What Is A Trust?
Your Guide to Trusts: A Flexible Financial Planning Tool
You’ve worked hard to build your wealth. You realized the more you put in, the more you got out. Now you’re at the stage where you might have a strong enough nest egg to see you through your retirement years, but have you thought of what you’ll do with any remaining money after you’ve passed away? Do you plan to send it all to charity, or will you provide a legacy for your family? Do you want to give your kids and grandkids opportunities you may not have had?
Trusts are where most high-net-worth investors turn to for estate instructions.
Trust are legal sets of instructions that create the opportunity for the funding party to design how assets are managed and ultimately, passed down. They can provide the ability to specify terms, dictate who receives inheritances and when they receive them, and more. Control and flexibility trusts can provide indeed is one advantage, but there are also other benefits. Depending on the structure of the trust, it can shield your assets from any creditors. And some forms of trusts can effectively remove assets from an estate, which may soon prove invaluable for many people who wish to reduce estate taxes.
Trusts also keep assets outside of probate, which can preserve privacy as well as save time and a ton of money.
Watch a recent Aloha Fridays episode with San Diego estate planning attorney Elizabeth Blust and learn from real world examples why you’d want to keep your assets out of the probate process. Watch below from 1:15 to 8:30.
Understanding Trust Terminology
It’s important when setting up a proper trust to understand the terminology. The terms “grantor”, “trustor”, and “settlor” are all used interchangeably within estate planning and all really mean the same thing. The terms refer to the person who creates the trust. Depending on the type of trust, the grantor may also be the trustee, the beneficiary, or both.
“Trustee” is a firm or individual that holds ultimate power over the trust and manages assets on behalf of the beneficiaries which may or may not be the grantor, trustor or settlor. Their responsibility is to manage the trust and make decisions with the beneficiaries’ best interests in mind. Trustees typically have a fiduciary responsibility, meaning they are legally required to act in the best interest of the trust.
The term beneficiary is used to describe the person or persons who are designated to receive benefits from the trust.
Structuring a Trust: Control is Key
All trusts fall into two different categories: revocable or irrevocable. The key thing to consider when choosing between the two is how much control you want over the assets. A revocable trust can be changed and altered at any time during the grantor’s life. This give the trustee the flexibility to move assets as they deem appropriate and allows more control than an irrevocable trust.
In an irrevocable trust, the trust becomes its own entity and this can only be altered in specialized circumstances. A trade-off for giving up control and ownership with an irrevocable trust is that it provides greater asset protection from creditors and can reduce estate taxes as the assets are not considered to be part of the estate.
Types of Trusts
Trusts are incredibly flexible instruments that can be fine-tuned to provide different benefits in many unique circumstances. Mostly they are used for the following categories:
Providing income for a Spouse:
One way to provide income for a surviving spouse is through a marital trust. This type of trust is revocable and goes into effect when the first spouse dies. Marital trusts avoid probate and thanks to the marital deduction, assets can be passed to the surviving spouse without triggering a taxable event. When the second spouse dies, the trust is then passed to the designated beneficiaries. These types of trusts used to be called “AB” trusts.
Used in tandem with a marital trust, a bypass trust is a type of irrevocable trust that is designed to reduce the overall amount of estate taxes paid. In a bypass trust, after the first spouse dies, the estate is split into two separate trusts. One trust holds the assets for the surviving spouse and the bypass trust holds assets for the named beneficiaries. If a couple’s estate exceeds the estate tax exemption ($11.7 million in 2021), when the surviving spouse dies, the estate would be responsible for estate taxes. With separate trusts, the goal is to divide the estate in two so the value of the estate is below the tax exemption.
Another trust that can help provide for a spouse is a qualified terminable interest property (QTIP) trust. This is most commonly used when the grantor has children or family from different marriages. While the surviving spouse serves as the initial beneficiary and receives income from the trust for life, the grantor can designate additional beneficiaries. QTIP trusts are similar to marital trusts, but the main difference is that QTIP trusts are more restrictive and limit the control of the surviving spouse. For example, with a marital trust, the surviving spouse is able to name the final beneficiaries. With a QTIP trust, the beneficiaries cannot be changed from the grantor’s original designations.
Provide for Beneficiaries:
A generation-skipping trust, also referred to as a GST, is an agreement in which assets are passed down to the grantor’s grandchildren. By effectively skipping a generation, the assets avoid estate taxes that would otherwise be due if the immediate children of the grantor accepted them. Similar to the bypass trust, estate taxes are only due if the inherited estate exceeds $11.7 million (as of 2021). It’s also important to note that while generation-skipping trusts are typically passed down to family, anyone under the age of 37 1/2 can be named the beneficiary regardless of relation.
Grantor retained annuity trusts (GRATs) are irrevocable trusts that aim to minimize taxes when being passed on to the next generation. GRATs give the grantor the ability to place assets into the trust and receive annuity income over the term of the trust. When the term is over, the assets are distributed to the named beneficiaries.
An irrevocable life insurance trust (ILIT) is created to hold a life insurance policy. Since it is irrevocable once the policy is transferred, the grantor must give up all rights and ownership. Those who have large life insurance policies tend to benefit the most from ILITs because once the policy is transferred, it is not included in the taxable estate.
Charitable Giving:
For a charitable, tax-favored strategy, charitable remainder trusts (CRTs) and charitable lead trusts (CLTs) are both useful options. While both trusts are irrevocable, there are a few key differences. As the name suggests, charitable lead trusts provide income to the grantor’s charitable beneficiary of choice for a period of time and then the remaining assets are distributed to non-charitable beneficiaries. Charitable remainder trusts operate inversely, providing income to non-charitable beneficiaries first, and then distributing the remaining assets to charity.
If an estate has assets that would incur large capital gains taxes upon sale, transferring the assets to the CRT allows the trust to sell the appreciated assets without facing capital gains tax. The CRT is then able to distribute income to the beneficiaries. When transferring assets, the grantor receives a charitable income tax deduction. In addition, those assets are removed from the grantor’s estate, which can reduce estate taxes.
Charitable remainder trusts can be categorized in two different types – charitable remainder annuity trust (CRAT) and charitable remainder unitrust (CRUT). CRATs provide income in the form of fixed dollar amount and CRUTs provide income based on a fixed percentage amount. For example, with a CRAT valued at $1,000,000 with a 5% payout rate, the beneficiary would receive $50,000, regardless of investment performance. However, with a CRUT, if the account value dropped to $900,000 the beneficiary would only receive $45,000.
Conclusion
Trusts are a flexible tool that can be used for many estate planning purposes. We can help to determine what type of trust may work best, depending on the desired outcome, and also what assets to fund the trust with.
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