Although many Americans are familiar with the broad concept of a trust, there are numerous misconceptions about what they are, who they're for, and the benefits they can - and cannot - provide. One of the most common misconceptions about trusts is that they are only a tool for the ultra-wealthy. This is quite simply incorrect. Trusts can be established to achieve a variety of goals, and although some trusts are quite complex, the majority are likely used for pragmatic "everyday" estate planning. Before dismissing a trust as a potential solution to meet your goals, find out if you fell into one of our common misconceptions about trusts below.
Important disclosure: The material in this article is intended to provide generalized information only as to some of the financial planning considerations regarding trusts and should not be misconstrued as the rendering of personalized legal or tax advice. We strongly recommend you consult an attorney to discuss your personal situation and estate planning needs.
Misconception #1: Trusts are only for high net worth individuals
We'll leave the definition of high net worth open to interpretation, but trusts can be set up to serve a variety of purposes and aren't only for the "super rich." Perhaps the most common type of trust is a living or revocable trust. As the name implies, the revocable trust can be modified, dissolved, rescinded, and so on during your lifetime as the grantor of the trust.
Establishing a trust provides the benefit of naming a trustee. A trustee is responsible for managing the assets in the trust and satisfying the wishes of the grantor as outlined in the trust document. When the grantor is also the trustee, which is common in living trusts, successor trustees are named to step in after death or incapacitation.
Why set up a living trust? There are quite a few reasons, depending on your goals. Here are a couple of examples of how trusts are commonly used in estate planning:
- When you have young children: If you (or you and a partner) have young kids, a living trust can help ensure your children are provided for in the event that you pass while they're still minors. The trust can allow you to specify how they should receive the funds, when, and even for what purpose. Without a trust, you lose control over how your children may be provided for. Even if you have siblings or other family members in the picture, money complicates things and they may need to prioritize their own families or financial issues.
- When you have multiple beneficiaries: A beneficiary is the individual(s) who are designated to ultimately receive all or a portion of the assets in the trust. If you have multiple assets (e.g. home, collectible, cash, stocks), a trust could be the easiest (or only) way to ensure who-gets-what. A trust can also help avoid family disputes as there is a very clear record of your wishes.
Misconception #2: Trusts are too expensive to set up and maintain
Although this is a subjective measure, for many high-earning, high-saving individuals, the costs to set up and maintain a trust will be less than the cost of probate court, which is a legal process where certain assets in your estate are distributed by the court. The probate process can take a few months or even a year and some estimates place the costs of probate at 3% - 7% of the value of the estate.
Each state will have its own rules regarding trusts, so it is important to work with an attorney in your state to set up a trust. Generally, a complete estate planning package will cost a few thousand dollars depending on your location and the complexity of your situation. During your life, there are generally no additional costs associated with the trust (unless you move and need to work with another attorney to modify the terms).
When you die, a revocable trust becomes irrevocable and it typically cannot be changed. At this point, there will be costs associated with the ongoing management and administration of the trust. Those expenses, often paid out of trust assets, will depend on a number of factors, such as the complexity of the trust and who you have chosen as trustee and trust administrator. Common costs include: administration costs, investment management fees, tax preparation, and attorney fees.
Misconception #3: You no longer control assets held in a trust
With a revocable or living trust, you maintain full control over trust assets during your lifetime. However, if you use a irrevocable trust, then it is true that you no longer control assets held in the trust. So why would someone want to use an irrevocable trust? Generally, irrevocable trusts are used to accomplish asset protection or tax mitigation goals.
Assets in a revocable trust may not be protected from creditors or lawsuits because the terms of the trust can be modified at any time during your lifetime. If properly set up, irrevocable trusts may be able to shield certain assets from creditors or judgments. Keep in mind, like most estate planning issues, credit protections vary by state and you should always work with an estate planning attorney to understand your options.
Other instances where irrevocable trusts are used: to help qualify for government programs (like Medicaid) or to minimize estate taxes (federal or state) on the proceeds of a life insurance policy.
It is worth noting that these strategies are not only quite complex, but they may not end up working as intended. Legislation impacting the tax code, estate tax, healthcare, and entitlement programs are not within your control and may be subject to change at any time.
Misconception #4: Trusts are only for cash or financial securities
Trusts can be set up to hold a variety of assets, such as real estate, art, and privately held interests in a business. The primary benefit of putting an asset in a revocable trust is to remove the asset from your probate estate and to help ensure the assets are distributed according to your wishes. A revocable trust does not provide creditor protection or remove an asset from your taxable estate at death.
Accordingly, to avoid the costly and lengthy probate process at death, individuals may choose to put their home in a living trust. Leaving real estate assets to a spouse or children in a will causes those assets to pass through probate. This becomes especially important if you own real estate in multiple states as each state will have its own probate proceedings which can be costly, time-consuming, and also completely avoidable.
Although there are many other factors to consider when developing an estate plan for a small business, a living trust may be a solution for some business owners. Keeping a small business running during probate may end up being an impossible task. Depending on how a privately held business is set up (LLC, partnership, etc.) and the succession plan for the company and among the other relevant stakeholders, transferring the assets to be held in the name of the trust may be one solution.
Misconception #5: After I set up a trust, my assets will automatically flow as planned
This is a bit of a tricky one. In theory, this is true, as the whole point of setting up a trust is so your assets will ultimately flow as outlined in the trust document. However, this is not automatic and you must be careful not to inadvertently contradict the terms of the trust.
To establish a living trust, you will work with an attorney as previously discussed. However, once the trust is set up, it also needs to be funded in order for the assets to actually flow as directed. Typically, funding the trust by retitling assets in the name of the trust is outside the scope of standard attorney agreements. If you are working with a financial advisor, you will likely have the benefit of their oversight and assistance to help ensure this is done properly. If you're managing your own investments, you will want to make close attention to make sure you're doing this step properly.
One of the biggest mistakes investors make with trusts is forgetting to actually fund it and retitle assets in the name of the trust after it is set up. Forgetting to retitle your assets typically means they will be included in your probate estate instead of your trust.
Another way individuals can inadvertently derail their estate plan is by making contradictory beneficiary designations. Here's an example of one way this could happen:
Husband and wife both name each other as primary beneficiary (100%) on their IRA accounts. They set up a living trust to benefit their children and name the trust as 100% contingent beneficiary. The husband inadvertently checks the "per stirpes" box when naming his wife as his primary beneficiary. In this instance, if the wife were to predecease the husband, then when the wife died the remaining IRA would flow directly to their "lineal decedents" and bypass the trust. Although the funds would still go to the children, all of the provisions of the trust including distribution terms, successor trustee, and so on would never apply because the assets have passed outside of the trust.
Misconception #6: I don't need a trust if I have a will
Having a will in place is a great first step into estate planning. However, having a will does not mean assets will avoid probate. Further, wills can be contested and they provide much less assurance that what you want to happen actually will. Generally, unless you want to make an outright bequest or distribution to an individual, and you don't have much opinion on how that asset should be consumed afterwards, a will alone may be enough to meet your needs.
However, there are a number of situations where a will does not provide enough control for the grantor. Although not an exhaustive list, here are some of those circumstances:
- Assets going to children
- Family dynamics: perhaps you or your adult children have previous marriages or children from previous marriages
- History of mental illness or substance abuse
- Real property that you wish to be retained or used for a specific purpose
While you can specify your wishes in a will, there isn't necessarily a mechanism to ensure your requests are upheld over time.
Misconception #7: It is generally a good idea to name a family member or friend as a trustee
People often name relatives or immediate family members as executor of their estate and trustees on a trust. For a number of reasons, having family members and/or beneficiaries also serving as trustee can strain family dynamics and is not typically advisable. Acting as trustee or executor can be a significant amount of work and there are legal implications if certain functions are handled improperly.
Consider appointing an independent third party or corporate trustee to manage the assets and execute the wishes of the grantor. By alleviating family members of this burden and assigning a "neutral" party to act as trustee, it significantly reduces any potential in-fighting about perceived improprieties regarding the distribution of assets amongst the beneficiaries or other family members.
Misconception #8: Trusts can only be set up to benefit a family member
Trusts can be set up to benefit a charity, business organization, or even a pet. A pet trust is a type of trust fund designed to pay for the care of your animal after you pass away, as some of your assets will go to fund the pet trust. The trustee managing your pet trust will make payments every year to the caregiver of your pets to cover the expenses. Again, you'll need to work with an estate planning attorney to include provisions for your pets.
Final thoughts on trusts
Trusts can be powerful tools that you can use during your lifetime and after to accomplish a wide range of goals. As evidenced by the length of this generalized discussion, trusts are complex instruments that require professional support to be properly drafted and implemented. Although Darrow Wealth Management is a financial advisory firm and does not provide personalized legal or tax advice, we often work in conjunction with our clients' team of legal and tax professionals in various stages of strategy development and execution.