What are you trying to accomplish with your estate plan? For many, it’s important to have a plan that will make it easy for their children, grandchildren, other relatives, friends, or favorite charities to inherit their assets in a clear and deliberate fashion. It may also be important to try to maximize the amount that is ultimately transferred to heirs and charities, which means using strategies that help reduce or potentially eliminate federal and state estate taxes (also referred to as transfer taxes). The opportunity for professional management of transferred assets (e.g., trust services or investment management) may also be appealing. With these objectives in mind, revocable or irrevocable trusts may make sense as components of an estate plan. When considering a trust, it’s important to decide whether you should give away assets today, or at some point in the future. When should you let go?
While this article discusses the "nuts and bolts" of different trust strategies, the topic of estate planning is a very broad one and we are just skimming the surface. It's important to work with your attorney, your accountant, and other professionals to help ensure that your estate plan aligns with your needs and goals. Your financial legacy is also very personal, and before making decisions regarding trust strategies and when to relinquish control of any assets, it’s important to talk to your family about your estate plan. Your wealth management adviser can guide you through this process so you can have successful family conversations about your estate plan and your legacy.
A revocable trust may make sense if you want to maintain control
If keeping things simple is a goal, a revocable trust could be a good option because it offers individuals (grantors) the greatest flexibility. The grantor retains ownership and is typically the trustee of any assets placed in the trust. When an asset is retitled to a revocable trust, it can be withdrawn for the grantor's benefit at any time.
If an individual already has a will that specifies how their assets should be distributed, why might a revocable trust still be needed? The main reason to use a revocable trust would be to avoid probate. Probate is the legal process used by state courts to distribute assets at an individual's death that are either designated by a will or, in the absence of a will, by the intestate laws of the decedent’s state of domicile. Be aware that some assets, like IRAs or tax-deferred annuities pass according to the beneficiary designation, and thus are not subject to a will or revocable trust (unless the individual's estate or revocable trust have been named as the beneficiary). This means, in general, these types of assets are not subject to the probate process. Generally, the assets selected by a grantor for inclusion in a revocable trust would not include these types of assets.
Avoiding probate is generally a good idea if an individual lives in a state that may have a complicated, time-consuming, or an expensive probate process. Other states, however, may have a relatively simple, straightforward, and less costly probate process. These factors and the anticipated amount of an individual's estate are just some of the items to consider when discussing with an attorney whether to establish a revocable trust. If an individual owns real estate in multiple states, a revocable trust may help avoid ancillary probate—a second probate heirs would have to go through for the assets located in another state.
Another consideration, though, is that the probate process is a matter of public record as a result of the court's involvement. If privacy is of concern, the use of a revocable trust may still be warranted.
By establishing a revocable trust, a grantor is making the decision to keep control of his or her assets while providing a plan that will distribute the assets in the trust in a clear and deliberate fashion. A "pour over" will is often done in combination with a revocable trust. This type of will directs any assets that a grantor does not retitle to his or her revocable trust while the grantor is alive to the revocable trust at death. The pour over will does not bypass probate but does provide for a coordinated distribution of any assets that pass through the will which can avoid potential conflicting provisions.
However, by only establishing a revocable trust, the grantor may not address the potential desire to lower any federal or state taxes that the grantor's estate may be exposed to at his or her death.
An irrevocable trust may be a sensible option to increase the amount you leave to your heirs
Deciding when to give up control of one's assets is complicated, and often involves balancing different, and often conflicting, objectives. It is a decision that shouldn’t be entered into lightly, and should be made with the careful guidance of financial and legal professionals, and following conversations with family members, loved ones, and other intended heirs.
The decision to release control may go hand in hand with the decision to fund an irrevocable trust. Once an asset is contributed to an irrevocable trust, it is removed from the grantor's taxable estate and the grantor loses control of it. In other words, the grantor permanently gives away the asset. Therefore, before deciding to fund an irrevocable trust, a grantor must be certain they will not need the asset in the future.
Why gift assets to an irrevocable trust? Generally, people fund irrevocable trusts to try to maximize the amount that is ultimately transferred to heirs and charities, and reduce the amount of potential federal and/or state estate tax paid. This might sound relatively simple to accomplish, especially if the grantor does not need the funds. However, the Internal Revenue Code (IRC) limits taxpayers' ability to give money away. In order to avoid gift taxes (another type of transfer tax), the taxpayer making the gift must ensure that the value of the gift is within certain annual limits, or use part of the taxpayer’s lifetime transfer tax exclusion amount. The IRC permits an individual to gift to any other person (or trust) up to $15,000 ($30,000 if the transferor is a married couple) per year in 2019.1 This is called the "annual exclusion." By gifting the annual exclusion amount to an irrevocable trust, the transferor removes the asset from his or her ownership (estate), which, in turn, lowers any potential federal or state estate tax. Estate taxes are generally computed on the value of assets held by an individual at death. Therefore, if assets are removed from ownership, presumably, the individual will lower one of the factors on which estate taxes will be computed.
Generally, a revocable trust can be changed (or revoked) during a grantor's lifetime, while the ability to change an irrevocable trust depends on state law and the trust provisions, or may need the permission of a court.
If a gift in any one year is made with a value above the annual exclusion amount, it is considered a taxable gift. The IRC further provides each individual with a federal lifetime estate and gift tax exclusion amount (which is $11.4M in 2019).2 In a year when a gift exceeds the annual exclusion, the taxpayer files a gift tax return (IRS Form 709) to inform the IRS how much of the taxpayer’s lifetime exclusion amount is being allocated to protect the gift from transfer tax. Once this lifetime exclusion amount is exhausted, either during life or at death, any gifts above the $11.4M would then be taxed, currently at a maximum rate of 40%.3
A key benefit of gifting either the amount of the annual exclusion or of the lifetime exclusion to an irrevocable trust is that once the assets are removed from an estate, any future appreciation is also removed. This is why funding irrevocable trusts is also called An "estate freeze" technique. The value of the gift is determined as of the time the gift was made and not when the beneficiary actually receives the asset, essentially freezing the account balance from an estate tax standpoint. Keep in mind, however, that even though the appreciation is escaping estate tax, capital gains taxes may still be due. Capital gains taxes may be paid by either the trust or the beneficiaries once the asset is sold.
How "portability" changed the game
A discussion of the lifetime federal estate and gift tax exclusion would be incomplete without addressing the concept of "portability." For legally married couples, portability allows the transfer of all or any remaining portion of the first-to-die spouse's lifetime federal exclusion amount to the surviving spouse. Therefore, if at death, the first-to-die spouse had only used $3,000,000 of his or her lifetime exclusion amount, the surviving spouse would then be able to leverage the remaining $8,400,000, bringing the surviving spouse's lifetime federal estate and gift tax exclusion amount to $19.8M. The total exclusion amount for married couples remains the same ($22.8M). Prior to 2011, this transfer between spouses was not allowed; it was a "use it or lose in" proposition.
There are many types of irrevocable trusts that may be suitable for many different situations and goals There are A/B trusts (also known as marital and credit shelter trusts), GRATs, SLATs, QPRTs, IDGTs, and ILITs, among others. This list is intended to help you navigate the alphabet soup of irrevocable trusts and briefly outlines a handful of the options available, which should be reviewed in detail with your attorney and tax professional.
Which type of trust might be right for you?
As you can see, there are many different types of trusts that may be beneficial depending on your particular circumstances, and this list is not exhaustive; there are many more available. The type of trust you choose will depend on your particular circumstances, as each has benefits and drawbacks. Also, there are many other technical considerations related to these trusts that we did not address. By working with your attorney and your tax professional, you can help ensure that the estate plans you make will help you meet your longterm needs, both for your lifetime and for your estate.
To determine the most effective plan for your estate, you will likely have to decide if you are comfortable letting go of certain assets and control. If you are not comfortable with relinquishing control, then you may be subject to higher estate taxes. If you are comfortable letting go, you will need to plan accordingly to help ensure that you have enough for yourself. Sufficient funds are needed not only to meet your current expenses, but also any unexpected costs you may incur in the future, should your circumstances change. A comprehensive financial plan, which incorporates all aspects of your finances and takes into consideration how your income and expenses may play out over time, can help you make that decision.
Your Fidelity Private Wealth Management team can help you think through these issues and work with your advisors, to help you develop a plan appropriate to your unique circumstances and goals.