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Setting up a trust can be a valuable part of your wealth management strategy. In recent years, trusts have been favored as a common gifting mechanism and a potential tax shelter from creditors. But they are also costly and complex, and they are not the only way to protect your wealth.
Determining whether or not you should consider one, and what type, depends on several factors, such as the size of your estate and the assets you are looking to protect. Contrary to popular belief, trusts are not just reserved for the wealthy, said Perry Smith, vice president of Business and Estate Planning at Commonwealth Financial Group. In fact, many people have more to protect and pass on than they think.
“A lot of people have estates in excess of a couple of million without realizing it,” he said. “When you include life insurance, retirement plans, a residence, checking accounts, and other investments, it amazes people. It may not feel like you have a lot, but it adds up.”
Trusts: Basic Types and Benefits
There are two major types of trusts: revocable and irrevocable.
Irrevocable trusts are primarily set up for estate and tax reasons. Once you put assets into an irrevocable trust, they are effectively no longer your property, which removes them from your taxable estate and may relieve you of tax liability associated with those assets.
Little to no changes can be made to an irrevocable trust once it is in existence. Because the grantor (the person whose trust it is) gives up all ownership of any assets transferred to the trust, he or she has no further say in what happens to those assets.
Irrevocable trusts are often used to transfer assets to the next generation, such as large sums of money, life insurance policies, residences or investment properties in a more tax efficient manner.
However, according to Smith, irrevocable trusts “are very specialized [and] only apply to a small group of people,” because the inflexibility and complexity of the irrevocable trust makes them less user-friendly and more expensive to create. He said they’re primarily used for larger estates as a strategy to reduce state and federal estate and gift taxes.
He estimates that for every irrevocable trust set up, there exists six to eight of the more common kind: revocable, or “living,” trusts.
A revocable trust allows you (the grantor) to maintain ownership and control of your assets as long as you live or at least as long as you are competent.
The grantor may receive income from the trust, and changes can be made to the terms of the trust as well as allowing the grantor to add and remove assets from the trust at will.
One common use of this type of trust involves providing money to beneficiaries while the grantor is still alive, often at specific ages.
But be careful. If the trust is designed to distribute assets outright to, say, your grandson when he turns 30, those assets, once distributed, will be subject to his creditors and legal claims against him, including those of an angry ex-spouse, for example.
For this reason, Smith said he often recommends that trust documents require beneficiaries to request the distributions in writing, rather than opting for automatic distribution.
“People want to keep the money in the bloodline,” said C.J. Millett of Commonwealth Financial Group in an interview. “They don’t want to fund ex-spouses. They want to fund their grandkids.”
The beauty of a revocable trust, according to Millett, is that they are flexible: you can have an attorney set them up almost any way you want to protect your assets for yourself and future generations. Revocable trusts go one step further, allowing changes to be made as life happens.
Trusts can also, when executed properly, keep trust assets out of probate, the potentially lengthy legal process of assessing and distributing your assets after you die. When the courts get involved in handling estates and wills, the process can take months or even years before they are transferred to the beneficiaries, depending on state laws, the filing of taxes, and the complexity of the estate in question.1
Property that goes through probate is also subject to probate fees and administrative costs, which can take a chunk out of the amount you intended to leave to your beneficiaries.
Another benefit of trusts? Unlike probate, which is a matter of public record, assets transferred to a beneficiary through a financial trust also remain private – which may be of value to you, depending on your situation.
Trust Cons and Other Options
Trusts are one way to protect your wealth, but they don’t come without drawbacks.
Because a trust is a legal contract, you need a lawyer to set it up for you, and that means legal fees.
Those can vary depending on how the attorney charges, but because trusts can be complex, drafting fees in the thousands of dollars are not unheard-of.
Irrevocable trusts may have more than just the initial cost involved depending on terms of trust, and may require a separate income tax return each year if more than $100 of taxable income is generated within the trust, according to Smith.
Revocable or living trusts can have recurring costs too, because in addition to initial costs, any changes will incur the cost associated with bringing in your attorney to make revisions to the document.
One note: If the owner of a revocable trust makes the mistake of failing to re-title assets in the trust’s name, those assets would not be protected by the trust and would still be subject to probate down the line.
Yet, it is possible to arrange for your assets to pass to your heirs outside of probate, even without a trust.
Assets held as joint tenancy with right of survivorship may allow property to pass seamlessly to one spouse when the other passes away. It is important when it comes to transferring assets to the next generation, to list beneficiaries for all assets – and make sure you keep those designations up to date.
According to Skip Johnson, advisor and founding partner of Great Waters Financial, almost every property can avoid probate without a trust, provided the correct paperwork is done. Please note, avoiding probate does NOT mean assets are not includable in one’s estate for estate taxes, merely that they pass directly to the named beneficiary, unlike with an irrevocable trust which if structured correctly does keep assets outside of one’s estate.
With 401(k)s and other qualified investment vehicles you choose beneficiaries when you enroll, but you can also select beneficiaries for brokerage accounts, life insurance policies, and even checking and savings accounts.
“The most commonly-missed asset we see is bank accounts,” Johnson said. “People often don’t know you can set a beneficiary for a regular bank account by making the account POD, or Payable on Death, which allows the contents of the bank to skip probate and go immediately to the listed beneficiary.”
You also have the option to gift property away during your life to remove it from your estate, though be aware that some gifts may be subject to federal gift tax.
Whatever You Do, Do Something
When it comes to estate planning, procrastination is the biggest enemy. All too often, an attitude of “I’ll deal with it later” prevails, said Millett, noting that can come back to haunt you.
No matter where you are in life, and especially if you have individuals you would like to inherit your assets, it is wise to estimate the size of your estate — including life insurance, retirement plans, properties, investments, and other assets — and start planning now for how you want those assets distributed down the line.
If you need help getting started, contact your attorney or talk to a financial professional.
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1 LegalMatch.com, “How Long Does Probate Take?”, Aug. 21, 2014.