You may have noticed a pattern in legal terminology. Words ending in -or, like trustor and grantor, are always the person in control of the property. Conversely, words ending in -ee, like trustee or grantee, are always the person receiving something from the -or. An easy way to remember this is that -ee receives something from -or. Put it together as ee-or and you have Winnie the Pooh's buddy.
If the deed is used only as a property transfer mechanism at the grantor’s death, the deed may not be considered a valid will substitute form and is subject to probate. Check with your attorney about state laws to find out what requirements are needed for a deed to be
considered a will substitute form.
IRAs and your other retirement accounts
Even if you’re just beginning your estate-planning efforts, you may already have will substitutes as part of your estate and not even know it.
Most of your retirement savings accounts — your IRA, 401(k) or 403(b) plan, your Roth IRA, and other retirement-oriented investments — are forms of will substitutes. For example, for a 401(k), the spouse is automatically listed as the beneficiary.
Chapter 4
Understanding Trusts
IN THIS CHAPTER
Defining trusts
Looking at how trusts can enhance your estate planning Examining major categories of trusts
You can use a trust to save on estate taxes, to protect property in your estate, and to avoid probate.
You can even use a trust to get dents out of your car and clean the toughest stains in your carpet.
Okay, the last two items are fake, but various types of trusts may be the secret weapons in your estate planning. Beware, though: Trusts are also the most overhyped part of estate planning.
This chapter helps you make sense of the extremely complicated topic of trusts: what they are and why you may want to consider trusts for your estate plan. Before you seriously start considering trusts, you must understand the basics covered in this chapter so you can make informed decisions about what does — and doesn’t — make sense for you.
Defining Trusts, Avoiding Hype
Trusts can be difficult to understand when you hear some estate-planning professionals talk about them. But those people may be more interested in selling you expensive investment vehicles than they are in making sure you understand enough about trusts to make wise and informed decisions yourself.
Don’t worry. This chapter helps you get a handle on trusts — with three definitions:
An incredibly oversimplified definition
A slightly more complicated definition but still using plain language
An “official” definition that uses just enough legalese but still won’t cause your head to start spinning
Shazam! An oversimplified definition of trusts
In many comic books and related movies and TV shows, an ordinary person goes into a “special place” and comes out a superhero with a new identity and, very often, with superpowers. Bruce Wayne goes into the Batcave and comes out as Batman. Clark Kent goes into a phone booth and comes out as Superman. Billy Batson says “Shazam!” and turns into Captain Marvel.
Think of a trust as a special place in which ordinary property from your estate goes in and, as the result of some type of transformation that occurs, takes on a sort of new identity and often is bestowed with superpowers: immunity from estate taxes, resistance to probate, and so on.
So in many ways, a trust is your own personal Batcave — a place to go when you want to change the identity of some of your estate’s property. And even though Batman doesn’t have any
superpowers, he does pick up that nifty utility belt with all kinds of weapons while he’s in the Batcave. Similarly, when property is in your trust, it can “pick up its own utility belt” and do things that aren’t possible outside of the trust.
Adding a bit of complexity with an ingredient list
Suppose you want to set up a trust. Just like with a cooking recipe or building something in your garage workshop, you need to make sure you have everything you need before you start. To cook up a trust, you need these seven basic ingredients:
The person setting up the trust (that’s you)
The reason you want to set up the trust and certain objectives you want to achieve The trust document itself
The property that you decide you’re going to place into the trust
The trust’s beneficiary (or beneficiaries, if more than one), whether that beneficiary is a person (your oldest daughter, for example) or an institution, such as a charity
Someone to watch over and manage the trust and the property that is now in the trust
A set of rules that tells the person watching over and managing the trust what he or she can and can’t do
All the items in the preceding list come together, and when everything is done properly — Shazam! — you now have a trust.
Adding some lawyer talk to the definition
If you’re comfortable with a little bit of legalese, here’s a somewhat more “official” description than comic book analogies and simple recipe-style lists. Here, we add a tiny bit of attorney talk to the seven basic elements:
Person setting up the trust: The person is commonly known as the trustor, though you may sometimes see the terms settlor or grantor.
Objective of the trust: You use different types of trusts to achieve a variety of specific estate-planning objectives. You can use some trusts for a single estate-planning objective, while others help you achieve more than one goal. Some of the most common estate-planning objectives for trusts (discussed later in this chapter in more detail) are to reduce the amount of estate tax liability, to protect property in your estate, and to avoid probate for certain property.
Before you decide whether you need one type of trust or another, you must think about what you’re trying to accomplish in the first place.
Specific kind of trust: As discussed later in this chapter, trusts come in many different varieties. And just like ice cream, yogurt, or pudding, you find different colors and flavors, some of which you may like and others which just don’t do it for you. Regardless, when you’re setting up a trust, you need to decide what type of trust you want and make sure that you follow all the rules for that particular type of trust to make sure that it’s proper and legal, and carries out your intentions.
Property: After you place property into a trust, that property is formally known as trust
property — that is, just like with the Batcave analogy, the property now has a different identity and, in one way or another, isn’t quite the same as it was before you placed it into trust.
Beneficiary: As with other aspects of your estate plan (your will, for example), a trust’s beneficiary (or, if more than one, beneficiaries) benefits from the trust in some way, usually because the person or institution will eventually receive some or all of the property that was placed into trust.
Trustee: The person in charge of the trust is known as the trustee. The trustee needs to clearly understand the rules for the type of trust he or she is managing to make sure everything in the trust stays in working order.
Rules: Finally, some of the rules that must be followed are inherently part of the type of trust used, whereas other rules depend on what is specified in the trust agreement. You’ll find still more rules in state and federal law.
Putting all the preceding information together, the trust agreement is a document that spells out the rules that you — the trustor — want followed for the property that you’ve placed into the trust to benefit the beneficiary (or beneficiaries) of the trust, as managed by the trustee.
(Got all of that? If not, keep rereading until it makes sense, checking back with the list to help clear up the parts that seem difficult.)
Consider the following simple example. You decide to put $300,000 in a trust for your two twin 10-year-old daughters, and you want your sister to oversee the trust. You specify that neither daughter is allowed to receive anything other than interest on the property in that trust before reaching the age of 25, and then they can receive a maximum of only $10,000 each year on their birthday until the age of 35, at which time the remaining money in the trust (which hopefully has been growing along the way because of your sister’s wise investment choices) will be split 50-50 between the two of them.
In this example, you are the trustor, your twin daughters are the beneficiaries, and your sister is the trustee. The conditions about when your daughters can start receiving money, how much, and until when are part of the terms of the trust agreement.
But what kind of trust can you set up? Aha! That is often the $64,000 question (or $300,000
question, or $1 million question, or perhaps the $5,000 question … all depending on the value of the property you place in the trust). You can use different trusts to achieve different objectives, and
we discuss the major categories briefly later in this chapter.
Attaching all the bells and whistles to a trust
Beyond the basic definition (or, in this case, multiple definitions) of what a trust is, you need to be aware of several little tidbits about trusts. When Batman enters the Batcave, he needs to know where his utility belt is, whether the Batmobile has enough fuel, and where he’s headed as soon as he gets outside. Otherwise, he may be in big trouble.
The same is true for trusts, which is why you need to work with your estate-planning team — particularly your attorney — to make sure that before that trust goes into effect, you have
everything in order and haven’t set yourself up for the estate-planning equivalent of an ambush by the Joker.
The following list may seem a bit nitpicky, but you can use the items in this list when you work with your attorney to avoid any problems. For example:
Make sure the trust agreement is in writing. Although an oral trust may be considered valid, just like an oral (nuncupative) will can be, certain trusts, such as those dealing with real estate, must be in writing. Therefore, just like with your will, you should put the trust agreement in writing instead of relying on word of mouth so misunderstandings or other problems don’t arise.
A trust must provide duties and obligations for the trustee (again, the person in charge of the trust). Typical duties and obligations include how and when to make payments from the trust, or how to manage or oversee the property in the trust (such as paying property taxes on real estate in the trust, renewing certificates of deposit in the trust, and so on). In legalese, a trust that adequately features such duties and responsibilities is known as an active trust.
If the trust doesn’t adequately include trustee duties and obligations, a court may consider it to be a passive trust. Watch out! The court may deem it as “no trust at all.”
Furthermore, the law automatically transfers the trust’s property to the beneficiary or
beneficiaries, and everyone loses out on whatever the objective of the trust was, such as tax savings. So make sure that when you (or, more accurately, your attorney) set up a trust that the trustee’s role is well defined so you won’t have any problems down the road.
The wording of the trust agreement must clearly specify that you’re actually setting up a trust and indicate what property you’re placing in the trust (or intend to place in the trust at some future date).
The trust agreement must clearly identify the beneficiary or beneficiaries — the person or people by name and other identifying characteristics (“my daughter Ellie Mae Clampett,” for example) or an institution (“The Meow Cat Shelter of Tucson, Arizona”).
Don’t take the process of deciding on and appointing a trustee lightly. Make sure that whoever you select as a trustee has the right background — education or profession, for example — for the job at hand. If you want someone to manage a trust containing lots of money, make sure that the trustee understands and has adequate experience in portfolio management, diversification strategies, and other investment management techniques. But just as important (maybe even more important) than education and professional background is that your trustee has the honesty, character, and integrity to fulfill the responsibilities. Sometimes being in charge of lots of money intended for someone else (the trust’s beneficiary or beneficiaries) can be, shall we say, a bit too tempting.
A trustee may have a legal interest in the property in a trust but doesn’t have a beneficial interest.
The trustee is responsible for managing the trust’s property, but he or she can’t benefit from the trust other than receiving the agreed-to trustee compensation (fees and costs) for taking on this job.
Designate a successor trustee — a pinch hitter to step in if the primary trustee can’t serve or continue to serve for some reason — when you set up a trust. Otherwise, the court that has jurisdiction may appoint a successor trustee, and that may not be someone whom you want.
Trust Power — Making Your Beneficiaries Smile
You’re probably thinking: “Why should I care about trusts?”
In a very general sense, the primary reason you set up a trust is to benefit a person or institution more than if you didn’t set up the trust. After all, trusts are often complex, can be time-consuming to set up and oversee, and cost you some amount of money (a modest amount for a straightforward trust, or perhaps a lot of money for a very complex setup involving multiple trusts, different
jurisdictions’ laws, and so on). So you should have a good reason to go to all this trouble.
Here are some examples of benefiting a person or institution better:
You have some part of your estate or your overall personal financial situation, such as a life insurance policy, that under applicable law is likely to cost your estate some amount of money in estate taxes. But by setting up a trust, your estate can avoid paying some or all taxes,
meaning that more money is left over for your trust’s beneficiaries.
As described in Book 5, Chapter 3, the probate process can cause problems for your estate, anywhere from minor annoyances and delays to major costs and inconvenience. However, you can use trusts for certain property that you absolutely, positively don’t want to be subjected to the problems and delays of probate. Your beneficiary may gain ownership and use of that property more quickly if you had set up a trust than if you used the regular method of having that property as part of your probate estate.
The following sections look at the most significant objectives you likely want to achieve by using trusts.
Avoiding taxes
Some trusts have the “special power” (or maybe that’s “superpower”) to avoid estate-related taxes that otherwise may apply. One of the most common tax-saving trusts is an irrevocable life insurance trust. The proceeds from your life insurance policy (the death benefit amount) are added back into your estate, often turning an estate that isn’t subject to federal estate taxes into an estate that needs to write a substantial check to the IRS.
However, an irrevocable life insurance trust is one of several ways you can shelter life insurance death benefit proceeds from estate taxes. After setting up the trust, you still have life insurance, and your beneficiary or beneficiaries still receive the proceeds from your policy upon your death.
But now, estate taxes may not be a problem.
Avoiding probate
Book 5, Chapter 3 discusses living trusts as a form of will substitute to help you avoid probate.
By keeping certain property out of your probate estate — the part of your estate that is subject to probate — you may be able to avoid many of the hassles, costs, and concerns about privacy that are related to probate.
You have a number of other means at your disposal to avoid probate for other property — joint tenancy with right of survivorship, payable on death (POD) accounts, and others
discussed in Book 5, Chapter 3 — so work with your estate-planning team to figure out what the best probate-avoidance tactic may be for each type of property in your estate. For some, the costs of a trust may make sense, particularly if you’re not only trying to avoid probate but also trying to accomplish one of the other goals talked about in this section (avoiding estate taxes, protecting your estate, and so on). For other property, a simpler, less costly way to avoid probate, such as joint tenancy, may be a better choice for you.
Protecting your estate
One of the primary uses of trusts is to protect your estate — not only while the estate is yours but also when your estate becomes someone else’s estate (and so on).
For example, suppose you want to leave $500,000 to your only son, but you’re concerned that if you were to die while your son is still relatively young (say, under 30), he won’t be responsible or mature enough to adequately manage a large amount of money. Before you can say, “sail around the world,” you’re afraid he will have spent the entire half million.
You can use a trust in the manner described in the previous paragraph to parcel out the money to your son as you see fit. The trust can give him a little bit each year for some duration and then a final lump sum at some age when you think he’ll be mature enough to protect the money as if he had actually earned it himself. Or you can add conditions to how the money in the trust is
dispersed, such as your son receives a little bit of money until a certain age, and then he gets the rest only if he graduates college or meets some other criteria you determine when you set up the trust.
Trusts are an important part of your estate plan when you want to leave money to your minor children and make sure that
The money is available to them when they reach certain ages.
The money is set aside (think “officially reserved” meaning that nobody else can touch it) for your children and managed by a trustee, instead of just leaving it to your brother-in-law and saying, “Please don’t spend this money on a Rolls Royce; make sure you keep it safe for my kids.”
Providing funds for educational purposes
Another common use for trusts is to make money available to your children, grandchildren, other relatives, or even nonrelatives (your employees’ children, for example) for educational purposes, such as college tuition and living expenses.
You can set up and fund trusts that parcel out money for educational purposes, but that also come with the restriction of “no school, then no money!”
Benefiting charities and institutions
You can help out charities in many ways: through gift giving or by leaving money or other property to one or more institutions as part of your will.
Alternatively, you can set up some type of charitable trust that may, for example, annually give money to the charity while you’re still alive, give a larger amount upon your death, and then from what is left in the trust after you die, continue to make regular payments to the charity. You can even set up a charitable trust to make regular payments to the charity for some amount of time but eventually “give back” whatever is left to you or, if you’ve died, to someone else in your family.
Alternatively, you can set up a charitable trust to work the other way — pay you while you’re still alive, and upon your death, the remaining amount in the trust goes to the charity.
Sorting Out Trusts — from Here to Eternity
In general, there are two different ways of categorizing trusts:
Those trusts that are in effect while you’re still alive versus those that take effect upon your death
Trusts you can change your mind on versus those that are absolutely, positively, unchangeable
Trusts for when you’re alive versus when you’re gone