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What’s the Point of a Trust?

The following is an excerpt from my book More than Enough: A Brief Guide to the Questions That Arise After Realizing You Have More Than You Need.

There are some cases in which assets should not be left directly to one or more of your intended heirs (e.g., because the heir is a minor, disabled, or simply has a history of making poor decisions).

Or consider this scenario: after your death, your surviving spouse remarries. And, when your surviving spouse later dies, all of the assets that you currently think of as your assets are ultimately left to the new spouse. And when that new spouse dies, all of the assets go to his or her kids rather than to your kids or other intended beneficiaries.

A trust is the solution to situations such as the above.

There are many different types of trusts, each of which serves a particular purpose. The basic idea though is that a trust is a legal entity which can own assets. Sometimes trusts are used for tax planning purposes. In many cases though, the purpose is to allow the person who created the trust to exert some control over how their assets will be managed after their death or incapacitation. That is, somebody can create a trust, fund it with assets, and write the terms of the trust in such a way as to stipulate certain requirements as to how the assets will be invested or spent—and then those rules will have to be followed even after the person who created the trust dies or becomes incapacitated.

With trusts, it’s important to get guidance from an attorney who specializes in estate planning. If the attorney is not a tax expert, it’s critical that the firm has somebody on their team who can provide expert tax guidance, as there are both income tax and estate/gift tax considerations involved with trusts.

In order to understand the various purposes for a trust, you first need to know a bit of terminology.

Parties to a Trust

A trust involves three parties: the grantor, the beneficiary, and the trustee.

  • The grantor (sometimes called the donor or settlor) is the party who defines the terms (rules) of the trust, transfers property to the trust, and, usually, retains the right to change the trust until his or her death.
  • The beneficiary (or beneficiaries) is the party for whose benefit the assets in the trust are held/managed.
  • The trustee is the party in charge of managing the trust (e.g., making investment decisions, distributing assets to the beneficiary when applicable, and fulfilling any administrative requirements). The trustee owes a fiduciary duty to the beneficiary (i.e., a duty to put the beneficiary’s interests above the trustee’s own interests). And the trustee must manage the trust in such a way that is in keeping with the terms of the trust.

These parties may be actual human persons, or they may be legal entities. For instance, you could name a law firm or CPA firm as the trustee to a trust. And it’s common to name a non-profit organization as a beneficiary of a trust.

The trust may also designate somebody as a successor trustee, to take over when the initial trustee dies, becomes incapacitated, or relinquishes the role.

The trust may also designate one or more parties as secondary beneficiaries (also referred to as contingent beneficiaries), for whose benefit the assets would be managed if the primary beneficiary has died.

Another important point is that, while there are three parties to a trust, one person may actually be in multiple roles—or even all three roles.

EXAMPLE: Collin is the grantor of a trust (i.e., he funded it with his own assets). The trust is set up so that Collin is also the trustee and beneficiary while he is still alive, with his sister named as the successor trustee and his children named as the secondary beneficiaries.

One way to think about this is that before Collin created the trust, he had various rights in his assets. When he created and funded the trust, he transferred some of the rights in his assets to himself as the grantor, some to himself as trustee, and some to himself as beneficiary. Consequently, he retained all the rights in his assets that he held before the trust was created, but he now holds them in different capacities. In so doing, he creates a mechanism for others to act in the various capacities in the future.

As time passes, his sister may take over management of the trust as successor trustee when, for example, Collin becomes unable to manage his assets on his own. In addition, at Collin’s death, if his sister hadn’t already, she would become successor trustee and his children, the contingent beneficiaries, would become entitled to the benefits of the trust.

Note that there is no successor grantor because the main power given to the grantor is to change the trust. However, when the grantor dies, a trust becomes irrevocable, and cannot be changed.

More Trust Terminology

A trust can be an inter vivos trust or a testamentary trust. An inter vivos trust is created by the grantor during his or her lifetime, whereas a testamentary trust is created at the time of the grantor’s death. That is, with a testamentary trust, the grantor’s will provides for the trust to be created and funded upon his or her death.

A trust can be revocable or irrevocable. With a revocable trust, the grantor can change the terms of the trust (or even terminate it completely) as long as he/she is still alive and of sound mind. With an irrevocable trust, there are some exceptions, but changes generally cannot be made once the trust has been created. (The fact that you cannot make changes to an irrevocable trust is not, in itself, beneficial. But there are certain goals that can only be achieved with irrevocable trusts. For instance, if somebody sues you, they often will not be able to access assets in an irrevocable trust. Similarly, as mentioned later in this chapter, irrevocable trusts can be helpful for minimizing estate taxes.)

More Trust Usage Examples

With the above terminology discussion out of the way, we can go through a few examples of cases in which a trust would be useful.

EXAMPLE: Susie is a widow with three adult children (two daughters and a son). Her son has a long history of making poor financial decisions. In Susie’s will, rather than leaving 1/3 of her assets to each of her children outright, she leaves 1/3 to each of the daughters, and she leaves the remaining 1/3 to a trust. Susie names her son as the beneficiary of the trust, and she names her attorney as the trustee. This way her son still receives the benefits of the assets, but somebody else (the trustee) will be choosing how to invest and spend the assets.

EXAMPLE: Luther and Harriette are married, in their 60s. Harriette has two adult children from a prior marriage. Luther does not get along with Harriette’s children. Harriette is concerned that if she dies before Luther and her assets are simply left to Luther at her death, he will ultimately disinherit her children. As a result, Harriette provides in her will for a testamentary trust to be created upon her death and for her assets to be placed into that trust. The terms of the trust are that Luther will receive the income from the assets while he is alive, and then the assets will be left to her children upon Luther’s death.

EXAMPLE: Nigel and Veronica have an adult son who is disabled. The son is currently receiving Social Security disability benefits. And because of his low level of income and assets, he also qualifies for Supplemental Security Income (SSI) and Medicaid. If they simply leave their assets to him outright, he would lose eligibility for SSI and Medicaid. Instead, they create a special needs trust, which will receive their assets upon the death of the second spouse. Their son is named as beneficiary of the trust, and a trusted CPA is named as the trustee. Because the son has no control over the assets in the trust, it will not disqualify him from receiving SSI or Medicaid. The trustee will not be allowed to outright give the assets to the son, but the assets can be used for a variety of purposes for the benefit of the son.

Trusts are sometimes used to reduce potential estate tax costs. One of the ways to do this is to transfer assets to an irrevocable trust (thereby removing the assets from the grantor’s taxable estate), often while maintaining some current benefit (e.g., the right to take income from the assets for a period of years). By transferring assets now, the grantor will often have a taxable gift, but a significant advantage is that the gift is at today’s value, rather than at some more highly appreciated value at the date of the grantor’s death. There are many different variations on this concept though (e.g., intentionally defective grantor trusts, qualified personal residence trusts, charitable remainder trusts, etc.).

Another common use of trusts is simply to avoid probate. Assets that are placed in a trust do not have to go through probate upon the death of the grantor, because the terms of the trust (rather than state probate laws) govern how the assets are transferred. In some cases, avoiding probate can result in significant savings in terms of costs and time. (The cost of probate and administrative hassle involved vary considerably by state.)

In other cases, people may want to avoid having their assets go through probate for the sake of privacy. Probate records, including the will and estate inventory, are generally public information, whereas trusts are not.

Note though that if your goal for a trust is to have assets pass to beneficiaries without having to go through probate, it will be important that the trust is an inter vivos trust rather than a testamentary trust. Testamentary trusts do not avoid probate. (They come into being as a part of probate, via the will.)

Responsibilities as Trustee

The trustee of a trust has certain responsibilities and powers, which should be spelled out in the trust document.

One of those responsibilities is that the trustee has a fiduciary duty to the beneficiaries of the trust. That is, the trustee must manage the assets in a prudent way for the benefit of the beneficiaries, and the trustee must put the interests of the beneficiaries above the trustee’s own interests (other than to the extent that the trustee is a beneficiary).

The details vary by state law, but the trustee generally has a duty to keep the beneficiaries informed as to the administration of the trust. This often includes providing (at least) annual statements as to the trust’s assets, liabilities, income, expenses, and distributions. If/when the trust is closed, the trustee should send each beneficiary a record of all the major actions taken as trustee, including distributions made.

As with an estate, a trust is a taxable entity. If a trust has gross income of $600 or more for the year (or any taxable income more than zero), the trustee must file a Form 1041 reporting (and potentially paying tax on) that income. (Note: there are some exceptions while the grantor is still alive. That is, with some types of trusts, the trust’s income is simply treated as if it were the grantor’s income. However, once the grantor dies, the trust will be considered a separate taxpayer going forward.)

If you are trustee of a trust, it’s important to keep records of your actions in that role. Document any significant actions that you take (investment decisions, distributions from the trust, etc.) as well as your reason for those actions.

Professional Trustees

If you have (or plan to create) a trust, one important decision you’ll have to make is whether to name a family member or a professional entity as the trustee (or as the successor trustee, if you’re naming yourself as the original trustee).

The primary benefit of naming a family member as trustee (or multiple family members, as co-trustees) is that doing so will avoid some costs. Professional services are not free of course. An additional potential benefit is that a family member will have better knowledge of family dynamics, which can be helpful in some cases.

There are, however, significant points in favor of hiring a professional trustee.

Firstly, having a professional serve as trustee can prevent conflict in some cases, as the trustee will be an outsider, impartial among beneficiaries. And even if conflict isn’t avoided, it can be nice if the ill will is at least directed toward an outsider rather than toward a family member. (In some cases, the beneficiary of a trust comes to see the trustee as “the person who keeps me from getting to my money.” If the trustee and beneficiary are family, this can create permanent rifts.)

Second, naming a family member as trustee often imposes a significant burden on that person, in terms of time, stress, and potentially family conflict. And that burden may last for years.

Third, a professional trustee will have relevant skills and knowledge (e.g., investment experience), which a family member may not have.

And finally, hiring a professional trustee will generally provide some level of oversight. That is, the firm providing the service generally will have some level of internal controls to prevent theft, mismanagement, etc. In contrast, if you name, for example, your adult son as the trustee of a trust with your adult disabled daughter as the beneficiary, there may be no meaningful oversight—nobody checking to make sure that your son is performing his responsibilities appropriately.

Chapter Simple Summary

  • A trust is a legal entity that can own property. There are many types of trusts, each with a different purpose, but the most common uses of trusts are to avoid probate, minimize estate taxes, or exert some control over a pool of assets after the grantor dies or becomes incapacitated.
  • The grantor/donor is the party who creates the trust, defines its terms, and funds the trust with assets.
  • The trustee is the party in charge of managing the trust.
  • The beneficiary is the party for whom the trust’s assets are managed.
  • The trustee of a trust has a fiduciary duty to the trust’s beneficiaries.
  • Naming a professional as trustee of a trust does result in some additional costs, relative to naming a family member. But it also adds meaningful safeguards and may help to prevent family conflict.

What Comes After Financial Independence?

Among people who read personal finance books, many save a high percentage of their income through most of their careers. One thing that eventually happens for some such people is that they reach a point at which they realize they have not only saved "enough," they have saved "more than enough." Their desired standard of living in retirement is well secured, and it’s likely that a major part of the portfolio is eventually going to be left to loved ones and/or charity. And that realization raises a whole list of new questions and concerns.

This book’s goal is to help you answer those questions.

More than Enough: A Brief Guide to the Questions That Arise After Realizing You Have More Than You Need

Topics Covered in the Book:
  • Impactful charitable giving
  • Talking with your kids or other heirs
  • Qualified charitable distributions
  • Deduction bunching
  • Donor-advised funds
  • Trusts
  • Click here to see the full list.
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