If your retirement planning objectives include managing estate taxes and leaving a legacy for heirs, a trust may be an effective strategy to help you balance these goals.
What Is a Trust
A trust is an arrangement in which a trustee holds and manages money or other assets for the benefit of another. Trusts may be created to accomplish broad or specific goals:
Personal and financial safeguards for family and other beneficiaries
A means of controlling or administering your assets
Simplifying the estate administration process by bypassing the probate process
Deferring or reducing taxes
Who's Who in a Trust
Grantor: The person who creates the trust and provides the trust property. This person may also be referred to as the trustor, donor, or settlor.
Trustee: The individual, institution, or organization that holds legal title to the trust property. In some cases, a grantor can serve as the trustee. It is also possible for two or more trustees to serve together, or for both an individual and an organization to act as co-trustees. Separate trustees may also be named to manage different parts of the trust.
Beneficiary: The person or entity entitled to receive the benefits or advantages (such as income) of a trust. In general, any person or type of entity may be a beneficiary, including individuals, charities, or organizations.
Types of Trusts
Basically, there are two types of trusts:
A testamentary trust is part of an individual’s will and is established at an individual’s death
A living trust is established during an individual’s lifetime and is sometimes referred to as an “inter-vivos” trust
Living trusts can be either revocable or irrevocable.
Revocable living trusts are often established to simplify the management and distribution of your assets. In a revocable living trust, you (the grantor) own the assets and are typically the trustee, meaning you have control. The terms of the trust provide that the trust property be used for your (the grantor’s) benefit during your life. After your death, the trust becomes irrevocable. Assets held by the trust are not subject to your state’s probate process, so the distribution of trust property is often accomplished more quickly. In addition, the terms of how assets are distributed remain private.
A trust is irrevocable when the grantor permanently transfers property to the trust and cannot alter, amend, revoke, or terminate the arrangement or reclaim the property. Appreciated assets in the trust generally are not subject to estate taxes. According to the American Taxpayer Relief Act of 2012, the federal estate, gift, and generation-skipping transfer (GST) tax exemption amounts are all $5,000,000 (indexed for inflation effective for tax years after 2011); the maximum estate, gift, and GST tax rates are 40%.
Income-tax consequences with respect to trusts can vary depending on whether the trust is considered a grantor or non-grantor trust under the Internal Revenue Code. Income generated inside a grantor trust is taxable to the grantor. Income inside a non-grantor trust is taxable to the trust itself and the tax is paid using trust assets. A revocable trust is considered a grantor trust because, for example, the grantor has the power to revoke the trust. An irrevocable trust can be structured as a grantor trust or non-grantor trust depending on the powers retained by the grantor over the trust assets. A tax and legal advisor should always be consulted when structuring a trust so it meets the grantor’s goals and circumstances. For example, a grantor may prefer that an irrevocable trust be structured as a grantor trust to avoid the compressed income tax schedule that could apply to a non-grantor trust.
Frequently Asked Questions (FAQs)
When considering a trust, it is important to consult your tax and legal advisors.
Q. Do I need a trust?
A. It depends on your specific situation. If you’re a single individual or a married couple without children, and without significant assets, a living trust is generally not needed. On the other hand, the greater the value of your assets, especially if you own real estate, the more a living trust may be warranted. Also, a living trust could be an important document to have in the event you suffer from a major accident or illness and are unable to make decisions independently going forward.
Q. What is the difference between a trust and a will?
A. Your will states how and to whom everything in your estate will be distributed upon your death and is subject to probate. A trust dictates how and to whom assets in your trust will be distributed upon your death and may not be subject to probate.
Q. What is probate?
A. Probate is the legal process of proving the validity of a will in court once an individual dies. The process also involves identifying the individual’s assets, having property appraised, paying off any debts and taxes of the individual, and distributing the remaining property as directed in the will. Administering an individual’s probate estate can be expensive (for example, attorney, executor, and accounting fees) and can be a lengthy, time-consuming process. If an individual dies without a will, state default rules (intestate laws) will determine how assets are distributed.
Q. If I establish a living trust, will my assets avoid probate?
A. Using a living trust is one way to have assets avoid probate. The first step is to create the trust agreement. Once the trust agreement is signed, you will need to work with your attorney and/or tax advisor in identifying which assets are appropriate to re-title (or change ownership) to the name of the trust. Once the trust becomes owner of the asset (and not you), only then will the property avoid probate.
Q. What do I need to set up a living trust?
A. It is important to consult with an attorney to set up a trust. The attorney will assist you with determining what type of trust, who the trustee and successor trustee should be, who the beneficiaries will be, and what assets should be included in the trust.
Q. Who should be named as trustees?
A. Typically you will name yourself as trustee, and if you’re married, you may name your spouse as co-trustee. A trustee must be a person over 18 years of age, or an entity such as a bank, attorney, or trust company. You may also want to name a successor trustee who would take over upon your death.
Q. What property can I put in my living trust?
A. Almost everything you own can be placed into your trust, with the goal to avoid the probate process upon your death. But you may retain ownership of assets that already avoid probate because they have beneficiaries, like life insurance, annuities, and retirement accounts. These types of assets do not need to be added into your trust to avoid probate.
Q. How often should I update my living trust?
A. As a general rule, you should review and consider changing your trust with your legal advisor anytime there is a significant life event or change to your goals and objectives.
Q. Am I required to file a tax return for my revocable living trust?
A. You typically do not need to file a tax return for a revocable living trust that is taxed as a grantor trust. Since you control and are permitted to revoke your living trust, it is treated as your income and your trust identification number remains your Social Security number.
Q. Am I required to record my trust with any government agency
A. You are not required to record your trust with any government agency. A trust is a private document that will remain private even after your death and distribution of your estate.