Creating a Tax-Beating Trust

Should you set up a trust? Maybe you've been to a seminar where they scare the life out of you, convincing you to start one. Let’s demystify this murky but very important area.
 
Trusts are legal arrangements that give control of assets to a person or an institution (the trustee) for the benefit of others, such as children. Trusts can save on taxes, ease inheritance squabbles and ensure that beneficiaries are treated fairly and according to your wishes.
 
Let’s examine some uses of trusts:
 
To Minimize Inheritance Taxes.  Some call them “death taxes,” but that term has acquired a political tinge, so we’ll try to avoid upsetting partisan sensibilities. This year, you have to own at least $5 million in total assets -- including your house, your cars, brokerage accounts, individual retirement accounts, 401(k)s and life insurance -- before the tax kicks in. Taxes are typically due upon the second spouse’s passing, not the first to die. 
 
Above $5 million, without proper estate planning and a trust, you pay 35% to the feds. A way around this is to set up a credit shelter bypass (or A/B) trust. Here, you split your assets between yourself and your spouse, thereby doubling the $5 million exemption amount to $10 million. 
 
Most people don’t have $5 million in assets, so they don’t have to worry about this tax, right? Sorry. If no legislation is passed by year-end, the tax exemption drops to a mere $1 million. Plus, everything over $1 million is taxed at 55%. 
 
Maybe you have less than $1 million and think your estate is in the clear. Wrong. Your state may tax your estate below $1 million. For instance, in the beautiful state of Ohio, we have an estate tax that charges 6% on all assets between $338,333 and $500,000, and then 7% death tax on everything over that half-million.
 
I believe the government should fix the exemption amount at $3.5 to $5 million or so, and then adjust it for inflation, including energy and food. Congress has had trouble dealing with this issue. Due to lawmakers’ squabbling, the federal estate tax expired in 2010. If you were going to die, 2010 was the year to do it. 
 
To avoid probate. That’s a court that rules on inheritance questions if your wishes are not clear. If you don’t have a trust or a valid will, anything you own that doesn’t have a specific beneficiary designation goes through probate. Probate can be very time-consuming and emotionally draining. If your estate includes property held outside the state of residence, it may have to go through probate there as well. If the property is outside the U.S., the situation is even more complicated.
 
Probate can be pretty expensive. Attorneys have the right to charge either a flat percentage rate, based on the value of your total estate, or they can charge “reasonable compensation,” which is debatable, but typically not negotiable.
 

To Keep Your Family Finances Private. If you don’t have an estate plan properly executed by your death, your whole financial life can be public record, available to the masses. Yeah, you don’t even have to drive to the courthouse to snoop through someone’s estate.  In many places, it’s available online these days.

To Look After Disabled, Young or Irresponsible Children. Having a trust makes a ton of sense if you have a child with disabilities who can’t take care of himself. Or maybe we don’t want him showing assets on paper. Also, if your estate passes to a minor, when the kids turns 18, she gets a big, whopping check for the whole thing at once. If I were a dead man, I wouldn’t want my son getting my entire estate at 18. 
 
You can set up anything from basic to very creative trusts in order to protect children from themselves. For instance, I have a trust in which my son would get a third of our estate at 28, a third at 34 and the last third at 38. This way, the trust gives him financial support for what he absolutely needs. But he still has to go out, get an education, start a career and learn the value of a dollar. 
 
There are other, more complicated trusts you can put together. We have a client who has what I call an “incentive-based trust.” His daughter has never held down a job for longer than a few months – and she’s 30. The daughter thinks she’s going to hit the Mega Millions at her parents’ death. But the trust is set up so that she must prove (via W-2s) that she made $10,000 to take 1% out of the trust; $20,000 to take 2% out; $30,000 to take 3%, and so on.
 
To Avoid Problems Surrounding Divorced and Remarriage. Trusts are especially helpful if you and your second spouse both have kids. Trusts ensure that your estate is handled by the person you want, and that the money is given to whom you want, when you want.
 
My firm has as clients a couple with a trust that, upon the husband’s passing, gives his kids 20% of the estate immediately, and then puts the rest into a trust to benefit his wife until her death. When she’s gone, the remainder goes to the kids. She has a separate trust that grants 20% to her daughters right away, 80% to him while he’s alive, and then the remainder to her daughters at his passing. 
 
To Give to Charity and Help Your Family. Through proper, creative planning, you can set up a charitable trust that will: Give money to your kids, increase tax deductions, reduce taxable income while you’re living, eliminate capital gains and dividends taxation, and then give a bunch of coin to charity at your demise – all at once. 
 
A charitable trust pays no tax. So if you have any assets that have appreciated in value, and you put them into this trust, you get a tax deduction right off the top. Then, when you sell the asset inside the trust, you pay no capital gains tax. You retain control here, and you still benefit from the income in the trust.
 
The next step is to use a portion of the income from the trust to buy a second-to-die life insurance policy on you and your spouse’s life. You put that policy into a different kind of trust, called an irrevocable life insurance trust (or ILIT). When you die, the government can’t put its sticky hands on the policy. 
 
Once the policy is paid up, you can increase your income again if you want, since you won’t have to pay insurance premiums any longer. Then, when you and your spouse are gone, the money in the charitable trust goes to the charities you chose, your kids collect a tax-free death benefit from the policy in the life insurance trust, and you collected a bunch of tax-free income along the way.
 
If you have questions about trusts, give your financial advisor or your estate planning attorney a call. 
 
Adam D. Koos, CFP, is founder and president of Libertas Wealth Management Group in Columbus, Ohio.
 
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  All performance referenced is historical and is no guarantee of future results.  All indexes are unmanaged and may not be invested into directly.
 
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