Creative Commons LicenseUsing a Trust for Estate Planning

This is the second part of a two part series on estate planning by JoeTaxpayer.   Be sure to check out the first post What is Estate Planning.

Earlier, we talked about designated beneficiaries. It’s important to note that the accounts which use designated beneficiaries avoid probate and are not subject to public disclosure. This leads us to the next topic, trusts. Trusts also are not part of the probate process, but there are different types of trusts each with their own additional benefits.

Special Needs Trust (Also called a Supplemental Needs Trust)

This trust lets you set aside assets for a beneficiary who has a disability and would otherwise be disqualified from receiving government assistance if they inherited these funds outright. The trust must be set us as an irrevocable trust funded while you are still alive.

A spendthrift trust is similar to the special needs, except it can be either revocable or irrevocable. Its main purpose is to protect the beneficiary from his own reckless spending. You can work with the attorney setting it up to specify the exact withdrawals that will be allowed, as a percent, fixed dollar amount, or some combination of the two. You can further specify the circumstances permitting additional withdrawals, if any. I recommend using any rules beyond a distribution amount sparingly. A beneficiary can request that a trust be broken if the conditions go against the public good. You want to protect your heirs, not rule their lives from the grave.

Estate Tax Exemption Increased

Not too long ago, the estate tax exemption amount was $1,000,000. It’s been increased to $3,500,000 this year, and the House just voted, this past week, to keep the current estate tax laws in place. As these numbers are subject to a vote and in any year may revert back to as low as $1M, I’d prefer to continue the discussion based on $1M. Do you really want to count on the kindness of lawmakers to not change the rules while you are nearing the end of your life and potentially unable to do any last minute planning? A million dollars used to mean you were rich, set for life. Now it may reflect a nice middle class lifestyle including a house and insurance proceeds as part of one or both spouses passing. Consider a $2M estate. Absent any planning, when you pass, your spouse inherits an unlimited amount with no tax due. When she passes on, however, the estate, valued at $2M, will be taxed at 55% of the amount over $1M. $550K to the taxman.

Time to introduce a Bypass Trust.

In Passing
Creative Commons License photo credit: redagain

This is a way of preserving that first exemption, while still providing income for the surviving spouse during her lifetime. The mechanics of the trust are simple. Trusts are set up to receive the exemption amount upon the passing of the first spouse. (Note – the trust can actually be written to specify the receipt of the exemption amount in effect at the time of passing. Otherwise, one would have an annual visit with a lawyer, which could get expensive.) That trust then offers the surviving spouse the right to withdraw 5% or $5,000 whichever is greater, each year. Addition amounts are permitted under specific situations such as medical bills, but the withdrawal right is not unlimited. When the surviving spouse passes, the trust can be disbursed in full to the next beneficiary, with no tax due regardless of growth within the account. There is no step up in basis, as that occurred when the trust first received the assets, so a cost basis is established and capital gains may be due upon sale of the assets. In the end, the cost of creating these trusts is nothing compared to the potential estate taxes this process helps avoid.

Irrevocable Life Insurance Trust

The last type of trust (yes, there are even more) I’ll discuss is an ILIT, an Irrevocable Life Insurance Trust. There’s a misconception out there that life insurance proceeds aren’t taxable. As a spouse can inherit unlimited amounts from the deceased’s estate, this may be true in many situations, but not all. If a couple passes at the same time, their heirs will find that the proceeds of insurance policies are part of their estate. Or, even if they pass at different times, the proceeds of both policies are then part of the second spouse’s estate. Given how inexpensive insurance can be, this is not such an unusual event. Enter the ILIT. Instead of direct ownership of your insurance policies, the ILIT is set up for the insurance of each spouse. It, and not you, is the owner of the policy, thus, when you pass, it is not part of your estate. It’s also typical to set up the ILIT with similar provisions as the bypass trust, to provide first for the surviving spouse, and then the next beneficiaries upon passing.

Gift Tax Exclusions

This is a good place to add some discussion of the annual gift exclusion. If you are in a position that you are comfortable to give away assets while you are still alive, keep in mind the current exclusion is $13,000 per year per recipient. This may seem to be a small sum, but once you count the potential recipients and include giving from both you and your spouse it can multiply quickly. Two children, their spouses, and four grandkids add up to eight recipients, or $208,000 total you can gift each year. If any of those grandkids are in college, you’re welcome to pay their tuition bills in any amount, with no tax due. As with any of the numbers I’ve presented, this number is subject to change over the years. It was $12,000 in 2008, and $13,000 for both 2009, and 2010.

Before I close this discussion, I’d like to talk for a moment on the use of life insurance as part of one’s estate planning. There are a number of circumstances where an insurance policy can provide needed cash for an otherwise illiquid estate situation. It’s not unusual to find that towards the end of one’s life that their house is paid for and comprises the bulk of their assets. Tough to split a million dollar home and a few hundred thousand dollars in cash and stock among two or more beneficiaries. The same issue of indivisibility can occur when leaving a business to one child, but still wanting to treat the other(s) fairly. In both situations, a well-planned insurance policy can help avoid a forced sale of a house or business.

Keep in mind, the numbers change, as will your own situation, over time. This article is my attempt to bring to light some of the details of estate planning which can help you better preserve the assets you’ve worked so hard to accumulate over your lifetime. If you decide to pursue the implementation of a trust, seek the advice of a knowledgeable trust attorney. This is not something to bring to someone with a general practice; it’s not a simple matter to keep up with the latest laws in this area.

Creative Commons License photo credit: Julie Lyn


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