The Retirement Corporation of America

Coping With The Complicated World Of Trusts

A Short Course in Trusts

TRUSTS SOUND VERY legal and complicated and only for the very wealthy. In fact, trusts aren't all that complicated. And although they are only useful if you have enough wealth to fund a trust, that doesn't mean you have to be very wealthy to create a trust. Trusts have been widely used in the past to reduce estate taxes--meaning they will be less useful in the future if the estate tax does, indeed, vanish.

But if Congress restores the estate tax, you probably would want to make use of trusts. The lawyer planning your estate may decide you should create a trust or two to cover the years between now and 2010 when the estate tax is supposed to disappear. Furthermore, there are reasons for creating trusts that go beyond just reducing estate taxes. One way or another, you should have at least some knowledge of trusts: what they are, how they work, and how you might want to put one to work for you.

Put most simply, a trust is a legal creation established to hold assets that have been designated for some special use. It might be established to move assets out of your estate. But you also might establish a trust that would carry on your interest in "saving the whales" after you have died. You can establish a trust for any purpose that you desire.

•  The person establishing the trust is the grantor.

•  The property in the trust is called the "principal" or the "corpus."

•  The person who has been given legal ownership of the assets transferred to the trust is the trustee.

You, the grantor, establish the trust. You use your property to fund the trust. You designate the trustee, who will carry out the purpose of the trust after you are dead. The trustee has the legal obligation to use the property in the trust only as you have instructed him or her to do so.

If the trust is established while you are still alive, it is a living trust. If it is established under the terms of your will, after you are dead, it is a testamentary trust.
A revocable trust is a living trust. It can be revoked by you at any time and for any reason. An irrevocable trust is a testamentary trust with the terms of the trust stipulated by your will. It cannot be changed once created.

Trusts are complicated enough that you should never attempt to create one on your own. You should discuss the subject with your attorney, and jointly decide whether there are circumstances in your life that might make a trust advisable. If you feel there should be a trust in your future, then the attorney will make all the necessary arrangements--including whether the trust should be revocable or irrevocable. There are reasons why the trust would be one or the other, but they are complicated enough that we suggest that you follow your attorney's advice.

A Sampling of Trusts You Might Consider

There are all sorts of trusts, and all sorts of reasons why you might want to establish one. Just to give you the basics, here are the most common types of trusts--and when they might prove useful:

Bypass trust. This is used between husband and wife. Used in conjunction with the unlimited martial deduction, it can eliminate estate taxes entirely at the death of the first spouse, and minimize the estate tax burden when the second spouse dies.

Remember, there is no estate tax on transfers of assets between spouses. All assets of the first spouse to die could pass to the surviving spouse, absolutely free of estate taxes. But that would waste the exemption ($1 1/2 million in 2004 and 2005, climbing to $3 1/2 million in 2009). And that, in turn, would leave the entire estate of the surviving spouse exposed to taxation. The bypass trust takes advantage of the exemption to minimize that exposure to estate taxes when the second spouse dies.

So, $1 1/2 million of the estate of the first spouse to die goes into a bypass trust for the benefit of the surviving spouse. The surviving spouse would get the income from that bypass trust—and, under some circumstances, the principal as well.

Everything beyond that $1 1/2 million would go to the surviving spouse, tax free, because of the unlimited marital deduction. The surviving spouse then determines how to distribute the bypass trust when he or she eventually dies. Because of the exemption, whatever is in the bypass trust would not be part of the estate of the surviving spouse—hence beyond the estate tax—when he or she dies.

Don't ignore a bypass trust or any other estate planning tool just because your estate isn't anywhere near the threshold. Expect your estate to keep growing during your life to a point where a bypass trust might prove essential when you die.

As the exemption rises (again, to $3 1/2 million by 2009) the amount of an estate that can go into a bypass trust will rise. Be sure your estate plan is flexible enough to reflect it. Don't say the bypass trust will be funded by $1 1/2 million from the estate. Say, instead, that it will be funded to the maximum amount allowed by the law at the time of your death.

Qualified Terminal Interest Property (Q-Tip) Trust. This is most often used when there is a second marriage. If you were to die first, the Q-tip trust would enable you to control where your estate assets will ultimately be distributed. When you die, assets would go to your spouse for his or her lifetime. When your surviving spouse dies, it is your will that controls how all of the remaining assets will be distributed.

For example, let's say that you have children from a first marriage and you want them to benefit from your estate when you die. You also have a second husband or wife and you want to provide for him or her after your death. So you create a Q-Tip trust. It supports your second husband or wife after your death. At his or her death, the estate then goes to the children of your first marriage, rather than to heirs of your second husband or wife.

Qualified Personal Residence Trust (QPRT). You would make use of this when you have a taxable estate and the home is a big piece of it. You put the house into the trust for a period of years during which time you can continue to make use of the dwelling. You set how long you want the trust to run. When the term has run out, the house belongs to the beneficiaries of the trust—usually your children. Meanwhile, all appreciation in the home's value belongs to the trust—not to your estate.

In a smaller estate, the home may be the biggest single asset. Taking it out of the estate and putting it into a Qualified Personal Residence Trust may make it impossible to fund the bypass trust which your will calls for.

Life Insurance Trust. As the name implies, this is a trust created to buy life insurance. At your death, the benefit from the insurance is used to facilitate the payment of whatever estate taxes are owed. It makes a lot of sense forsomeone likely to leave a taxable estate.

As with everything else connected with estate planning, the rules are complicated and must be followed exactly. For instance, the trust, and not you, must own the insurance policy from its inception. The trust must have all the beneficial interests in the policy. You, as grantor of the trust, don't retain any ownership interest, and you don't have the right to make any changes in the policy.

The way the insurance benefit is used at your death also gets pretty complicated. The sales pitch on such policies will often imply that the death benefit can go directly to pay estate taxes. In fact, the benefit goes to the trust, and the trust itself has no estate tax liability. What the insurance trust does, is loan the death benefit to the estate or use it to buy assets from the estate. Only when the death benefit is transferred to the estate can it go to pay the estate tax.

Crummey Trust. Invented by a man named Crummey, a typical Crummey Trust would be funded by gifts from parents or grandparents to pay the future costs of sending children to college. A Crummey Trust offers some special tax advantages which make it highly useful in financial planning, but a little tricky to set up.

For a gift to qualify for the $11,000 annual gift tax exclusion, it must be a "gift of present interest." The recipient must be able to take the money and spend it now. It would be wonderful to have money put aside for your grandchildrens' college education qualify for the gift tax exclusion. Yet, for the gift to qualify for the exclusion, the child must be free to spend it immediately.

The idea behind a Crummey Trust is that the gift is of present interest—meaning it qualifies for the exclusion. But the child who is beneficiary of the trust agrees not to take advantage of that by spending the money immediately.

One way to handle a Crummey Trust is that once the money goes into the trust, the children have 30 days to take it out if they want. If they don't, it stays there pursuant to the regular terms of the trust. The understanding is that there won't be any money taken out during that 30-day window.

Special Trust. You create this trust while you are alive—to carry out some special function after your death. For instance, you might make special trust provisions for the care of a disabled child. The trust would start at your death. It would then pay for whatever special care the disabled child needs beyond what available government programs would pay for.