Trusts originally served four primary purposes. (Yes, there are others, but these, historically, have been the big four)
Avoiding probate. Probate is seen as a “big, long, expensive, painful” process. It takes court filings, hearings, money, etc. General consensus has been to put all of a person’s assets into a trust or have a pour-over will that moves things to a trust when the person dies to avoid probate.
Depending on the state where someone lives, this may or may not still be valid. I don’t know the probate process in all of the states. (I’ve only probated wills in two states). In Texas, this concern is over-blown. The process of probating a will is not that expensive. If an estate is too small for a normal probate process, there’s even something called the “small estate affidavit” that allows heirs to “skip” most of the formal probate process. I personally think, in Texas anyway, the use of a revocable/pour-over trust for purposes of avoiding probate is unnecessary;
Avoiding taxes. Depending on the year, the estate tax exemption has ranged from $0 to $11m for couples and everything in between. This means if someone had as little as $500,000 (which I realize for a lot of people is a TON of money, but there are millions of people that have more than that in this country), that person’s heirs could (again depending on the year), find the government taking upwards of 33% and 40% of that when they inherit. This is particularly problematic if a large amount of real property (land) is included in the inheritance because that isn’t particularly liquid.
What happens when there is family property? For example, should a family own a ranch worth $5m. When parents die, the children inheriting the ranch will have to either come up with $2m cash or sell the property to pay the 40% tax. The other option would be for the parents to setup trusts to transfer outside of estate taxes years ahead of their demise. (It is more complicated than that, but that is the general premise).
Since the estate tax exemption is currently around $11m for couples, this is much less of a problem today than it was in the past. Of course, there are democratic candidates calling for the elimination of the exemption and taxing estates at 100%…so this could go back the other way. I refer to the constant changing of the estate laws as the “Estate Lawyer Employment Acts.” You should have seen the mad scramble at the end of 2012 when there was a chance the exemption was going to $0 (didn’t happen);
Protecting Minors. For parents who have a lot of money or who may have life insurance policies with large payouts, upon their deaths, they don’t necessarily want their 12-year-olds to have a million dollars at their disposals. A trust continues to be a good way to help manage the funds until any children are old enough to manage the funds independently.
- Liability Protection. If a person moves assets to an irrevocable trust in which that the person is not the named trustee, the assets can be shielded from liability. Meaning if I have the right to income and “expenses to maintain my standard of living” but NOT the right to actually control the trust, and I get sued for $10m, that trust, if setup correctly and in advance, might protect against that judgment or from creditors. This is still a legitimate use of trusts, but I personally prefer investment companies, particularly in Texas with how strong the corporate liability shields are and/or the difficulty (if not impossibility now) of piercing the corporate veil in the state.
Of course, there are some MAJOR disadvantages to passing assets via a trust:
No step-up in basis. To me, this is the number one reason to be cautious about using trusts (living trusts aside). A step up in basis means the heirs don’t have to pay capital gains tax. So if a trust includes stock ABC that was bought at $100,000 for $1 per share that is now worth $10 per share (so $1m total), without a step-up in basis, that’s a $900,000 capital gain the heirs will have to pay in taxes. If you get a step-up in basis, you don’t have to pay that tax;
Tax inefficiencies. During the lifetime of the trust creator, trusts are tax inefficient, particularly irrevocable trusts. LLC’s, if you have real estate, tend to be a much better vehicle from a tax rate perspective. Why put something into a trust that’s going to get taxed at over 33%, when if it is put into an LLC, the tax rate will be lower on the property. (TALK TO YOUR ACCOUNTANT/LAWYER ABOUT THIS AND WHETHER IT ACTUALLY HELPS IN YOUR SITUATION);
- PODs. For many assets, it’s just as easy to pass them via a POD (payable on death)/beneficiary designation. IRAs, bank accounts, insurance, brokerage accounts, etc, all allow holders to designate beneficiaries upon death. This happens as soon as upon death — no need for probate, trusts or anything else. MOST assets can be passed this way, which eliminates the need for paying for a trust).
The answer to the question “Are trusts the best way to leave money to heirs” is “it depends.” Why are you using one? What state do you live in? How much do you have in assets? What KIND of assets are they (real property, cash, stocks?); How old are you? How much life insurance do you have? Do you have kids or young heirs? Do you care what your heirs do with the money?
No matter what people decide for dispersal of wealth after death, it is better to make these plans when young, than when on death’s doorway. Doing it later in life removes options. Trusts aren’t as necessary as they used to be — which doesn’t mean they aren’t necessary — it just means people need to have discussions with their attorneys and advisors.
Christopher Welsh is a licensed investment advisor and president of Lorintine Capital, LP., LP. He provides investment advice to clients all over the United States and around the world. Christopher has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Christopher has a J.D. from the SMU Dedman School of Law, a Bachelor of Science in Computer Science, and a Bachelor of Science in Economics. Christopher is a regular contributor to the Steady Options Anchor Trades and and Lorintine CapitalBlog.