Updated July 2014 — Certainly your will is an important vehicle to distribute property among your heirs and beneficiaries, but trusts also can play a key role in your wealth transfer plan. Planned well, trusts have the potential to help minimize estate tax and can help smooth the way for your executor to settle your estate.
Types of trusts
Simply put, a trust is a contract between a grantor, a trustee and a beneficiary. Trusts can be either revocable, which means the terms can be modified, or irrevocable, which means that the terms cannot be modified. However, keep in mind that most states now have laws that allow irrevocable trusts to be changed if all parties agree, so the guidelines may not be quite as clear as the names suggest.
Trusts also can be categorized another way, says Christopher Cline, Senior Vice President and Senior Regional Fiduciary Manager with Wells Fargo Private Bank: as living trusts that are created during the grantor’s lifetime, or testamentary trusts that are created after death.
Revocable trusts are almost always living trusts while irrevocable trusts are generally testamentary — and there’s no overlap of the categories. “They serve completely different purposes, and there is almost no relationship between them,” Cline says.
So what are some purposes of revocable and irrevocable trusts?
Revocable living trusts
There are two reasons to create a revocable trust, according to Cline:
- To help avoid probate, a potentially expensive and lengthy process. A revocable living trust may serve as a substitute for a will.
- To designate someone to manage the grantor's assets in case of incapacity.
Among those who may consider revocable trusts as appropriate choices for their situation are the elderly or people facing life-threatening illness at any age.
Keep in mind that revocable trusts must be kept funded to be viable: The grantor transfers all current assets to the trustee, as well as assets acquired in the future. “If not transferred, the assets that aren’t in the trustee’s name will have to go through probate,” Cline says.
An irrevocable trust is generally created for the purpose of helping to protect assets from potential circumstances that could reduce their value or impact, Cline says. Potential pitfalls that could impact the assets include:
- Gift or estate taxes: Say you want to give your spouse $5,430,000 (the exemption limit for 2015) — an irrevocable trust could help protect that gift from taxes. “If you put the funds in a trust for the spouse’s benefit, your husband or wife would still have access, but this action helps to avoid taxes at your death by applying your exemption, and the sum is not includable in the spouse’s estate when he or she dies.” This is called a shelter trust. Long-term irrevocable trusts for your children can also create tax savings, Cline says. “A trust set up today with $5.43 million could grow to be much larger by the time the grantor dies. That keeps future appreciation out of the estate by doing that during the grantor’s lifetime.”
- Dueling beneficiaries: If you see potential conflict — maybe between a spouse and children from a previous marriage — an irrevocable trust can help keep each party’s interests separate, thereby minimizing discord.
- Unplanned claimants to funds: “Maybe you trust your child to manage the money, but if that child ever divorced, the property could wind up in the hands of an ex-spouse,” Cline says. An irrevocable trust can help prevent that.
- Poor or inexperienced decision-making: Setting up a trust for younger children could help protect their best interests if the grantor dies while the beneficiaries are still minors. This type of protection also could apply to meeting the future needs of beneficiaries who are incapacitated.
Cline encourages clients to ask plenty of questions when deciding if a trust is appropriate for their situation, and to be sure they fully understand the agreement into which they are entering. If they don’t, or they have remaining concerns, the advisor’s work is not done. “Our whole goal as advisors is to help people sleep better at night,” Cline says. “If they’re not sleeping better because they don’t understand a trust that is supposed to benefit them – either as a beneficiary or a grantor – you’re not helping them.”