The Brooklyn FI Guide to Trusts
By John Owens, CFP®, EA, ECA, CPWA®
Trust me, you’re gonna wanna read this… Okay, so maybe that wasn’t as punny as I wanted it to be but nonetheless, a key component of many estate plans is a trust. But there are SO many different kinds of trusts out there - some that make sense for lots of people, and some that are exceedingly rare. All of them, however, are filled with jargon, legalese, and lots and lots of pages and provisions lay people simply don’t understand. That’s why we’ve put together the Brooklyn FI Guide to Trusts as an overview of some of the common (and less common) trusts we see, and who they might make sense for.
A quick note - this is not legal advice, and you should always discuss what type of trusts may make sense for you with a qualified estate planning attorney!
The Revocable Living Trust (RLT) - aka the Toyota Corolla of Trusts
There have been over 50 million Toyota Corolla’s sold since it was rolled out in the 1960s, making it one of the best-selling cars in the world - hence the analogy. You can say something similar about the Revocable Living Trust - this is arguably the most commonly used trust instrument in estate planning today.
What is it: A RLT is a trust that you establish during your lifetime. I like to think about it like a bucket. While you’re alive you can put assets in the bucket, take assets out of the bucket, or even throw the whole bucket away (revoke it). But when you pass away, a lid goes on the bucket, and rules of the bucket (trust) establish where your assets flow.
Pros of an RLT:
Relatively inexpensive to set up (few thousand dollars)
Helps avoid probate for assets held in it - (probate is the public process - via court - that your will is validated and your assets are transferred - it can be expensive and time consuming).
Can customize or build out scenarios (in the event of a second marriage, special needs beneficiary, incapacity, etc).
Allows additional privacy vs. going through probate
Cons of an RLT:
Many people don’t understand their own trusts
Funding issues - people don’t actually ‘fill up the bucket’
Trusts as beneficiaries on retirement accounts can be ‘tricky’
Who should consider: Almost everyone, depending on the probate process in their state and the amount of control they want over assets upon passing.
The Testamentary Trust - the Bicycle of Trusts
Okay, okay, maybe I’m not great at these vehicle analogies but bear with me. A bicycle is great and makes sense in many situations, but it doesn’t get you there as quickly as a Corolla does. And that’s why we’ll call this the Bicycle of trusts. With that being said, as someone who lives in the city and uses a bike to get around, the Testamentary trust can be suitable in many situations with greater ease of use compared to a car.
What is it: A Testamentary Trust is one you establish at death - it’s part of your Last Will and Testament (hence the name!). While a RLT is something you fund during your lifetime, a Testamentary Trust only comes into existence when you pass, and is set forth by the provisions in your Will.
Pros of an Testamentary Trust:
Relatively inexpensive to set up (few thousand dollars)
No need to worry about funding it while you’re alive
Can customize or build out some scenarios (in the event of a second marriage, special needs beneficiary, incapacity, etc).
Can function as a back-up - for example, you only set up a trust in the event an heir is under age 30 when you pass, otherwise, you just distribute the assets outright.
Cons of an Testamentary Trust:
Does not avoid probate
Doesn't allow for increased privacy
Can slow down the process for getting your assets to heirs
Trusts as beneficiaries on retirement accounts can be ‘tricky’
Who should consider: Someone with a simple, straightforward estate plan that’s not concerned about probate but still wants to exert some control over assets in certain circumstances.
The Charitable Remainder Trust (CRT) - affordable luxury vehicle of trusts
So, I’m struggling a bit with the car analogy, but I think this one makes sense - it’s a Lexus or Volvo of the trust world. It’s not as common as the Corolla, as simple as the Bike, but not as rare as some of the other tools out there that we haven’t covered yet.
What is it: A Charitable Remainder Trust (CRT) is a trust you can transfer assets into tax-free, that will then produce an income stream to you or your designated beneficiary - the shorter of 20-years or their life expectancy. At the end of that period, the assets remaining in the trust will be distributed to the charity of your choice.
How much income is distributed, and how that income amount is calculated can be determined when the trust is established. There’s a few different options here.
For example, you can set up a Charitable Remainder Annuity Trust (CRAT) with $1M that distributes 10% annually to a beneficiary for 15-years. Since it’s a CRAT - the 10% is based on the initial $1M you placed in the trust ($100,000). So regardless of how the investments in the trust perform, the beneficiary receives $100,000/yr for 15-years (assuming the trust doesn’t go to $0).
Alternatively, you can set up a Charitable Remainder Unitrust (CRUT) with $1M that distributes 10% annually to a beneficiary for 15-years. Since it’s a CRUT - the 10% is based on the value each year. So if, for example, you put in $1M in shares of a Pre-IPO company before it goes public, and the price doesn’t change in year 1, your beneficiary would get $100,000 in year one. But, let’s say the company goes public and the stock is now worth $3M in year three. Then your beneficiary would get 10% of the $3M that year ($300,000).
Pros of a CRT:
No tax paid on the unrealized gain of assets donated - so a nice way to diversify.
Assets get out of your estate.
Partial charitable deduction for your estate that reduces the value of your taxable gift to the beneficiary.
Best of both worlds - and income stream and a remainder benefit to charity
Cons of a CRT:
Irrevocable - can’t change it after it’s set up
Pay income tax on the distribution of income - potentially as ordinary income
Modest set-up and maintenance costs
Goals and taxes can change, but your CRT can’t
Who should consider: Folks with plenty of assets that want to avoid a huge tax bill on unrealized appreciation, create an income stream for themselves (or another beneficiary), and also happen to have a charitable goal. Ideally for folks with a taxable estate or concerns about estate taxes.
The Net Income with Makeup CRUT (NIMCRUT) - The Bronco - it’s cool, and it’s back
I’m calling this the Bronco of trusts because it’s pretty damn cool and may be even more popular now than it was before with the pending tax changes! This is probably one of my favorite types of trusts - for the right client.
What is it: Well it’s a CRUT, but a CRUT with special features. While a normal CRUT is required to distribute X% of the assets in the trust annually, a NIMCRUT distributes the lesser of the income in the trust, or the fixed percentage. And the undistributed amount gets carried forward and can be distributed in future years.
Let’s do an example to better understand how this works:
Say we put in $1M with a 10% distribution rate initially. At the end of year 1, there’s $1.2M in the NIMCRUT and it produced $50,000 in interest and dividends that year. So the distribution would be the lesser of the fixed percentage ($120,000) or the income ($50,000). The undistributed $70,000 gets carried forward and is ‘made-up’ in future years - essentially deferring income until later on.
Pros of a NIMCRUT:
No tax paid on the unrealized gain of assets donated
Assets get out of your estate
Partial charitable deduction for your estate that reduces the value of your taxable gift to the beneficiary
Best of both worlds - and income stream and a remainder benefit to charity
Can be used to defer income to later years - i.e. great for a liquidity event, or to tap into after high income years
Can somewhat replicate a retirement plan
Trustee can invest in income or non-income producing assets.
Cons of a NIMCRUT:
Irrevocable - can’t change it after it’s set up
Pay income tax on the distribution of income - potentially as ordinary income
Modest set-up and maintenance costs
Goals and taxes can change, but your CRT can’t
You or your beneficiary may want a steadier income stream than the NIMCRUT provides
Who should consider: The same folks who should consider a CRUT, especially if they don’t have immediate needs for cashflow, but will later on.
The Charitable Lead Trust (CLT) - The Ford Thunderbird
We’ll call this one the Ford Thunderbird for one specific reason - it was rumored that the Kennedy’s used a Charitable Lead Trust to transfer tons of money to heirs without paying estate taxes - and as it turns out, JFK loved the Ford Thunderbird.
What is it: This type of trust is almost the opposite of the CRT. With a CLT, you transfer assets into a trust that produce an income stream to charity for a specific number of years. At the end of that period, the assets in the trust are distributed to your heirs.
For example, you put $1M in a CLT. It pays out 10% each year for 10 years. Let’s say that at the end of the 10 year period, there’s $500,000 left in the trust. That $500,000 transfers to heirs without triggering any estate or gift taxes.
Pros of a CLT:
No tax paid on the unrealized gain of assets donated
Gets assets and appreciation get out of your estate
Minimizes the amount of the lifetime gifting exclusion you use
Can direct the charitable donation to a Donor Advised Fund for added control
Cons of a CLT:
Irrevocable - can’t change it after it’s set up
Lose control of assets and income
Most of the time does not trigger an income tax deduction
Goals and taxes can change, but your CLT can’t
Little control over how much your heirs ultimately end up with - open-ended.
Who should consider: This is often a helpful tool for folks who have a taxable estate and can afford to give up assets (and income streams) now, but want to leave assets to heirs with minimal estate tax impact.
The Grantor Retained Annuity Trust (GRAT or GRUT) - The Lamborghini
Okay, so there’s a lot trusts and while I don’t have a JFK like story about this one but I think you get the point - this makes sense for folks who have a lot of money - a lot, lot, lot of money and a taxable estate - the kind of folks who can buy a Lambo for cash and not blink an eye.
What is it: This one is a little tricky - so bear with me here. A GRAT is a trust where the person creating the trust (the grantor) puts assets in it, and the trust owes that grantor a percentage of the assets in the trust (determined at funding or annually, depending on how the grantor sets it up) for a fixed period of time.
Grantor’s do this to get assets out of their estate with little gift tax impact - but can only do so if they outlive the term of the trust. In the ultimate planning scenario, the value of the income stream to the grantor is significant enough that the trust doesn’t use up any of the gift tax exemption.
For example, you put $1M in a GRAT that will pay you $200,000 a year for 5-years. And, let’s say that the IRS actuarial tables say that the the value of your benefit is $950,000 - so the gift to your heirs uses up $50,000 of your lifetime gifting exemption. At the end of year 5, there’s $200,000 left in the trust due to the investment growth. In this case, you’ve transferred $200,000 to heirs while only using $50,000 of your lifetime gifting exclusion - not a bad deal!
Pros of a GRAT:
Little gift tax impact
Assets get out of your estate - if you outlive the term
Maintains cash flow stream from assets
Cons of a GRAT:
Only works well if you outlive the term
Higher scrutiny under proposed tax changes
Who should consider: This is often a helpful tool for folks who have a taxable estate, want to leave money to heirs with minimal estate and gift tax impact, and would also benefit from an income stream.
The Qualified Personal Residence Trust (QPRT) - The Dodge Neon
Ahh, throwback car pick for this trust - I had to go with the Dodge Neon because I’m pretty sure everyone owned one at some point in the 1990s - and when I think of a QPRT, I think about the 1990s. You see, back then the estate tax threshold was a lot lower - and most folks kept their wealth in their homes, so the QPRT was common among everyday families trying to minimize the likelihood of paying estate taxes. With the thresholds where they are today, you just don’t see QPRTs (or Dodge Neons) around as often.
What is it: This is a trust where you put your home (residence or even a vacation home) in. You make this gift irrevocably (permanent) but you’re allowed to live there rent free for a certain number of years. Like a GRAT, the goal is to outlive the term, such that the property is out of your estate. At the end of the term, you’ll need to pay rent if you want to continue to live there.
Pros of a QPRT:
Assets get out of your estate - if you outlive the term
Can help keep a family home in the family, without much estate or gift tax impact
Cons of a QPRT:
A bit complicated
Paying rent to your heirs is strange
Irrevocable decision
Who should consider: This is often a helpful tool for folks who have a taxable estate, want to leave a specific property to heirs with minimal estate and gift tax impact, and who also need a place to live.
Okay, so that’s a lot of trusts - and some of the most common ones we see for estate planning or gifting purposes. But that’s not all of them. While the rest of these are slightly less common, we’ll give a brief overview of them all (TL;DR - I’m running out of car analogies).
The Generation Skipping Trust (GST) - This trust designed to leave wealth to multiple generations - beneficiaries that are two or more generations younger than the grantor. Using the GST can allow trusts to avoid paying estate tax at each generation. GST provisions can be built into a variety of trusts for this purpose.
Irrevocable Life Insurance Trust (ILIT) - This trust is typically funded with a whole life insurance policy. When done properly, the proceeds from the life insurance policy pass outside your estate (without any estate taxes). We commonly see these in a taxable estate situation where there’s not much liquidity expected at death to pay estate taxes (i.e. a closely held family business).
The Qualified Domestic Trust (QDOT) - This is a trust commonly used for non-citizen spouses. While citizen spouses of US citizens get an unlimited marital exclusion for estate taxes, non-citizen spouses are not treated the same. The QDOT trust allows the non-citizen spouse to defer the estate taxes on money they inherit from their citizen spouse until the non-citizen spouse passes away.
Special Needs Trust (SNT) - The Special Needs Trust language is often incorporated into a variety of trusts to provide for beneficiaries that are disabled. Since many government programs limit their eligibility to those with little or no assets, a SNT can help maintain access to assets for certain expenses while retaining government benefits.
Domestic Asset Protection Trust (DAPT) - The Domestic Asset Protection Trust is a type of self-settled trust designed to offer creditor protection. They’re only allowed to be set up in certain states and typically require you to appoint an independent trustee to determine whether you’re allowed to take distributions. In certain cases, these can potentially be used in lieu of a prenuptial agreement to protect your assets in the event of divorce.
Deferred Sale Trust - This type of trust is used predominantly in real estate sales where there are large capital gains at stake. Instead of taking the tax hit all at once, the property is sold to the trust on an installment agreement, and the trust then completes the sale and invests the proceeds - paying back the seller over a course of years to spread out the tax liability.
Whew! There’s a lot of trusts out there. For some folks none of these make sense, for others, there’s some on this menu and more to consider as part of your estate plan. At Brooklyn FI, it’s one of our many jobs to help you navigate the complexities of estate planning and help you find the right attorneys and tools you need to reach your goals. Trust me!