By Allison L. Lee
Grantor retained annuity trusts, intentionally defective grantor trusts, spousal lifetime access trusts, oh my! If you overhear two estate planning attorneys at a coffee shop, it would not be unreasonable to think that all clients have estate plans filled with trusts.
In fact, many types of trusts are designed to achieve very specific goals and, thus, are generally relevant for only a small percentage of individuals. That said, if your estate planning needs are relatively simple, it doesn’t mean that a trust cannot benefit you. Below are three types of trusts that have a broader appeal and that you may want to consider when embarking on your own estate planning journey.
Revocable Trust
A revocable trust, also called an RLT, is one of the most flexible types of trust you can make. With an RLT, you can revoke or change your trust at any point during your lifetime as long as you’re competent. For example, you could transfer more assets to your trust, add or remove beneficiaries, or sell trust property.
Many grantors name themselves as the initial trustee of their RLT, which lets them use and control their property while they’re alive and capable. If you choose this route, you should name a successor trustee who will manage your trust after you become incapacitated or pass away. The inherent transfer of the legal ownership of trust assets from the initial trustee to the successor trustee upon incapacitation is a reason why revocable trust planning is often seen as a simple way to plan for one’s disability.
To take full advantage of your revocable trust, you should “fund” or transfer assets to it. Not all assets can or should be transferred to a revocable trust, and those that can be transferred may require different processes. For example, to transfer your brokerage account you will complete a series of paperwork. To transfer your house, on the other hand, it will require a new deed that is then filed in the land records. Items like tangible personal property are generally transferred by a simple assignment instrument.
Once you pass away, your RLT becomes irrevocable, meaning it generally can’t be revoked or changed. At that point, your successor trustee will follow the instructions in your trust document to manage and distribute your trust’s assets. RLTs are especially beneficial in states like California, with a lengthier and more expensive probate process than other states (some of which have adopted more streamlined processes).
RLTs provide flexibility and, if the grantor’s wishes are fairly straightforward, it’s possible to create a revocable living trust with the assistance of self-help online solutions, which makes them a popular planning option. However, assets in a revocable trust are considered part of your taxable estate, which means they are subject to estate taxes when you pass away. Revocable trust assets also aren’t immune to creditor claims and lawsuits against the grantor. This means any debts or legal settlements you owe when you pass away could be taken from the value of your trust. Only what’s left will be distributed to your beneficiaries.
Testamentary Trust
A testamentary trust is a trust that is established in accordance with the instructions contained in a last will and testament. A common example is a trust for a child that outlines when assets will be distributed to them by the nominated trustee, and for what purposes, e.g., commonly their health, education, maintenance, and support, or “HEMS.”
Even for individuals with relatively modest estates, trusts for children can be appealing because they can essentially be designed to function as “built in prenuptial agreements.” That is, assets held in trust for the lifetime of a child are in many cases protected in the event of a failed marriage of the child. That means the child’s inheritance will not be subject to equitable distribution. If protecting trust assets from a beneficiary’s divorce is an important objective, a qualified attorney can employ certain drafting techniques to help increase the likelihood of protection.
Another common example is a pet trust: an arrangement providing for the care and maintenance of your companion animals in the event of your passing.
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Irrevocable Life Insurance Trust (ILIT)
Did you know that the proceeds of your life insurance policy may be subject to estate taxes? For that reason, many people choose to establish an insurance trust, allowing them to remove life insurance proceeds from their taxable estate.
Whether life insurance proceeds are included as part of the taxable estate depends on policy ownership at the time of the insured’s death. In most cases, the insurance trust must be the owner by purchasing the insurance policy and naming the insurance trust as the beneficiary.
If the trust is not drafted prior to application for and purchase of the life insurance policy, it’s still possible to transfer an existing policy to the trust. There are, however, some potential challenges in this second approach: if the insured does not live more than three years after the transfer, they will not have succeeded in removing the life insurance proceeds from their taxable estate.
Creating a life insurance trust that fits your needs is not straightforward. One oft-cited aspect of the ILIT is the presence and design of “Crummey powers” (note: Crummey comes from the name of a famous case Crummey v. Commissioner rather than any play on the word crummy). Crummey powers can allow gifts to the trust, such as the insured’s annual payments of the premiums, to qualify for the federal annual gift tax exclusion. Crummey powers are frequently used in ILITs. A qualified attorney can help walk you through the process of implementing an insurance trust and ensure the integrity of its structure for tax purposes.
To the average person embarking on their estate planning, trusts can seem overwhelming or unnecessary. However, when drafted properly and used appropriately, they can be tremendously helpful in protecting the affairs of an individual and their loved ones.
About the author: Allison L. Lee
Allison L. Lee is the Attorney-at-Law, Director Trusts & Estate Content for FreeWill, a mission-based public benefit corporation that partners with nonprofits to provide a simple, intuitive and efficient platform to create wills and other estate planning documents free of cost. Through its work democratizing access to these tools, FreeWill has helped raise more than $4 billion for charity.