Six ways they can be used.
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Danny Lohrfink is the co-founder and chief product officer of Wealth.com. Previously, he was business lead of SoFi’s wealth management division, SoFi Invest, and held several roles at Goldman Sachs Private Wealth Management, including VP on the PWM Management team. |
By Danny Lohrfink
The Holistic Guide to Wealth Management
Contrary to popular belief, a person’s net worth is not the only – or most important – factor when deciding if a trust is appropriate for them. After all a trust is simply an agreement between someone who owns an asset and a trusted person whom they choose to hold and manage that asset for them.
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This common misconception that trusts are only for the wealthy has long prevailed as a leading narrative because of the historically high costs associated with establishing and managing a trust. These costs presented a barrier for many individuals who lacked the financial resources to hire an expensive estate planning attorney. The result was that only the wealthy had these vehicles because they were the only people who could afford them.
The tide is changing, however, as the estate planning industry shifts into a new era that is being defined by broadscale digital adoption and modernization. This includes the development of advanced legal technologies (some even incorporating artificial intelligence), and the rise of alternative legal service providers that are being directly integrated into the tech stacks, and service offerings, of CPAs and financial advisors. As a direct result of these innovations, high-quality trusts have become more affordable and accessible to a greater range of clients.
Of course, the decision to establish a trust should be based on a variety of factors beyond just cost, including a client’s financial goals, estate planning objectives, family dynamics and personal preferences. Each of these factors exists independently of net worth. Let us now take a closer look at the criteria:
- Estate Planning Goals. Trusts are often used to facilitate the efficient transfer of assets upon one’s death quickly and efficiently, without needing a court’s approval. If your primary goal is to control how your client’s assets are distributed and to ensure that their beneficiaries are taken care of without the delays that accompany a court’s involvement, a trust is often the best option.
- Emergency Planning. A trust can also help people prepare for emergencies while they are still alive. A trust will name a trustee who can act when your client is no longer able during your client’s lifetime in addition to after your client’s death. That means that assets held by the trust, such as a family business or home, can promptly be managed by someone your client trusts, even if they lose capacity.
- Asset Protection. Certain types of trusts can shield assets from creditors and lawsuits. This can be important for business owners and professionals, or simply to protect a spouse or child’s inheritance.
- Complex Family Situations. Trusts can be especially useful in complex family situations, such as blended families, where your client may want to provide for both a spouse and children from a previous marriage.
- Tax Planning. In addition to potential federal and state estate taxes, there are often death tax and income tax considerations when administering an estate. For individuals with a high net worth, a trust can play an essential role in minimizing estate taxes. However, even those with more modest assets should preserve the option of creating trusts that minimize their potential estate and income tax liabilities. States with estate taxes usually have much lower thresholds (“exemption amounts”) before the estate becomes taxable, and even at the federal level, the exemption amount has historically been as low as $350,000.
- Privacy and Control. When a person dies with an estate plan that’s designed around a will, that will must be publicly filed with a probate court in order for a judge to oversee the probate and authorize the estate administration. In contrast, many trusts are private documents that offer control over financial affairs and estate succession, without sacrificing privacy from the public.
As you can see, a trust is a tool that can adapt to your client’s evolving needs during their lives and its value goes beyond a specific financial threshold. Whether a person has substantial wealth or modest assets, a trust can play a vital role in securing their financial future and ensuring that their wishes are fulfilled. And it accomplishes all this while reducing the eventual burden on their loved ones. But the conversation does not end there. It’s important to recognize that trusts come in various forms, each serving distinct purposes and accomplishing different objectives. One of the most common distinctions is the difference between revocable and irrevocable trusts. The choice of trusts should align with your client’s goals and circumstances. Working with an estate planning professional or a quality outsourced service provider can help guide you and your client to the best option for accomplishing their objectives.
Characteristics of a Trust
In simplest terms, a revocable trust can be revoked (i.e., undone), whereas an irrevocable trust is generally intended to be permanent and cannot be revoked without involving the beneficiaries or an independent fiduciary. A revocable trust is often used as a substitute for a will and outlines the trust creator’s wishes for what happens to the trust property (the assets owned by the trust) if the creator can no longer manage that property because of death or disability. An irrevocable trust can be created to serve many purposes, from asset protection to tax planning.
But there are many other factors to consider when creating a trust besides making it changeable or permanent. Your client must decide whether to make their trust joint or individual, lifetime (inter vivos) or testamentary and grantor or non-grantor, among others. It can be disorienting when trying to determine what’s best for your client’s situation. However, once you understand which feature of a trust is being described, and what the point of comparison is, it becomes much easier to understand each type of trust’s purpose and use case.
This table below should help you determine which structure is best for each client’s situation:
Every term describes a different aspect of a trust, and the terms are not mutually exclusive. In fact, every trust can be described by using one of the two choices from each category above. For example, if you use a trust as a substitute for a will in your foundational estate plan, you likely created a revocable, individual, inter vivos, grantor trust (commonly shortened to “revocable trust”). If you have a will that creates a marital trust when you die, that marital trust will be an irrevocable, individual, testamentary, non-grantor trust. Unpacking each of these terms shows how various trust types can accomplish certain objectives in an estate plan.
Revocable vs. Irrevocable Trusts
The revocable trust, as the name implies, can be undone or unwound. The person who creates the revocable trust can simply “revoke” or “pull back” the trust. The irrevocable trust, by contrast, is much harder to change.
The revocable trust is often used as an alternative for a will. It can also be used as an alternative to other vehicles for asset ownership, such as an LLC or corporation, to own an asset more privately while the asset owner is still alive.
The irrevocable trust is often used to give away assets while maintaining control over how the assets are used, or to protect from specific types of taxes or creditors.
Given that most people’s introduction to trusts occurs when they first start deciding between making a will or a trust, the type of trust your client is likely considering is a revocable trust. Just as you would be able to change or completely revoke a will (in most states, all it takes is tearing up the original document!), you should be able to change or completely revoke your revocable trust. For a core estate plan, this provides important flexibility because you could change your mind over the course of your life about key terms, such as who should serve as trustee or get what assets. While you are alive and have mental capacity, you can easily change or revoke your revocable trust by signing a new trust document or by making an amendment to your existing document.
An irrevocable trust is much harder to change, and it becomes especially difficult to remove or add beneficiaries or modify their individual rights. In most states, once an irrevocable trust is established, an independent trustee must be appointed (if the trust allows for it), or the agreement of all beneficiaries, or a formal court proceeding. Each of these options may be expensive and may require an attorney’s involvement to be modified correctly. For this reason, you and your client must be clear about the powers and benefits they are giving up when they transfer property into an irrevocable trust.
Irrevocable trusts are powerful vehicles for wealth transfer and preservation because they allow the creator to control how their assets will be used, even after the creator’s death. When properly structured, irrevocable trusts provide protection against death taxes and creditors – something revocable trusts cannot do. In essence, when establishing an irrevocable trust, you are creating a new entity that is viewed as wholly distinct and independent from the individual who created it, for both legal ownership, tax and credit protection purposes.
One commonly utilized irrevocable trust is the irrevocable life insurance trust (“ILIT”). The ILIT is a specific type of irrevocable trust used to hold life insurance policies. One of the primary reasons for establishing an ILIT is to mitigate estate taxes by keeping the death benefits outside the policy owner’s taxable estate.
Without an ILIT, the death benefits from a life insurance policy on the owner’s life will be included in the estate that the IRS considers taxable. As of mid-2024, the taxable estate of the owner must exceed $13.61 million (unmarried individual) or $27.22 million (married couple) for the federal estate tax of 40 percent to apply. Thus, if the death benefits from the insurance policy are large enough, or the policy owner is already wealthy enough, those benefits will be subject to the estate tax, and any dollar above $12.92 million will incur a 40 percent tax. To keep the death benefits from counting toward the taxable estate, the owner can hold the policies inside an ILIT instead of in their own name.
When setting up an ILIT, the trust creator (”trustor”) establishes the trust and names the trust as the owner of the life insurance policy on their life. The trustor then gifts or transfers funds to the ILIT to cover the life insurance premiums. The trustee of the ILIT, in turn, uses these funds to pay the premiums. When the trustor passes away, the life insurance policy pays out a death benefit to the ILIT. Because the ILIT is irrevocable and legally viewed as a “separate entity” outside the trustor’s taxable estate, the death benefit is not included in the trustor’s “taxable estate.” This helps to reduce the overall value of the taxable estate for the IRS’ estate tax calculation purposes.
For example, say the trustor died in 2023 with a policy that pays a $3 million death benefit, and their taxable estate, including the death benefit of the policy, was $14.92 million (i.e., $2 million in excess of the federal exemption threshold of $12.92 million). By utilizing the ILIT as the recipient of the death benefit, the trustor’s taxable estate is considered to be only $11.92 million – under the taxable threshold – and the estate avoids the 40 percent federal estate tax on the $2 million overage, saving $800,000 for the heirs.
Importantly, the ILIT can specify how the insurance proceeds are then distributed to beneficiaries, typically without subjecting the beneficiaries to income taxes.
Individual vs. Joint Trusts
An individual trust has a single creator (called a “trustor,” “grantor” or “settlor”), whereas a joint trust has two or more trustors.
It is important to consider the pros and cons of creating a trust with someone else. The most common reason to set up a joint trust is to ensure that all assets are shared equally between spouses. A joint trust might make sense if your client already shares in the ownership and management of all assets (e.g., they live in a community property state), file income taxes together, and share similar values, goals and beneficiaries.
Joint Revocable Trust: Real World Example
Michael and Shauna are a married couple in their 60s with three adult children. They have accumulated substantial assets, including a home, investment accounts, and various personal possessions. They own most of their assets jointly and file their income taxes as “married, filing jointly.” They want to ensure that their assets are efficiently managed during their lifetime, and they want to simplify the transfer of their assets to their children after their passing. By and large, they are aligned about who their beneficiaries are.
By creating a joint revocable trust, Michael and Shauna can place their assets into the trust during their lifetime. When one of them passes away, the assets in the trust can transfer seamlessly to the surviving spouse without going through the probate process. Probate can be time-consuming, expensive and a matter of public record, so avoiding it can help maintain privacy and reduce costs.
A joint revocable trust also allows Michael and Shauna to consolidate their assets into one entity. This makes it easier for them to manage their finances and investments because they are no longer dealing with multiple individually owned accounts. In the event that one of them becomes incapacitated, the other spouse can continue to manage the assets held in the trust without the need for any additional intervention or approval. If both pass away, they will have specified in the trust document how they want their assets distributed upon their respective deaths. For example, they can outline that all assets are to be distributed equally among their three children.
Importantly, the trust is revocable. Usually, this means that Michael and Shauna can make changes or revoke it altogether as long as both spouses agree. This flexibility allows them to adapt the trust to changing circumstances or wishes, such as if one child were to become meaningfully more successful financially relative to their siblings, resulting in a desired amendment to the asset distribution so that it is no longer in equal proportions.
Inter Vivos vs. Testamentary Trusts
Inter vivos trusts (or lifetime trusts) are created during the trustor’s lifetime, whereas testamentary trusts are created only at the trustor’s death. This distinction centers on the timing of when a trust exists and can begin to hold assets.
Inter vivos trusts allow the creator of the trust to transfer assets during their lifetime, whereas testamentary trusts lie in wait until the creator has passed away, receiving the assets only then. For this reason, the most common way to create a testamentary trust is to draft it as a provision into a will, or within another trust (i.e., a “subtrust”), where the creator’s death serves as a trigger to create and fund the testamentary trust.
When helping clients create their foundational estate plans you may encounter both inter vivos and testamentary trusts. For example, if they use a revocable trust as a substitute for a will, they are effectively creating an inter vivos trust because they can immediately begin transferring assets to it. In fact, if minimizing probate is important to your client, it is important for them to transfer as much of their assets as possible into this trust during their lifetime.
Your client’s estate plan may also involve any number of testamentary trusts (created under their will or revocable trust) in order to specify how their assets can be used or given away after their death or to allow their loved ones to minimize future taxes. For example, they might set up a relatively short-lived testamentary trust called a “holdback trust” just so someone can help their child manage their financial affairs until they are older and more mature.
To understand the benefit of a testamentary trust in action, let’s revisit the example of Michael and Shauna, the married couple in their 60s with three children, who create a joint revocable trust as their main estate planning vehicle. This time let’s look at another specific type of testamentary trust in action: the credit shelter trust.
The credit shelter trust (which may also be referred to as a “bypass trust” or a “family trust”) is incorporated into Michael and Shauna’s estate plan as a set of provisions within their joint revocable trust. The credit shelter trust will only be created (i.e., go into effect and be able to hold assets) once either Michael or Shauna has passed away. This makes it a testamentary trust.
Why would they include the credit shelter trust in their estate plan? As mentioned earlier, Michael and Shauna have accumulated significant assets during their lifetime. They want to minimize taxes so that their children inherit as much of the estate as possible. In this scenario, Michael has a taxable estate of $15 million, which doesn’t account for the other $15 million that Shauna owns in her own right. In effect, they have a combined net worth and taxable estate of $30 million.
In 2023, the federal estate tax exemption amount was $12.92 million per individual, and Michael and Shauna could share their estate tax exemptions so that they can protect $25.84 million of assets together. In this scenario, let’s imagine that Michael passes away in November of 2023 while the exemption amount is still at $25.84 million for married couples. If Michael and Shauna have a credit shelter trust embedded in their joint revocable trust (i.e., a “subtrust”), this enables the credit shelter trust to be funded with enough assets to equal all of Michael’s remaining estate tax exemption (i.e., $12.92 million, assuming he hasn’t used any of his exemption up yet through lifetime gifting) and for the rest of his assets to pass outright to Shauna.
The result of this planning at the death of the first spouse to die is that Michael and Shauna have preserved a pocket of assets within the credit shelter trust that will not be subject to the estate tax again, even after Shauna passes away. This is true even if the initial $12.92 million of assets appreciates during Shauna’s life.
More importantly, the credit shelter trust allows for generational tax planning. If properly structured, Michael’s exemption will protect assets so that they are never subject to the estate tax or generation-skipping transfer tax, as each descendant of his passes away and his trust benefits new generations of descendants. To do this, the credit shelter trust must be properly structured so that its assets are not considered “includable” in the taxable estate of the beneficiaries (i.e., Shauna or the children).
Note that the credit shelter trust is not usually motivated by a desire to control the surviving spouse (i.e., Shauna) from enjoying her inheritance and continuing to spend the assets for her needs, or even so that Michael can guarantee that his assets will eventually pass to his children once Shauna, too, has passed. That being said, if providing checks and balances on the spouse’s management and spending of the assets is also important, the credit shelter trust can serve that function as well. In this case, if Michael fully trusts Shauna to continue managing his share of their marital assets and not to disinherit their children, their credit shelter trust could give broad powers to Shauna (within the bounds of the tax code). The surviving spouse can serve as trustee to manage and distribute assets, be a beneficiary, including receiving any income generated from the trust’s assets through required distributions or withdrawal rights, and gifting away trust assets through a trust feature called “power of appointment.” The trust just needs to have the proper limitations on Shauna’s powers and enjoyment of the assets so that when Shauna eventually passes away, the tax rules consider the assets held in the credit shelter trust account not to be included in her taxable estate. At the heart of the credit shelter trust is the object to maximize the use of both spouses’ individual estate tax exemptions for the benefit of future generations.
Grantor vs. Non-grantor Trusts
If you’ve made it thus far, you are well on your way to understanding the features of a trust that are important to an estate planner. This last distinction is especially important for tax purposes. A trust may own assets that produce income (for example, real estate that is leased out and receives rent). It’s important to understand who is responsible for paying income taxes for trust assets: your client or the trust.
A grantor trust does not pay its own taxes; another person (usually the trust creator) must include the trust’s income on his, her or their tax return and pay any income taxes directly. A non-grantor trust must obtain a tax ID number and pay its own taxes using the tax brackets for estates and trusts, which are different from the tax brackets for individuals.
Grantor trusts retain enough connection to the trust’s “owner” (or “grantor”) under the tax code so that the grantor is responsible for and must pay the trust’s taxes. A complex set of tax rules is used to determine who the trust’s “owner” is, and estate planners often intentionally turn on or turn off grantor status for the trust to minimize taxes.
Having a grantor trust is beneficial if your client does not want to complicate tax reporting by having the trust file a separate tax return or if your client wants to treat the payment of taxes as an additional annual gift to their loved ones. In addition, a non-grantor trust generally pays more income taxes than an individual taxpayer would on the same amount of income. That’s because trust tax brackets reach the maximum tax rate at a lower income than individual income tax brackets do.
So, let’s incorporate what we’ve learned so far into a simple estate plan. If your client uses a revocable trust as a substitute for a will, they will “own” a grantor trust during their lifetime because they have the power to revoke the trust. This means you and your client must include the trust’s income on your client’s tax return and pay those income taxes. Revocable trusts are not an income tax planning tool for this reason because they pass through all income and other tax attributes of to their creator.
If you use a subtrust (or testamentary trust) in your will or trust, that trust will be created upon your client’s death and will usually be a non-grantor trust. It will need to obtain its own tax ID number and file and pay its own income taxes.
Conclusion: A Matter of Trust
Estate planning (like financial planning) is not a one-size-fits-all process. Importantly, many of the traditional barriers to entry have been lowered significantly because of modern considerations and developments in technology. Do not assume that estate planning techniques are only suited for the ultrawealthy. Instead, take advantage of quality services and planning professionals to determine what is best for your clients. Seize the opportunities that exist today to make life easier for your clients and heirs in the future.