Trusts can help ensure that your assets are put to work according to your wishes.
Contrary to what many people think, trusts are not reserved only for the wealthy. The truth is, people from all walks of life may benefit from a trust.
What Is a Trust?
In general, a trust is a separate legal entity created by a unique written document in which the owner of an asset—the trust’s creator or “grantor”—transfers legal title of that asset to a named trustee of the trust to hold and manage for the purpose of benefiting one or more beneficiaries, who are the equitable owners of that asset. Trusts may be revocable or irrevocable, and may be included in a will to take effect at death.
Revocable trusts can be changed or revoked at any time. For this reason, the IRS considers any trust assets to still be included in the grantor’s taxable estate. This means the grantor must pay income taxes on revenue generated by the trust and possibly estate taxes on those assets remaining after his or her death.
Irrevocable trusts cannot be changed once they are executed. The assets placed into a properly-drafted irrevocable trust are permanently removed from a grantor’s estate and transferred to the trust. Income and capital gains taxes on assets in the trust are paid by the trust to the extent they are not passed on to current beneficiaries. Upon a grantor’s death, with certain exceptions, the assets in the trust are generally not considered part of the estate and are therefore not subject to estate taxes.
Most revocable trusts become irrevocable at the death or disability of the grantor.
The Role of a Trustee
The trust’s grantor names a trustee to effect the terms of the governing trust document in accordance with the needs and circumstances of the beneficiaries as well as applicable local law, which may generally include: to receive and safeguard trust assets; manage trust investments, including the selection of investment managers where appropriate; and make decisions regarding distributions. A trustee is held to the highest standard and must be loyal and impartial in all his or her decisions. For a revocable trust, while the grantor is still alive, that grantor can work with the trustee on major decisions or the trustee can be assigned full authority to act on the grantor’s behalf.
A trustee may be a family member or a trusted advisor, such as an attorney or accountant, or it may be a professional entity that offers skill and experience in such areas as taxation and money management. Trustees have a responsibility—known as “fiduciary responsibility”—to always act in the beneficiaries’ best interests.
Benefits of a Trust
While trusts can be used in many ways, they are most commonly used to:
- control assets and provide security for the beneficiaries (of whom can be the grantor in a revocable trust);
- provide for beneficiaries who are minors or require expert assistance managing money;
- achieve charitable giving;
- avoid estate or income taxes;
- provide expert management of estates;
- avoid probate expenses;
- maintain privacy; and
- protect real estate holdings or a business.
Generally speaking, most people use trusts to help maintain control of assets while they’re alive and medically competent, and indirectly maintain control of the disposition of assets if they’re medically unable to do so or in the event of death.
Flexibility to Meet Your Needs
Different kinds of trusts are designed to meet different needs and objectives. For example, if your primary goal is to ensure privacy in the settlement of your estate, centralize control of assets, or take full advantage of estate tax credits provided by the IRS, you might choose a living trust.
The living trust allows you to remain both the trustee and the beneficiary of the trust while you’re alive. You maintain control of the assets and receive all income and benefits. Upon your death, a designated successor trustee manages and/or distributes the remaining assets according to the terms set in the trust, avoiding the probate process. In addition, should you become incapacitated during the term of the trust, your successor or co-trustee can take over its management.
A family trust or marital trust may be created under your will or during your lifetime, and are generally put in place to take full advantage of the estate tax and generation-skipping transfer tax exemptions that may be available to you and your spouse. When properly set up, these types of trusts may maximize tax savings and provide for the family into the future. Often times, these trusts are used in second marriages when there are children from the first marriage. With certain exceptions, they are typically irrevocable.
An irrevocable life insurance trust (ILIT) is often used as an estate-tax funding mechanism for estates with no or low liquidity. Under this trust, you make gifts to an irrevocable trust, which in turn uses those gifts to purchase a life insurance policy on you. Upon your death, the policy’s death benefit proceeds are payable to the trust, which in turn provides tax-free cash to help beneficiaries meet estate tax obligations.
A qualified personal residence trust (QPRT) allows you to remove your residence from your estate at a discount. Under this trust, you get to use the home for a predetermined number of years, after which ownership is transferred to the trust or beneficiaries. Any gift tax you might incur from giving away the property is discounted because you still have rights to live in the house during the term of years spelled out in the trust. The potential drawback is that if you die before the term of the trust ends, the home is considered part of your estate. Also, during the QPRT term, the house generally cannot be used as collateral for a mortgage, and it may be difficult to refinance an existing mortgage.
If you want to leave money to your grandchildren, you might consider a generation-skipping trust. This trust can help you leave bequests to your grandchildren and avoid or reduce your generation-skipping transfer tax exposure, which can be up to 40 percent on the federal level in 2014.
To help benefit your favorite charity while serving your own trust purposes, you might consider a charitable lead trust (CLT). This trust lets you pay a charity income from the trust for a designated amount of time, after which the principal goes to the beneficiaries, who receive the property free of estate taxes. However, keep in mind that you’ll need to pay gift taxes on a portion of the value of the assets you transfer to the trust.
Another charitable option, the charitable remainder trust (CRT), allows you to receive income and a tax deduction at the same time, and ultimately leave assets to a charity. Through this trust, the trustee will use donated cash or sell donated property or assets, ameliorate any capital gains tax, and establish an annuity payable to you, your spouse or your heirs for a designated period of time. Upon completion of that time period, the remaining assets go directly to the charity. Highly appreciated assets are typically the funding vehicles of choice for a CRT.
Is a Trust Right for You?
Different types of trusts and trustees can require a variety of fees for administration and wealth management. As you develop your trust strategies, remember to consider the costs that may be involved and weigh them carefully in relation to the benefits.
Although you may still need a will, trusts are becoming more widely used among Americans, wealthy or not. Increasing numbers of people are discovering the potential benefits of a trust—how it can help protect their assets, reduce their tax obligations, and define the management of assets according to their wishes in a private, effective way. iBi
Cathy S. Butler, CFP, CRPC is a financial advisor with The Butler/Luthy Group of Morgan Stanley in Peoria. For more information, call (309) 671-2873 or visit www.morganstanleyfa.com/thebutlerluthygroup.