Everyone, including the rich and not-so-rich, should have an estate plan to ensure that the maximum amount of the estate's assets pass to the owner's beneficiaries. Failing to appropriately plan ahead can lead to family conflict, unexpected taxes and higher probate costs, all of which are worth avoiding. Many people think a simple will is the answer. Unfortunately, although wills are important estate planning tools, they often aren't enough to do the job. An estate plan of any level of sophistication should include the use of one or more trusts, which are often used in conjunction with, or in addition to, a will. This article will outline the most common types of trusts and their characteristics and benefits. (For more tips on smart estate planning, read Getting Started On Your Estate Plan.)
Basic Characteristics of Trusts
A trust is managed by one entity (person or organization) for the benefit of another, although the managing entity owns the trust. A trust has the following characteristics:
- Grantor - All trusts have a grantor, sometimes called a settler or trustor. This is the person who creates the trust and has the legal capacity to transfer property.
- Trustee - The trustee can be any individual or organization that can take title to property on behalf of a beneficiary. The trustee is responsible for managing the property according to the rules outlined in the trust document, and must do so in the best interests of the beneficiary. This person may be the grantor, the spouse or adult child of the trust, or a third party. It is important to note that the trustee must be prepared to be held accountable to the grantor, the beneficiaries, or both. (For related reading, check out Can You Trust Your Trustee?)
- Beneficiary - The beneficiary is the party or parties benefiting from the trust. The beneficiary or beneficiaries are not required to have the same interests in the trust property. For example, the trust may provide one-third of the corpus to one beneficiary and the balance of the corpus to another. The beneficiaries do not have to be declared at the time the trust is created; they can be named later. (Choosing a beneficiary can be tricky; to learn more, read Don't Forget The Beneficiary Form and Problematic Beneficiary Designations - Part 1.)
- Property - Property is the asset that gets placed in the trust, and it is sometimes called the principal or the corpus. Property can be any type of asset and can be transferred to the trust during the lifetime of the grantor (living trust or inter-vivos) or under the will of the grantor after death (testamentary trust). Property can include assets such as money, securities, real estate, jewelry, etc.
- Revocable and Irrevocable - Depending on the language used to create the trust, a trust can be revocable or irrevocable, also called modifiable or non-modifiable. The difference here is that for a revocable trust, the grantor remains in control, whereas the grantor loses control of the property after it becomes irrevocable. Living trusts may be revocable or irrevocable.
- Funding - A trust may be fully or partially funded by the grantor during their lifetime or after the grantor's death.
- Taxes - Generally, each trust is a separate tax payer and must obtain a federal identification number and file an annual return. However, some living trusts do retain the grantor's tax identification number.
In the next section we will explore some of the most common trusts and what they can do for your estate plan.
Common Types of Trusts
Now that we have we reviewed the basic components of a trust, let's take a look at the most common types of trusts.
A living trust is usually created by the grantor, during the grantor's lifetime, through a transfer of property to a trustee. The grantor generally retains the power to change or revoke the trust. After the grantor dies, this trust becomes irrevocable, which means that the trust cannot be changed, and the trustee must follow the rules set forth in the trust concerning the distribution of property and the payment of taxes and expenses.
In addition to holding assets and providing specific instructions on the use and disposition of such assets, a living trust can offer the following advantages:
- Healthcare provisions and end-of-life or other non-financial desires of the grantor
- Protection against incapacity of the grantor and beneficiary
- Help to bypass probate delays and costs
- Easy succession of trustees
- Immediate access to income and principal by beneficiaries
- Privacy if the state requires the filing of an inventory of assets
However, a living trust has some of the following limitations:
- Titling of Property - In some cases, not all property should be included in the trust. If this is the case, a recommendation is to use, in conjunction with a trust, a pour-over will to coordinate the transfer of assets. For example, in some states (like Florida), primary residences are shielded from creditors by way of a "homestead exemption". If the primary residence, however, is placed in trust, the home may lose that creditor protection.
- Creditor Claims - Generally, a living trust does not provide protection from claims made by creditors because the grantor of the trust is considered to be the owner of the trust's assets. This is because the grantor has the power to revoke the trust at any time.
- Taxes - All income earned by the trust is taxable to the grantor, on the grantor's personal tax return, as if the property had never been transferred to the trust. (To learn how to set up a living trust for your estate plan, read Establishing A Revocable Living Trust.)
A testamentary trust, sometimes called trust under will, is created by a will after the grantor dies. This type of trust is designed to accomplish specific planning goals such as:
- Preserving assets for children from a previous marriage
- Protecting your spouse's financial future by providing lifetime income (also referred to as a qualified terminable interest property (QTIP) trust)
- Ensuring that a special needs beneficiary will be taken care of
- Preventing minors from inheriting property outright at age 18 or 21. Minors are unable to take legal title of assets or property until they reach legal age, which varies by state. Trusts are often used for the safekeeping of their assets until they can take full title.
- Skipping the surviving spouse entirely as beneficiary
- Gifting to charities
The testamentary trust allows grantors to take advantage of estate tax reduction through the unified credit shelter. This refers to the maximum amount of assets the IRS allows you to transfer tax-free during life or at death. The amount can be a substantial part of the estate, making this a very good option for financial planning. (For related reading, check out Encouraging Good Habits With An Incentive Trust.)
Other Special Trusts
Estate planning includes other types of trusts too. Some of them are:
Irrevocable Life Insurance Trust
An irrevocable life insurance trust (ILIT) is an integral part of a wealthy family's estate plan. The federal government allows individuals a $2 million estate tax exemption (the exemption amount may vary from year to year, as determined by U.S. Congress). Any amount above that will be exposed to estate taxes as high as 45% of the value of the estate. In estates that have more assets than the amount of the applicable exclusion, life insurance is usually a cornerstone of the estate plan. An ILIT provides the grantor a flexible planning approach and a tax savings technique by enabling the exclusion of life insurance proceeds from both the estate of the first spouse to die and from the estate of the surviving spouse.
The ILIT is funded with a life insurance policy. The trust becomes the owner of the policy and also becomes the beneficiary of the policy, but the grantor's heirs can remain beneficiaries of the trust itself. In order for this planning to be valid, the grantor must live three years from the time of the policy transfer, otherwise the policy proceeds will not be excluded from the grantor's estate. (For more information trusts for large estates, read Get A Step Up With Credit Shelter Trusts and Tax-Efficient Wealth Transfer.)
Charitable Remainder Trust
A charitable remainder trust (CRT) is an incredibly effective estate planning tool available to anyone holding appreciated assets that have a low basis, such as stocks or real estate. Funding this trust with appreciated assets allows the donor to sell the assets without incurring a capital gain. The CRT provides an effective way to transfer appreciated property, benefit from the charitable income tax deduction, and reduce estate taxes while continuing to reap the benefits of the underlying assets for income purposes.
A CRT has two types of beneficiaries; depending on how the trust is set up, the payments will continue for a fixed period of time, or until the death of the beneficiary.
- Income Beneficiaries - for example, you and your spouse receive a set income during the beneficiaries' lifetime
- Charities - charities you choose to name in the trust receive the residual principal of the trust at your, or your spouse's, death.
Qualified Domestic Trust
This is a special trust that allows the non-citizen spouse to benefit from the marital deduction normally allowed to other married couples. Unfortunately, the unlimited marital deduction is denied for property transferred to a spouse who is not a U.S. citizen unless the property specifically passes to a qualified domestic trust (QDT). With this type of trust, the surviving non-citizen spouse must be entitled to all income from the assets held in the QDT.
Estate planning is a very complex process and should have professional oversight. The best way to make sure that your loved ones are cared for in the way you intended after your death is to get some competent legal guidance. Trusts, like those we discussed, are likely to be a key component in carrying out your wishes effectively.