Trusts have been an essential estate planning tool for centuries. Once used only by the very wealthy, today trusts are widely used by the non-wealthy. Longer lives, more widespread wealth, second marriages, and blended families all cause greater interest in trusts. That is even before considering tax reduction strategies.
Trust use is so widespread that there is a danger trusts are being overused or misused. Here is an overview of the classic uses of trusts, and in a few cases alternatives to consider.
Marital deduction. Property from the estate goes into this trust, which pays all its annual income to the surviving spouse for his or her life. The trustee also can distribute principal to the surviving spouse to pay for certain expenses that are specified in the trust agreement, such as medical care and education. After the surviving spouse passes away, the trust principal goes to the children or other named beneficiaries. The trust is not included in the taxable estate of the first spouse, but it is included in the estate of the surviving spouse.
This trust often is used when at least one of the spouses is in a second marriage, especially if there are children from a prior marriage. The trust ensures that the remaining property eventually goes to the children or other beneficiaries designated by the spouse creating the trust. The marital deduction trust also can be used when there is concern that the surviving spouse might remarry and eventually give the property to the new spouse or family.
Spendthrift trust. Most states allow a spendthrift clause that prevents creditors of the trust beneficiary from getting access to the trust principal. Often there is a limit to the amount of wealth that can be protected by the spendthrift clause. When a spendthrift trust is in place, creditors can attach distributions made to the beneficiary. But the trustee can withhold distributions when that is in the best interest of the beneficiary. Creditors cannot force distributions or take control of the trust interest.
This trust is ideal when the beneficiary is financially irresponsible. It also is a good idea when there are concerns about gambling, substance abuse, lawsuits, failed businesses, debt, divorce or other potential wealth wasters.
A variation or alternative is to give the trustee the option to purchase an annuity and distribute that to the beneficiary. The annuity is protected from creditors in most states and limits the beneficiary’s access to the money. That could be better than paying the trustee for years to manage the trust and determine distributions.
But the annuity is not a good alternative in all situations. If the beneficiary has a problem controlling spending, the annuity can work because it limits the annual income. But if the problem is that the beneficiary will use any income to gamble or to abuse substances, then you want a trustee with the ability to withhold all distributions until the problem seems resolved.
Inheritance trust. When beneficiaries are young, it makes sense to write the will so that their inheritance goes into a trust. The money can be professionally managed and the distributions limited until the children mature. If you ar still around when they are older, you can revise the will so they would inherit the property outright.
The terms of the inheritance trust are the major issue these days. In days past, parents and grandparents were content to have principal distributed as the children reached certain ages, with the full trust paid out by age 35 or so. Now, many people want to use the trust as a carrot for the beneficiaries to achieve certain goals.
For example, some principal might be distributed when the beneficiary graduates from college or professional school. More might be distributed after the beneficiary stays employed for a minimum period or reaches a certain income level. Some trusts base distributions on the beneficiary’s income.
I have discussed these incentive trusts in past issues, and those discussions can be found in the Archive section of the web site. The trick is to ensure that the incentives do not create new problems, such as forcing the beneficiary into activities for which he is unsuited or has no interest. Lifelong incentives also are generally not a good idea.
Special needs trust. This trust is used when a child or grandchild is handicapped or otherwise is not likely to be able to fully care for himself or herself. Preparations must be made for the day when the parents will not be around to provide help. A trust, often including life insurance, usually is the best way to meet these needs.
Life insurance trust. Traditionally a life insurance trust is used primarily to pay estate taxes and other expenses so that a family business, real estate, or other assets do not have to be sold. When an irrevocable life insurance trust is properly set up and funded, the life insurance benefits escape all estate taxes.
Though fewer people face the estate tax, the life insurance trust still has its uses.
Life insurance can guarantee a minimum inheritance for the heirs and avoid probate and estate taxes. This gives the estate owner the freedom to manage his or her assets without worrying about the effects on the next generation. They will inherit the life insurance benefits. Anything they get from the estate is extra.
The trust also can be a good use of an existing life policy. Suppose you bought permanent (cash value) life insurance years ago to cover your mortgage and the children’s college expenses. Those expenses are in the past, but you still own the policy. Consider putting it in a trust. The benefits will be out of your estate, so heirs inherit the full face value.
An existing policy will be included in your estate if you die within three years of the transfer. In addition, there might be gift taxes when you transfer the policy. You need to check with a tax advisor.
You might not need a trust to get any of these results. A life policy can be put in a partnership or limited liability company. It also can be owned by individuals other than the insured. In any of these cases, you can make annual gifts that are used to pay the premiums. Using a trust ensures the gifts are used to pay the premiums and policy loans are not taken. If potential misuse doesn’t worry you, the costs and additional efforts of a trust can be avoided.
Living Trusts. Probate can be avoided by putting assets in a revocable living trust. After you die, the assets in the trust are managed or distributed according to the trust terms. The time and expense of probate are avoided.
Yet, a living trust can be inconvenient. Title to have to be changed so that the trust is the legal owner. Title must be changed on your home, cars, financial accounts, and other assets. If you put financial accounts in the living trust, it can take a while for the beneficiaries to be allowed to manage the accounts after you pass. They will have to provide the account sponsor with all the paperwork it requires.
Check on your state’s probate process and cost before using the living trust. A number of states have streamlined their probate processes in recent decades, especially for smaller estates. It might not be worthwhile to set up a trust to avoid probate in these states.
There also are other ways to avoid probate. Several forms of joint ownership avoid probate. Joint title, however, has its own potential problems. Past discussions of this can be found in the Archive on the web site. IRAs, annuities, life insurance, and some other assets automatically pass to the named beneficiary without going through probate. Remember, avoiding probate is not the same as avoiding estate or gift taxes.
There are many different Types of Trusts and ways to use them. Trusts also are very flexible. But they do have downsides, and sometimes there are alternatives to a trust.