There are three primary goals in estate planning, 1) to promote family harmony, 2) to ensure that your estate passes according to your wishes, and 3) to avoid estate taxes. Trusts are often used to meet one or more of these goals. However, trusts can make life more complicated for you and your family. This often comes as an unpleasant surprise to people after they have completed their estate plans. Before you use a trust in your estate plan, make sure the benefits are significant compared with the costs.
What is a trust?
When you own property outright, you hold both the legal title to the property and the right to use the property, whether it is your home, a car, or a checking account. A trust separates these two components of ownership. One person (the trustee) holds the legal title to the property and is obligated to manage it for the benefit of another person (the beneficiary). As the person creating the trust (the trustor), you spell out the terms of the trust in a trust document. This dictates how the trust should be managed, who will be the trustee, who will be the beneficiaries, and when and under what circumstances the property will be distributed.
Separating legal ownership and beneficial use of property provides many advantages in estate planning. Depending on the type of trust you use, you can, for example, remove assets from your estate to avoid taxation, protect assets from creditors, divorce, and lawsuits, and ensure your assets are managed to provide the most benefit to your family. However, there are some costs associated with creating and managing such trusts. These costs may include: 1) legal expenses to write the trust documents and re-title assets, 2) annual income taxes which the trust may have to pay, and 3) ongoing administrative costs.
Trusts are separate legal entities and pay income taxes in much the same way individuals do. However, tax rates for trusts are much higher than the rates for individuals. For example, a trust with $9,750 of taxable income is taxed at a top tax rate of 35% while an individual with that same amount of income would be taxed at a top tax rate of 15%. One way to avoid paying this additional tax is to ensure that income from the trust is paid out to the beneficiaries each year. When this is done correctly, the beneficiaries pay tax on that income at their individual rates. This lowers the overall taxes.
Because trust tax rules are somewhat different from the rules for individuals, getting professional tax help is advisable. The tax preparer will have to prepare annual income tax returns for the trust as well as a K-1 for each beneficiary showing the income distributed to them. In addition, the beneficiaries’ tax returns become more complex because they need to include the K-1s in their returns. So, they may also want to seek professional help. All of this adds up to higher fees for your family.
Another cost to consider is trustee fees. If the trust names a bank as trustee, the trustee fees can be 1-1.5%. Even when the trustee is an individual, it may make sense to direct the trust to pay the trustee a management fee for the services he or she performs on behalf of the trust. For example, if the trust is established for a minor child, the trustee may be performing trust duties for a long time, and it’s important he or she do the job well. It would be fair to provide some compensation for that work.
When the Benefits Outweigh the Costs
Generally, trusts are inappropriate when they hold small amounts of money. With less than about $200,000 in assets, the expenses for administration and taxes do not justify the creation of a trust. Trusts work best when there is a real need to be met, such as reducing estate taxes, protecting a minor child, or providing continuity of management.
If you are considering using a trust in your estate plan, make sure you have an estimate of all the costs associated with the trust. Trusts are a great tool in many cases, but no one likes to be surprised by unexpected taxes and fees. For help in determining if a trust is right for you, give us a call.