When you hear the word trust, you probably think of a revocable living trust that helps your loved ones avoid probate by establishing how your assets will be distributed after your death.
But an entire world of irrevocable trusts serves more specific estate planning needs.
A primary goal of an irrevocable trust is to reduce or eliminate estate taxes. Currently, the IRS estate tax exemption is $13.61 million per person. While this is more than double what it was just over a decade ago, thousands of high net worth families with complex asset portfolios may not be aware of the trust options available to protect their estate.
Estates valued below the IRS exemption limit aren’t subject to federal estate taxes. But if your estate exceeds the exemption threshold, the amount above the limit will be taxed up to 40% depending on the value of the estate.
An irrevocable trust can help you transfer assets from your estate to reduce or eliminate the taxes your beneficiaries must pay.
However, unlike a revocable trust, irrevocable trusts are far more difficult to modify once created. Understanding how the different types of irrevocable trusts work is essential before setting one up.
Before you consider these types of trusts, it’s also important to establish a relationship with a wealth manager you trust. They can work with you to design a full financial plan that incorporates these unique trust opportunities.
Grantor retained annuity trusts or unitrusts allow you to transfer wealth to your heirs tax-free while minimizing the use of your lifetime estate tax exemption. The goal of a GRAT/GRUT is to remove appreciation of assets from your estate and create an income stream for you during retirement. They may be worth considering if:
When you set up a GRAT/GRUT, you transfer assets into the trust. Those assets are used to make annuity payments to you during the term of the trust. The annuity payments return your original contribution plus interest based on a rate of return — known as the hurdle rate — set by the IRS. At the end of the term, the growth on the assets gets passed to your heirs tax-free.
But there are two catches:
However, these catches aren’t a deal breaker as the grantor estate retains all assets and are no worse off than if they had not created the GRAT in the first place. For this reason, they are a favored wealth transfer strategy for those experienced with high-net-worth families like Plancorp.
You might also read in certain places that GRATs create a supplemental income stream during retirement. Although true, for those a GRAT is relevant to (those with estates over the exemption), that is rarely a motivating factor and typically a sign the advisor isn’t attune to the needs of wealth at scale.
If you think donations are tax free and that’s the end of the story or potential to maximize contributions, you’d be mistaken. Charitable Remainder Annuity Trusts or Unitrusts are similar to GRATs/GRUTs, but instead of passing the appreciation on your assets to your heirs, you leave it to charity. These types of trusts help reduce the taxes you would pay and maximize the donation to a cause you care about.
You get a large charitable tax deduction when you set up the trust, and your donation isn’t immediately subject to capital gains tax when sold within the trust. Instead, you get to spread the gain out over multiple years to defer the tax burden.
They may be a good option if:
After transferring assets into the trust, your original contribution amount plus the hurdle rate are used to determine your annuity payments for the term of the trust. After all annuity payments have been made, the remaining assets get donated to charity tax-free — as long as the remaining balance of the trust is at least 10% of its initial value.
Spousal Lifetime Access Trusts help married couples lock in a significant portion of one spouse’s estate tax exemption by moving assets out of their estate and into the trust. You may want to consider a SLAT if:
When you fund a SLAT, you no longer have access to the assets in the trust, but your spouse does. Unlike GRATs/GRUTs and CRATs/CRUTs, SLATs don’t have ongoing payment structures. Your spouse can take distributions from the trust whenever they want — even if you’re still alive.
After your death, the remaining assets in the trust don’t count against your spouse’s estate tax exemption. And the appreciation of the assets is excluded from the value of both spouses’ estates.
A Qualified Personal Residence Trust removes the value of a home from your estate while allowing you to live in it, and allows any appreciation to pass to a beneficiary tax-free. This type of trust might be worth considering if:
When you establish a QPRT, your home is placed in a trust, but you the grantor retain occupancy of the property until the term of the trust expires.
Interesting to note that while the QPRT is in effect, the grantor can deduct the home’s real estate taxes and mortgage interest. Although mortgaged properties are rarely placed within QPRTs, this is worth understanding.
When the term expires, the residence passes to the named beneficiary, and you may no longer claim those deductions and will need to leave the property or enter into a lease agreement with the beneficiary.
You must be alive when the trust expires. Otherwise, the home’s value at the time of your death will be included in your estate, negating a major benefit of the trust.
When you set up an Irrevocable Life Insurance Trust, the death benefit from the policy isn’t included in the value of your estate after your death. An ILIT may be a good option if:
When you establish an ILIT, the trust is the owner of the life insurance policy, and the death benefit gets paid out to the trust. However, if an existing life insurance policy is transferred into the trust, the policy must be in the ILIT for at least three years before you die. Otherwise, the payout from the life insurance policy will be included in the value of your estate.
Tax planning is a critical component of a comprehensive wealth management strategy. Irrevocable trusts can be a powerful estate planning tool to help you reduce the tax liability your family members may face after your death. But they can be complicated, and if you don’t know and monitor the trust requirements closely, you’ll lose out on the benefits it could provide.
A financial advisor can review common types of trusts with you and take a deep dive into your finances to recommend the type(s) that may be best for you. Schedule a consultation today.