Your Guide to Trusts: A Flexible Financial Planning Tool

You’ve worked hard to build your wealth, you have the strong nest egg for your retirement years, but how are you going to pass down any remaining wealth to your family, kids, and grandkids?

Where most high-net-worth investors turn: Trusts.

Trusts are legal agreements that create the opportunity to design how assets are passed down and managed. Trusts provide the ability to specify terms, decide who receives inheritances, when they receive them, and more. The control and flexibility trusts provide is one advantage, but there are also other benefits. Depending on the structure of the trust, it can shield asset creditors. And some forms of trusts can effectively remove assets from an estate, which can reduce estate taxes.

Trusts are also outside of probate, which can preserve privacy as well as save time and money.

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 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.

On the flip side, the trustee is a firm or individual that holds and manages assets on behalf of the beneficiaries. 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 creates flexibility to move around assets and allows more control than an irrevocable trust.

On the other hand, once assets are placed into an irrevocable trust, the trust becomes the sole owner, and this can only be altered in certain 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 different and unique circumstances. Mostly they are used for the following categories:

Providing for a Spouse

One way to provide 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.

Used in tandem with a marital trust, a bypass trust is a type of irrevocable trust that was 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 ($12.92 million for an individual and $25.84 million in 2023 for a married couple)1, 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 the exemption amount. 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.

The Bottom Line

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.

If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ and owner of True Equity Wealth Management LLC. Email him at michael.shea@trueequitywealth.com or fill out a contact form.

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This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.

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