When approaching the estate planning process, many people assume that a simple will is all they need to effectively distribute assets among their heirs. While a will is an integral component of any estate plan and an important tool for spelling out your wishes after you die, trusts offer a variety of benefits and, in many cases, should be used in addition to a will. Trusts are often perceived as only being valuable for the ultra-wealthy or families with complex needs, but in reality, they can be used to fulfill a wide range of purposes.
What is a trust?
A trust is an agreement in which the settlor transfers assets to a trustee for the benefit of the third parties identified in the trust. The trustee owes a fiduciary duty to act with reasonable care as they manage the trust assets, administer the assets in accordance with the trust’s instructions, and distribute the trust’s income and principal to the designated beneficiaries.
The most common type of trust is a revocable, or living, trust. If you opt for a revocable trust, it will be created during your lifetime and typically not funded until your death. The revocable trust will include specific instructions for how you want your estate to be divided among your heirs. While you are alive, you will likely serve as the trustee and retain the power to buy, sell, trade, or remove trust assets, revoke the trust entirely, or make any other modifications needed as your estate planning goals evolve. Once you die or become incapacitated, a successor trustee will take over management of the trust assets.
An irrevocable trust, on the other hand, cannot be changed after it is created. Once you place assets in an irrevocable trust, no one—including you as the settlor—can remove them without the beneficiaries’ permission. Since transferring assets to an irrevocable trust essentially removes them from your estate, this type of trust is most commonly used as a way to avoid taxation, including the estate tax, or shield assets from lawsuits.
Why should you have a trust?
Trusts offer several different benefits, and your reasons for creating one will likely determine which type of trust is right for you. Here are five common reasons to consider setting up a trust:
- Greater control over your assets. When you bequeath assets to your heirs using a will, they simply receive the assets upon your death. This can be problematic if there is any concern about your heirs’ abilities to manage their inheritances—for example, if they are minors, spendthrifts, have special needs, or tend to make irresponsible choices. Unlike a will, a trust allows you to control exactly when, how, and to whom assets are distributed. It is common for trust settlors to specify that assets are to be used for a certain purpose, or that beneficiaries are not to receive anything until they have reached a certain age or fulfilled certain conditions.
- Avoid probate court. Any assets that you own at the time of your death—including those listed in your will—must go through probate, which can be a lengthy and expensive process for your heirs to navigate. However, when you transfer assets to a revocable or irrevocable trust, the trust effectively owns the assets. As a result, trusts do not go through probate; when you pass away, the trustee assumes control of managing and distributing your assets according to the terms of the trust. In addition to the time and expense saved by avoiding probate, having a trust preserves privacy because information about estates passing through probate become a matter of public record. With a trust, only the trustee and beneficiaries will have access to information about your assets.
- Planning for future incapacity. Revocable trusts allow you to plan for how your assets will be managed in the event that you become ill or otherwise incapacitated. In that case, your successor trustee will assume responsibility for managing assets, which may be used for purposes such as your medical expenses or long-term care. If you regain capacity, you will have the option to reclaim control of the trust assets. On the other hand, if you pass away, the trustee will be responsible for distributing the assets according to the terms of your trust.
- Shield assets from creditors. If you are concerned that you may be sued, you might consider using an irrevocable trust to protect your assets from potential plaintiffs. For example, doctors, lawyers, and other professionals who are regularly exposed to liability sometimes transfer their assets to irrevocable trusts—thereby effectively relinquishing ownership—so that the assets cannot be reached in a lawsuit.
- Avoid the estate tax. If the value of your estate—which includes all of your assets, accounts, investments, life insurance, and anything else you own—is greater than a certain amount at the time of your death, your estate will be subject to a staggering 40 percent tax. As of 2020, estates valued at less than $11.58 million per person, or $23.16 million per married couple, are exempt from the estate tax. However, these thresholds are set to expire in 2026 and revert to their pre-2018 levels of approximately $5 million per person—and considering that estate tax exemption amounts are a politically contested issue, the threshold could drop even lower in the future. Therefore, even if your estate is not large enough to be subject to the tax now, it may be at the time of your death. Transferring assets to an irrevocable trust is an effective way to reduce the size of your estate to an amount not subject to the tax, thereby preserving significant wealth for your heirs.
As you begin to think about your estate planning options, a trust may serve as a versatile tool both during and after your lifetime. To learn more, contact the Tax Diversification experts today.
-Stephanie Vance, J.D.
(Sources: https://www.kiplinger.com/article/retirement/t021-c032-s014-trusts-101-why-have-a-trust.html, https://estate.findlaw.com/trusts/types-of-trusts.html, https://www.lawyers.com/legal-info/trusts-estates/trust-planning/what-is-the-purpose-of-a-trust.html).
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