Exploring the Role of Trusts
Many people shy away from considering trusts when it comes to their personal financial planning. The word tends to conjure visions of complex paperwork, hours in a lawyer's office, and ultra-wealthy clients pondering ways to shield their massive wealth.
Trust arrangements, however, are not just for the very wealthy. Regardless of net worth, a trust can play a valuable role in estate planning. And the correct one for your personal situation can help provide for you, your family, or, if you choose, a charitable cause.
An overview of trustsA trust is a legal agreement in which you, as the creator (or grantor) of the trust, assign control of your property and assets to a trustee (who can also be yourself to retain control) that manages them for the trust's beneficiaries. Trusts are also used as a way to bypass probate, the sometimes lengthy legal process where a court assesses your final property and determines the validity of your will.
A trust can take one of two forms: revocable, which means you can change the arrangement's terms later, or irrevocable, which means you cannot.
As personal financial planning and estate planning needs have grown, so have the variety of trusts: inter vivos or living, testamentary, A-B, QTIP, legacy, dynasty, and various charitable trust options. Some arrangements are known as split-interest trusts, which provide tax benefits to the trust grantor and make distributions to both charitable and noncharitable beneficiaries.
Action Idea: In choosing a trust, decide who you want to receive income distributions first—your noncharitable beneficiaries or a qualified charitable organization.
Tax laws differentiate split-interest trusts depending upon how and when the trust makes distributions. The two most common grantor-established trusts are:
- Charitable remainder trust—This trust pays a fixed dollar amount or a percentage of its assets annually to one or more noncharitable beneficiaries. These payments may be for a specified number of years or for the life of the beneficiary. When the payments end, the remaining interest is transferred to one or more charitable organizations.
- Charitable lead trust—This trust makes a series of payments—fixed dollar amount or percentage of assets—to a charitable beneficiary for a period, after which the remaining assets are transferred to a noncharitable beneficiary.
Keep in mind: The payments noted are made directly to the charitable beneficiary. This option is most appropriate for individuals with large estates who do not plan to rely on the earnings of these assets for income.
The charitable remainder trust (CRT) has become quite popular over the last few years. The IRS reports that the number of tax returns filed by these entities showed a marked increase, especially in the 1990s when the stock market experienced unprecedented growth. In an effort to shelter their earnings from taxes, many investors turned to CRTs.
Basically, you place your assets in a CRT and the trustee sells them to create an investment fund that pays you income for a designated period of time. How the payment is made depends on the trust's structure. It can be either a charitable remainder annuity trust or a charitable remainder unitrust.
An annuity trust pays its noncharitable beneficiaries a fixed amount each year determined when the trust is established. The payment amount is based on the value of the assets initially placed in the trust. A unitrust arrangement distributes a percentage of its assets' fair market value to its noncharitable beneficiaries each year.
In both cases, when the trust terminates, remaining assets go to the selected charitable beneficiary.
In establishing a CRT, you transfer assets irrevocably into the trust and name your beneficiaries, who then may receive payments either over their lifetime (if individuals) or for a period not to exceed 20 years. When the payment period ends, the remaining assets go to your chosen charitable organization.
Charitable remainder trusts offer several tax benefits:
- You get a tax deduction when you establish the trust. If the gift is large enough to exceed donation limits, you can carry the additional amount forward for tax deductions in the next five years as discussed earlier in the IRS limitations section.
- When appreciated assets are donated to the trust, you can defer paying taxes on the unrealized capital gains until the trust sells the asset.
- At death, your estate may be eligible for a charitable deduction.
A charitable lead trust (CLT) is basically the reverse of a CRT. Distributions go first to a charitable beneficiary, with the remaining assets at the end of a specific term then going to your other beneficiaries.
Keep in mind: This option is most appropriate for individuals with large estates who do not plan to rely on the earnings of these assets for income.
Action Idea: Charitable lead trusts are usually more tax advantageous for your family if you have gift, generation skipping, or estate tax concerns.
Which charitable trust you choose depends upon your current personal financial needs, those of your family now as well as after you are gone, and what kind of benefits you want to provide to your favorite charity.
