Don’t overlook trusts in estate planning


An important finding of the new 2013 Insights on Wealth and Worth study is that trusts are being underutilized. Trusts aren’t for everyone, but they can be extremely beneficial to many who are in the midst of estate planning – and not just the wealthy.

There are many reasons to set up a trust, including avoiding probate, protecting your assets, providing for your loved ones after your death, and spelling out exactly how and when your heirs will receive their inheritance.

Normally, a person who owns property both controls and enjoys the property. A trust is a way of separating control and enjoyment.

A trust entity is created with a “trustee” to hold and manage assets for the benefit of “beneficiaries.” The person creating the trust funds the trust with assets, such as money, real estate, or life insurance proceeds. Trusts can be created in your will to take effect when you die or can be created “inter vivos,” while you are alive.

Trusts used to control

One reason to create a trust is because the person you want to benefit should not be in control of the property. A very common type of trust is one created for a child or grandchild. Because the beneficiary is too young or immature to control the assets, a trustee is named to manage and distribute assets according to your instructions.

You can spell out in the trust when and how the assets are to be distributed. For example, you might provide that the assets be paid to the child at age 25. Or you might provide that the assets be used to pay for your grandchild’s college education. There are other reasons you may want to control how property you have gifted will be used. You can create trusts for charitable purposes or to protect a spendthrift relative from wasting the assets you give him or her.

Living trusts

Probate is the court-supervised process of transferring ownership of assets from a deceased person to his or her heirs or beneficiaries. A living trust is the popular name for an inter vivos trust created primarily for the purpose of avoiding the probate process.

Why would someone want to avoid the probate process? In some states, the probate process may be time-consuming and expensive. If most or all of your assets can be transferred without going through probate, it may save the beneficiaries some money.

Another reason might be to avoid “ancillary probate” of real property owned outside the state where you die. For example, if you die in Ohio but owned a vacation home in Florida, your will would need to be probated not only in Ohio but also in Florida. However, if you transfer your Florida property to a living trust before you die, your heirs won’t have to go through probate in Florida to get the property transferred to them.

Living trusts usually are revocable, and the trustee is typically the same person who transferred the property to the living trust. This means the grantor who created the trust can still control and enjoy the property during his or her lifetime as if the property had not been transferred to the trust.

Typically, a living trust becomes irrevocable when the grantor dies, which means it can’t be changed. The property will go to whomever the grantor has named in the living trust, just as one might name beneficiaries in a will. Although living trusts are touted to “avoid probate,” you likely will die with some assets that never were transferred to the living trust. As a result, your advisor likely will recommend that you have a will with a pour-over provision that directs any assets of your estate that were not transferred to your living trust to be “poured over” into the trust at your death.

But keep in mind that these poured-over assets will not avoid probate because they were not a part of your living trust at the time of your death.

Bypass trusts

The federal government imposes an estate tax on assets you own at the time of death. Most states also have an estate and/or inheritance tax on assets owned at the time of death.

A common tool used to minimize federal estate tax is a bypass trust, also known under various other names such as family trust, A/B trust and credit shelter trust. Whatever the name, the technique involves two legal loopholes:

  • The exemption (applicable to any gift)
  • The unlimited marital deduction (applicable to gifts to the spouse outright without any trust conditions or limitations)

The federal estate tax exemption is currently $5.25 million per person. In other words, you can pass $5.25 million in assets to anyone before federal estate tax kicks in. The exemption also applies to lifetime gifts and, if used to avoid gift tax, is reduced accordingly.

In addition, recent changes in federal estate tax law allow surviving spouses to use not only their own $5.25 exemption but also any part of their deceased spouse’s exemption that was not claimed in the deceased spouse’s estate, provided an estate tax return was actually filed in that estate. (This applies unless the surviving spouse remarries and then survives his or her next spouse.) This new change is referred to as “portability” of the exemption to the surviving spouse’s estate.

The other main tool to avoid federal estate tax is the unlimited marital deduction. It allows for total estate and gift tax-free transfer of your assets to your spouse during your lifetime or at your death. As a result, all assets passing to the surviving spouse are not reduced by any gift or estate transfer taxes.

Example: Following the directions outlined in the estate plan, upon the first spouse’s death, the estate is split into two trusts, one that will not be subject to tax due to the marital deduction and another that will have property that is taxable but to which the exemption can be applied.

The A trust – or an outright distribution of assets to the surviving spouse – is estate tax free under the marital deduction. The B trust is held for the designated heirs, usually the children, with the surviving spouse named as trustee.

In this case, the surviving spouse receives all income generated by the B trust as well as $5,000 or 5 percent of the principal per year, if needed. Property in the B trust will be taxable in the first estate but often is funded in an amount equal to the decedent’s available exemption so it can be sheltered from tax.

The advantage of splitting the estate into two trusts is that the B trust assets, including appreciation that occurs after death, are not included in the estate of the second spouse when he or she dies, reducing the overall taxable estate of the second-to-die spouse.

At the second death, any assets remaining in the A trust will, however, be subject to estate tax, less the second spouse’s exemption and any unused exemption from the estate of the first spouse that is portable.

QTIP trusts

One catch to qualifying assets for the marital deduction is that generally the spouse must receive them outright without conditions or limitations. Sometimes that is not desired, perhaps due to concerns about creditors, remarriage or the desire to control the ultimate disposition of the assets when both spouses are gone.

A qualified terminal interest property, or QTIP, trust is created to provide a surviving spouse with lifetime income while, at the same time, giving the decedent the right to control the final disposition of the property. It is designed so that the property transferred qualifies for the marital deduction. Therefore, it is transferred estate tax free at the first death.

All of the trust’s income is required to be distributed to the surviving spouse. Upon the surviving spouse’s death, the trust assets are included in the spouse’s estate and subject to estate tax at that time. The trust document will decide how the trust will be allocated to the heirs upon the surviving spouse’s death.

A QTIP trust can prevent a diversion of assets from the decedent’s family, which occurs sometimes when the surviving spouse remarries. The trust especially helps to clarify asset distribution in the case of a second marriage involving combined families. The QTIP trust would be used in place of the marital or A trust in the example described above.

Life insurance

Life insurance can be a very important part of estate planning in terms of providing the necessary cash flow for beneficiaries and estates. Life insurance can also be important as a source of funds to help pay estate taxes or other expenses triggered by death.

Life insurance proceeds are part of your federal taxable estate if you own the policy. An important strategy regarding life insurance are to not own the policy on your own life.

  • Beneficiary-purchased policy If you need more life insurance, consider having the beneficiary, e.g., your spouse, own the policy on your life and retain all of the policy’s “strings.” Upon death, the insurance proceeds will be excluded from your estate and become tax-free income to your spouse.
  • Irrevocable life insurance trust This trust is established to own insurance policies on your life. Typically, you will make annual gifts to the trust for the premium payments. At your death, the insurance proceeds are free from federal estate taxes. The trust is designed to provide benefits to your spouse and/or other heirs.

The degree of estate planning you need depends on your age, your financial situation, your life expectancy and other nonfinancial reasons. But anyone with children or significant assets should begin developing an estate plan right away.

Estate plans should be reviewed at least every three to five years, particularly after a marriage or divorce, the death of a family member, an increase in family income or the birth of a child. It’s not a question of whether you need estate planning – it’s how much planning your estate needs.