How Should You Leave Your Assets Behind?


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The benefit of lifetime trust planning

When planning your estate, once you decide who is to get what portion of your assets, you then need to consider how to distribute those assets to your loved ones – by giving it to them all at once or using a trust to distribute the assets over time.

A trust is created when the owner of property (the grantor) transfers legal title to an individual (the trustee) who then holds the asset for the benefit of a third person (the beneficiary). For example, a grandfather may give a watch to his son to hold it for his grandson until the grandson reaches a certain age. The son technically owns the watch, but he cannot do what he pleases with it, as it is not his own property. Instead, he is charged with holding it safely until the time he gives it to the grandchild.

Many people leave their assets to their loved ones (e.g., children, siblings, nieces, nephews, friends) after their death as an outright distribution, meaning that the beneficiary gets all the assets at once.

Frequently, people are simply unaware of, or do not give sufficient attention to, the importance of trust planning. Trust planning can be advantageous for the following reasons:

  • To provide a loved one with help in managing money responsibly, and to teach them how to make informed financial decisions
  • To protect assets from potential creditors
  • To shift federal (and possibly state) income to individuals who pay lower tax rates
  • To minimize federal estate tax liability

Help in managing money

Your beneficiary may not be able to handle inheriting a large sum of money at one time. By setting up a trust, you allow your trustee to serve as a fiduciary, making financial decisions in your beneficiary’s best interests.

One crucial part of the trustee’s role is to make distributions of assets to the beneficiaries. Through the trust, you can mandate distributions of funds to your loved ones for needs including education costs, living expenses and other support. In addition, the trust may call for further direct mandatory distributions at set times, such as requiring one-half of the trust to be distributed to the beneficiary at age 30, and the balance at age 35.

Creditor protection

Today, potential creditor claims are an important consideration for everyone who is inheriting assets – especially for:

  • Loved ones with prolonged or permanent disabilities and who receive needs based assistance from local, state or federal agencies (e.g., Medicaid). Beneficiaries who receive an inheritance via a lump sum, rather than through a trust, risk losing their benefits.
  • Those who are spendthrifts
  • Those considering divorce or who have divorced
  • Those who face professional liability concerns due to the nature of their work, including physicians, engineers, attorneys, accountants and financial advisors.

When leaving assets to these individuals upon your death, consider leaving the assets in trust for their benefit rather than granting them the assets outright. The rationale is that the trust, because it is a separate legal entity, can provide some protection from creditors.

Income tax flexibility

If a beneficiary receives assets through an inheritance all at once, they then become responsible for paying taxes for any income those assets generate. By distributing the assets through a trust, you give your heirs options for how they wish to handle that income and the taxes it may create. A trust is a vehicle designed to pass items of income along to another taxpayer – the income beneficiary. To the extent that the income is distributed to the income beneficiary, it is taxed to the beneficiary. To the extent that the income is not distributed, it is taxed to the trust.

For example, assume that Arthur upon his death establishes a trust for the benefit of his daughter, Anne. The trust is initially funded with $100,000 in CDs, $100,000 in individual stock, and $100,000 in inherited IRA assets. Each year these investments will generate income which can include interest, dividends, gains or losses, and required minimum distribution amounts.

If the trust provisions direct the trustee to collect the trust income, and to reinvest that income along with trust principal, then the trust income is “accumulated” and will be taxed at the trust level.

Be aware, though, even seemingly nominal levels of trust income may be subject to high tax rates. Once a trust generates net income above $11,950 in 2013, it must pay federal income tax at the top federal rate. By comparison, individuals are not subject to these highest rates until they generate income above $400,000 if single and $450,000 if married. For this reason, many trustees should continue to review the trust investment portfolios on an ongoing basis and keep tax rates in mind when making investment decisions.

Estate tax efficiencies

Typically, if you leave property at your death to an individual without using a trust, and your beneficiary upon her death then leaves that property outright to her heirs, that property could be exposed twice to federal estate tax. Consider a parent who upon his death leaves $6 million to three children. Since the amount exceeds the parent’s available federal estate tax exclusion amount ($5.25 million for 2013), federal estate tax is owed.

Now assume that the parent’s daughter inherits $1.85 million net of federal estate taxes. Also assume that the daughter is also financially successful, and lives another 25 years after she receives her inheritance. At the time of the daughter’s death, the inherited $1.85 million is valued at $4 million. Also, the daughter’s personal net worth is $3 million. The inherited amount with appreciation ($4 million) and the personal net worth ($3 million) are aggregated for purposes of determining whether federal estate tax is owed. Had the parent placed the inherited amount into a lifetime trust for the daughter’s benefit – rather than distributing it outright to her – the inherited amount would not have been aggregated with the daughter’s other assets at the time of her death, thereby protecting it from federal estate tax. Thus, the inherited amount plus any appreciation could be distributed from the lifetime trust to grandchildren without exposure to a second round of federal estate tax.

To avoid the second round of taxation, some parents elect to leave all, or part, of their assets directly to their grandchildren through a trust instead – especially when their child is already well-off financially as in the previous example. Remember that under current law the federal government allows you to transfer up to $5.25 million with no federal gift tax in 2013 to grandchildren or to more remote descendants such as great-grandchildren. Amounts transferred in excess of this threshold are subject to a generation-skipping tax at a 40% tax rate. Married couples can transfer up to $10.5 million with no federal gift tax in 2013. We view the amount as an opportunity for transferors to use trust planning to shelter their estates from federal estate taxation for generations.

Assignment of generations is typically determined along family lines. For example, a transferor, the transferor’s spouse, and the transferor’s siblings are typically classified as one generation, their children are classified as the next generation, and their grandchildren are classified as two generations below that of the transferor.

Choosing the appropriate trustee

Selecting the appropriate trustee of a lifetime trust is important. The trust administration process can be complicated and the level of individual expertise may vary at each generational level. While each child, grandchild or other individual who is named as the primary trust beneficiary can serve as a trustee of his or her separate trust, it is generally advisable to also name an independent co-trustee to avoid any appearance of a conflict of interest. Oftentimes, the primary beneficiary of the trust will request a distribution of trust principal to provide for health, support, maintenance, or education needs. In such cases, an independent trustee should likely have sole discretion over such decisions because the other trustee (i.e. the child) is benefiting. An independent trustee can add an element of impartiality, which is the hallmark of any trust relationship. This could be important especially if the trust needs to defend against potential challengers in the future, such as creditors.

Next steps

There are many benefits to leaving your assets in a trust. Be sure to include planning how your assets are titled and who you plan to leave those assets to as part of the overall trust planning. Those considering a trust should consult with their advisor to discuss options and next steps.

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