Tax Tips
Trusts: A Powerful Planning Tool - September 2008
Richard Scrivanich - Partner
Few Financial topics create the confusion that trusts do. From avoiding probate to protecting heirs, and saving estate taxes to benefiting charities, a trust can serve almost any purpose. They are especially powerful in income, gift, and estate tax planning. But they are complicated, can be expensive to set up, and require professional advice. Should a trust be part of your financial plan?
What is a trust?
A trust is an entity created by a legal document that transfers title to certain property from the owner (called the grantor or donor) to a trustee, who holds and manages the property for the trust's beneficiaries.
In general, trusts fall into one of two main categories. A testamentary trust is created by a will and takes effect after you die. It names your beneficiaries and spells out the rules for paying out the income and assets to them. A living or intervivos trust, on the other hand, is created and takes effect while you are still alive. Living trusts may be revocable or irrevocable.
The amount of your assets, your current financial needs, and personal attitudes will influence the type of trust that might be right for you. While most trusts can be used for estate planning purposes, different trusts serve different specific needs.
Benefits of testamentary trusts
A testamentary trust can help ensure that an inheritance is used wisely. Instead of transferring assets outright to beneficiaries who may not be ready to handle them, you leave them in a trust to be managed by a trustee until a predetermined time.
Living trust
When you create a living trust, you must decide whether the trust will be revocable or irrevocable. With both types, you retitle your assets in the name of the trust. If you choose, you can serve as the trustee yourself, retaining control of your assets while you are alive and naming someone to succeed you as trustee when you die or if you are unable to act as trustee.
With a revocable trust, you can change beneficiaries, replace the trustee, remove assets from the trust or dissolve the trust entirely. Because you still retain control over the trust assets, revocable trusts do not remove assets from your estate. You must report the trust's taxable income on your regular Form 1040, and any assets remaining in the trust at your death become part of your potentially taxable estate. As such, revocable trusts, in and of themselves, offer few tax benefits.
By contrast, an irrevocable trust permanently removes assets from your estate. Any property transferred to the trust is no longer yours. The trust becomes a separate entity that pays taxes on the assets' earnings and, when you die, generally, assets in the trust are not subject to estate taxes. However, transfers of assets into the trust may be subject to gift taxes, and may reduce the estate tax exemption available on your death. While living trusts can accomplish a number of goals, the price you pay for this tax savings can be significant-once created, an irrevocable trust cannot be altered without court intervention.
Trusts and probate
When you die, the assets titled in the name of your living trust pass directly to your beneficiaries, avoiding probate-the legal process for administering a will-and its inherent costs. While a will makes the amount of the assets you leave behind and your wishes for the distribution of those assets a matter of public record, a living trust avoids probate and therefore maintains the privacy of your estate. In addition, a living trust can be useful in naming someone to administer your affairs in the event you become unable to do so. Remember, however, avoiding probate does not avoid estate tax.
Choosing a trustee
It is important to consider the health, age, and financial savvy of any trustee. Unlike someone with a durable power of attorney, who can act for you only while you're alive, a trustee of a living trust will manage the property after you die, for as long as the agreement remains in force. For this reason, people setting up large trusts sometimes name an institutional trustee such as a trust company with a qualified family member to act as co-trustee.
Trusts and estate tax savings
There are several trust strategies that can help you reduce or avoid estate taxes. The A-B trust, one of the more common trusts used by married couples currently, can , shield up to $2 million from estate taxes by using your estate tax exemption now. A charitable remainder trust can provide income for you or your beneficiaries until you die or for a set period, with the remainder going to the charity.
Special types of trusts
Certain types of specialized trusts can also play an important role in tax and estate planning:
Irrevocable life insurance trust. Generally, life insurance proceeds paid directly to your beneficiaries are not part of your taxable estate. However, if the proceeds are paid to your estate?because, for example, you failed to name beneficiaries?those proceeds may be subject to estate tax. Also, types of policies with an associated cash value will result in the inclusion of a portion of the policy's value in your estate. To avoid including policy proceeds in your estate, you can transfer ownership of the policy to either an irrevocable trust or to another person. However, you must survive the transfer by three years to avoid inclusion of certain amounts in your estate.
Generation-skipping trust. This type of trust allows you to gift assets to your grandchildren without incurring a generation-skipping tax, while the income from the trust can be paid to your children during their lifetimes.
Charitable trusts. Charitable lead trusts and charitable remainder trusts are tools that allow you to assist a charity while providing an income tax deduction and possible estate tax benefits to the grantor of the trust.
Trusts and your goals
The trusts just described are far from the only types of trusts. For example, there may be advantages to putting your residence into one of various trusts available for that purpose. The types of trusts available, and the purposes for which they can be used, are broad?but choosing the correct ones and setting up the correct arrangements is complex. If you would like to find out how trusts can assist you in your tax and estate planning, please contact our office.
If you have any questions regarding trusts or any other tax matter, please feel free to give me a call at (562) 698-9891.
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