishing a trust can cost thousands of dollars, and any changes will add additional fees. Depending on the type selected, the trust may have their own bank and/or investment account established, and may require their own tax return. There may also be fees paid to the Trustee for their work on behalf of the trust. All this can add up quickly.
Key Questions to Answer
Before establishing a trust, I would encourage you to consider the following questions.
Do you really need it?
A trust should exist for a specific purpose that you clearly understand. Attorneys (and Financial Advisors) may advise you to establish a trust, but you really need to understand what they are talking about and why they are recommending it. I have had clients come to me who don’t know why they have a trust, and in some instances, didn’t need a trust. Ask good questions and read broadly on the subject before you establish a trust.
Are there simpler options to consider?
Trusts add complexity, and can be encouraged by those who make money off creating and managing them. They have their place, but there may be simpler options that can help without the complexity and cost of a trust.
For example, if you are trying to avoid probate, consider using Transfer on Death (TOD) and Payable on Death (POD) designations on your taxable investment and bank accounts to reduce your probate expenses (though you want to keep some cash available outside these accounts to pay for any estate settlement costs). It may not be as comprehensive as a trust, but is much less complicated and easier to modify. If you want to give assets to charity, consider a Donor Advised Fund (DAF).
Ask your Attorney, Financial Advisor etc for all your options, and weigh them accordingly.
Should you just give it away?
Is the purpose for the trust to try and control others after you have died? Some trusts are established with specific milestones or signs of maturity that must be met before funds are distributed. If you have family members who do not handle money well, it may be better to give it away rather than allow it to be a snare to them.
Did I do everything correctly?
Years ago I had a new client come to me with an Irrevocable Life Insurance Trust (ILIT). The ILIT is established to purchase a life insurance policy. The Attorney drafted the trust document, and gave it to the client. Years later, there was no life insurance policy in it – so the trust was meaningless. The client had paid for the trust to be established, but didn’t know they needed to do something, thereby rendering the trust useless.
Be sure you understand what you need to do, and get it done. There is no point in spending thousands of dollars for a trust and then not following through on what is necessary. Memories get fuzzy, so write down in a way you understand what you need to do and follow through on it.
Should I give now instead of creating a charitable trust?
I am a big proponent of giving while you are alive rather than establishing a charitable trust or a long-term DAF. You may be able to invest the funds and provide more for charity, but the market can also decline. A trust and DAF have fees that eat into the assets available to give. As the old saying goes “Do your giving while your living, so you’re knowing where it’s going” is very important. Charities change over time, and you may not have an opportunity to change your trust before you pass away.
A trust can be a valuable part of your estate plan – when established and maintained correctly. However, you need to weigh whether the additional complexity, cost and limitations of a trust are the best way to address the problem you are facing.
Points To Consider
- Is a trust the simplest way to get what you need done?
- Getting at least two professional reviews of your situation before doing anything would be a wise course of action
- Is giving away assets more desirable than trying to control the actions of others?
- Review your trust regularly as estate taxes, trust structures etc change