The Use of Trusts in Estate Planning

Estate planning is the process to ensure your hard-earned assets are distributed the way you want. Trusts are a powerful tool in the estate planning toolkit because they provide versatility, protection, and tax advantages.

This article explains the world of trusts in plain English. It covers the various types of trusts, the benefits of each, the common pitfalls to avoid, and the process of setting one up. We always recommend working with a trusted tax and estate attorney.

The Trust Basics

At its core, a trust is a legal arrangement where one person (the grantor or settlor) places assets under the control of another person (the trustee) for the benefit of a third person (the beneficiary). 

Imagine you have a box. You put something valuable in it, like a rare toy. You then give the box to a friend, but you tell them it's for another friend's birthday next week. So, while you give away the toy, you still have a say in how it’s used. 

You are like the person who owned the toy.

The valuable stuff – from cash and real estate to stocks and jewelry – is what you put into the trust.

The friend who holds onto it is called the trustee.

And the birthday buddy? They’re the beneficiary – the one who benefits from the trust.

Types of Trusts

You can choose from a variety of trusts. The first step to picking the one that is right for you is to familiarize yourself with the different types. The two most common distinctions are:

Revocable Trusts. Also known as Living Trusts, these are trusts where the grantor retains the right to revoke or amend the trust terms during their lifetime. Assets within a revocable trust bypass probate, but they're still considered part of the grantor's taxable estate.

Think of it as a "Take-Back" Trust. You gave the toy box to your friend but now you want the toy back. With this trust, you can change your mind, take things out, or put more in, anytime you want.

Irrevocable Trusts. In comparison, an irrevocable trust is less flexible. Generally, once assets are placed in an irrevocable trust, the grantor gives up the right to amend, revoke, or access those assets. But, because you can't take it back, this trust has some compelling benefits, like providing more shelter for assets against taxes and creditors.

These are "No-Take-Backs" Trust. Once you hand over the toy, that's it. You can't change your mind. 

There are also specialized trusts to cater to specific needs:

Charitable Trusts. These are designed to benefit a charitable organization.

Special Needs Trusts. Purpose-built for beneficiaries with disabilities, this type of trust ensures access to government assistance is not lost.

Generation-Skipping Trusts (GST). These trusts allow grantors to transfer a significant amount of money tax-free to beneficiaries at least two generations younger than them, typically grandchildren.

Why Use a Trust?

Probate Avoidance. One of the most significant benefits is that assets held in a trust bypass the probate process, which is usually costly and time-consuming. This is like avoiding the crowd at the mall; trusts let you skip the line.

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Tax Advantages. Some trusts help you save on taxes, especially those that are irrevocable. The tax benefits can be substantial, from estate taxes to income taxes.  It's like getting a discount on the toy.

Control. Trusts allow you to determine how and when assets are distributed. For instance, a trust can stipulate assets be released to a beneficiary when they reach a certain age or achieve a specific milestone: like "My son gets this money when he turns 25," or "This money is only for my daughter's education."

Privacy. Unlike wills, which become public during probate, trusts offer privacy, keeping the details of one's assets and beneficiaries private. Unlike wills, which can be read by anyone, trusts keep your business private.

Protection from Legal Judgments. Certain types of trusts can offer protection from creditors or legal judgments against the grantor or beneficiaries. Think of this as guarding the toy from people who want to take it, like if someone sues you.

Why Opt for a Generation-Skipping Trust over a Revocable or Irrevocable Trust

Here are reasons why someone might opt for a generation-skipping trust over a revocable or irrevocable trust:

Saving on estate taxes is the primary advantage of GSTs. By skipping the intermediate generation, assets in the trust are not included in the children's taxable estate, which can mean significant estate tax savings if the children have sizable estates of their own.

Additionally, each individual has a Generation-Skipping Transfer Tax (GSTT) Exemption. The GSTT exemption can be allocated to generation-skipping transfers, shielding a certain amount from the GSTT. However, most people will never encounter the GSTT because of the high threshold: the tax only applies when the transferred amount exceeds $12.06 million per individual for 2022 and $12.92 million for 2023.

Third, assets in a GST can be protected from the beneficiaries' creditors, divorce settlements, or other potential liabilities. This can be especially useful if the grantor is concerned about their children's financial management skills or potential future creditors.

Because GSTs can be set up to last for several generations, family wealth can be preserved and potentially grow over time. In addition to control over distributions, the grantor can establish terms of the trust to specify how and when distributions should be made to the beneficiaries, ensuring that funds are used in the way the grantor intended.

Lastly, some grantors may have a specific wish to benefit more remote descendants, such as grandchildren or great-grandchildren, perhaps because their children are already financially secure or have chosen lifestyles or paths that the grantor doesn’t wish to further fund.

Making Your Trust

When working with a tax and estate attorney, you will follow these steps to set up a trust:

1. Determine the Purpose. Understand your goals. Do you want to avoid probate, reduce taxes, or maybe protect assets from creditors?
2. Select the Type of Trust. Based on your goals, decide whether a revocable, irrevocable, or one of the specialized trusts is most suitable.
3. Choose a Trustee. This can be an individual, multiple individuals, or a financial institution. They will be responsible for managing the trust's assets.
4. Draft the Trust Document. Typically done with the help of an estate planning attorney, this outlines all the terms of the trust.
5. Fund the Trust. Transfer the chosen assets into the trust. This could involve changing titles or deeds or designating the trust as a beneficiary. This can occur during your lifetime, after you pass, or both.
6. Maintain and Update as Necessary. Especially for revocable trusts, it’s essential to review periodically and update to reflect any changes in your wishes or financial situation.

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Common Pitfalls to Avoid

Mistakes can be made when setting up a trust. The common ones to avoid are the following::

Improper Funding. A trust only works for assets that are placed into it. It's a common mistake to set up a trust but neglect to fund it properly.

Choosing an Ineffective Trustee. This person has significant responsibilities. If they are not trustworthy or competent, it can have detrimental effects on the trust's operation.

Overcomplication. While trusts offer many benefits, not everyone needs a highly complex structure. It's essential to balance the trust's complexity with your actual needs to avoid unnecessary complications and costs.

Neglecting Communication. It's beneficial to communicate with beneficiaries about the existence and basic terms of the trust to prevent misunderstandings or conflicts later.

Not Reviewing and Updating. Life changes and so do laws. Regularly review your trust to ensure it remains aligned with your goals.

The Costs of Setting Up a Trust

Trusts offer many advantages, but they come with a price tag. When considering setting up a trust, make sure you understand the associated costs. These are broken into five categories:  

1. Attorney's Fees. The most significant cost typically is the fee you'll pay to an attorney to draft the trust document. Depending on the complexity of your estate and the type of trust you want, attorney fees can range from $1,000 to $10,000 or more. For a straightforward revocable trust, expect the lower end. But if you're looking at specialized trusts, such as those for charitable giving or special needs, the cost can be higher.
2. Trustee Fees. If you choose a professional or corporate trustee, like a bank or trust company, they will charge fees. These might be annual fees based on the trust's assets percentage or hourly charges for their services. While you can name a family member as a trustee and avoid this cost, ensure they're equipped for the role's responsibilities.
3. Filing and Registration Fees. Some jurisdictions might require trusts to be registered, incurring additional fees. While these costs aren't typically exorbitant, they're worth factoring into your budget.
4. Transfer Costs. When you move assets into a trust, you might face costs. For instance, if transferring real estate, there might be deed recording fees. If transferring stocks or bonds, brokerage fees might apply.
5. Ongoing Maintenance. Over time, as your life circumstances change, you may need to amend or update your trust. Depending on the adjustments, you might incur further attorney fees.

Trusts Are a Smart Estate Planning Tool

Whether you’re looking to protect assets, minimize taxes, or dictate the precise terms of inheritance, trusts offer a level of control and protection that simple wills cannot match.

By understanding the nuances of different trust types and being aware of potential pitfalls, you can utilize trusts effectively in your estate planning. Always consider working with an experienced estate planning attorney to ensure your trust is set up correctly and meets all your objectives.