Many folks think they should set up a Trust to avoid taxes or for other reasons. For many middle-class Americans, this is likely unnecessary.
Trusts are an interesting beast, and I don't have the time or space to describe them all here. After all, entire Law School courses are devoted to the topic, so it is hard to be an expert in this area or reduce it all to a few paragraphs. From the Wikipedia entry linked above is this concise summary:
In common law legal systems, a trust is a relationship whereby property (real or personal, tangible or intangible) is held by one party for the benefit of another. A trust conventionally arises when property is transferred by one party to be held by another party for the benefit of a third party, although it is also possible for a legal owner to create a trust of property without transferring it to anyone else, simply by declaring that the property will henceforth be held for the benefit of the beneficiary. A trust is created by a settlor , who transfers some or all of his property to a trustee, who holds that trust property (or trust corpus) for the benefit of the beneficiaries. In the case of the self-declared trust, the settlor and trustee are the same person.
You understood all that, right? The basic idea is to take something - a pile of money, stocks and bonds, a house or a real estate portfolio or whatever, and then create this legal fiction that you own it - but you don't own it. So if you die, it goes to someone else, but if you're alive, it is basically yours, but if you are sued, they can't take it from you, because you don't own it. Well, that's the intent anyway.
There are many, many reasons people set up trusts - to avoid taxes, to avoid paying medicaid, to control how people use money, to limit exposure of assets to lawsuits and judgments - just to name a few. For people with real, serious money (and by that, I mean millions of dollars) a trust is not a bad idea. But for most of us, it is just an expensive and unnecessary complication of our finances.
This is not to say that clever lawyers won't suggest a trust for you - on the contrary, it is an opportunity to generate billable hours for the attorney. But unless you are really rich, they are likely just a waste of time and money, even if it makes you feel more important to say you have a trust.
Let's look at some examples from real-life, with trusts, and illustrate how they work - or fail to work. The names have been changed to protect the innocent (or foolish):
1. Sarah was heir to a large dynastic fortune from her Grandmother. Under the old Gift and Estate tax law, the Federal Government took a pretty hefty chunk of an estate, in an effort to put an end to dynastic wealth - or at least limit it. Back then, Mr. and Mrs. Average American could leave up to $750,000 to their kids, without worrying about the Estate tax (which is paid by the Estate, not the recipient) and if married, they could have combined this for a total of $1.5 Million.
Today, the limits are far higher ($5 Million), an in a weird anomaly, the tax was abolished for a whole year, last year, which made 2010 a good time to die, if you were a Billionaire. But just a few years back, the exemption was much lower, and when you are talking a fortune in the tens of millions of dollars, well, taxes are a huge concern.
One way around this limit was to set up what used to be called a "Crummy Trust" - and if you are the recipient of one of these, you know they are anything but crummy. Some folks call this a generation-skipping trust, as well. The net effect is, by leaving the money to the grandchildren directly, the grantor avoids the taxman, for the most part.
Was this a good idea? Yes, at the time the trust was made, it was the only way around the Estate Tax. And it illustrates how easily some tax laws can be defeated, which is why people are pushing for tax reform today.
Today, with a $5 Million exemption on the Estate Tax, such a trust might not make any sense. However, as recently as 2009, there was talk about making this exemption as low as one million dollars. If you have a lot of wealth, maybe such gymnastics make sense. However, most middle-class and even upper-middle-class Americans will retire with a million dollars or less, and by the time they die, have much less.
So this sort of trust is a fancy of the really wealthy not the pretend-wealthy in the suburbs who make car payments on their luxury cars. And today, with an exemption of $5 Million, the Estate tax will not apply to an even larger group of millionaires.
2. Barbara's Husband set up a trust for her before he died. In the trust, he put all his stocks and bonds, and made Barbara the beneficiary of the trust, and his three grandchildren the trustees. Barbara had use of the income of the trust for as long as she was alive, and when she died, her three grandchildren would get what was left.
Sounds like a great way to avoid probate, right? Well, for the amounts involved, sort of a convoluted way to do it. And suppose after Barbara's husband died, one of their kids had another child? That grandchild would be left out of the trust - and receive no inheritance.
Many times, such trusts are set up by over-controlling people in an attempt to control, from the grave, our behavior. But most trusts have such liberal provisions that the control is illusory. For example, oftentimes a beneficiary has the right to "invade the corpus of the trust" - which means spend the principle in addition to the income - if it is deemed necessary for their maintenance.
What is necessary is, of course, debatable, and in many cases, a new Mercedes can be argued as a necessary expense justifying tapping into the corpus of the trust. It would be up to the trustees to challenge the actions of the beneficiary in court, which would lead to a messy family squabble. And likely, the trustees would lose.
Barbara's husband set up the trust to "avoid probate" - as if probating an estate was some sort of horrible thing akin to root canal. But in most cases, trying to avoid simple legal procedures though the use of legal chicanery just adds to costs with no apparent benefit.
In Barbara's case, once she died, her grandchildren inherited about $60,000 each, well below the threshold of the Gifts & Estate Tax, and the net effect of the trust was, well, bubkis, other than to make life a little more difficult for the heirs.
A simple will would have been as effective.
3. Eileen inherited a few hundred thousand from her parents. But by the time she got the money, she was diagnosed as being terminally ill. She wanted to leave a legacy to her children, which seems to be a compelling need for a lot of parents. But trust me, (pardon the pun) it doesn't compensate or make up for a lot of shitty parenting. Just spend the money.
But she also wanted to make sure her husband was provided for, even if he was a philanderer. So she had her lawyer set up a trust, naming her husband as both beneficiary and trustee with the children as "remaindermen" who would receive the corpus of the trust when her husband died. The theory was, she could control her husband from the grave, provide him with an income, but leave the corpus (body) of the trust to the children.
It was a theory, only.
In reality, like most trusts, the beneficiary/trustee is provided with a "get out of jail free" card, in that they can tap the corpus of the trust if they feel the compelling need. Eileen's husband felt compelling needs almost right away, tapping into the trust for one trivial reason after another - for example, to loan money to his grandchildren.
Of course, given the 4% rule for retirement, it is clear that Eileen's husband would end up tapping into the trust, eventually. The amount of money Eileen left for her husband was not enough to live on, on income alone. Eventually, he would be forced to tap into the trust, if he lived long enough - unless he left most of the trust in high-risk, high-yield stocks, which is not a good idea once you are over age 60.
Now, again, the reminadermen (the children) could challenge Eileen's husband on his use of the trust, but it would be a costly court battle and the amount of money involved not worth it. So the trust, designed to "control from the grave" ends up being a nullity.
The only one to profit from it was the lawyer who drew it up.
4. Joe was a middle-aged professional who had managed to build up an estate of over a million dollars. And as his net worth increased over time, he became increasingly worried about losing it. After all, it had taken a lifetime to accumulate this wealth, suppose he was sued and lost it all?
So Joe consulted a Trusts and Estates attorney and asked him about setting up a trust. "Should I put my house into a trust? What about my stocks and bonds? Suppose I end up getting sued? I could lose it all?"
The attorney looked at Joe's finances and said, "You really wouldn't benefit much from a trust at this point, even if it would generate over $2,000 in billables for me."
Joe found an honest attorney. It happens.
"You see," he continued, "most of your investments are in your 401(k), Roth IRA, SEP-IRA and regular IRA accounts, in addition to your whole life policies. None of these are attachable from judgments, except perhaps from the IRS. So a trust would not help you with those accounts."
"And, since you have a million dollars in umbrella liability coverage, you are protected from all but the largest of lawsuits. Chances are, if you did get sued, most plaintiffs would settle for a quick check from the insurance company, rather than trying to go after your personal assets, which can be protected from attachment pretty easily."
"So, for your situation, I would not recommend a trust. It would just make things more complicated."
"If you manage to multiply your fortune 5-10 times, well, then call me."
Joe was a bit shocked at this honest advice. He had heard from lots of other people about how great it was to set up a trust, and how he should do it. But now he was hearing just the opposite - from an expert in the field.
Of course, whether or not a trust makes sense - in shielding assets from attachment - depends on your State laws and your particular financial scenario. For example, in Florida, your personal residence cannot be attached with a judgement, which is why O.J. bought a house there, before he finally went to jail. It is one reason a LOT of crooks buy houses there.
Consult an Attorney for your specific situation - like Joe did - but ask hard questions as to why you need to do this. Attorneys make money by saying "Yes" and make no money by saying "No." Make sure your Attorney is recommending what is right for you - not him.
5. Jennifer was concerned that she and her husband would end up in a nursing home and, since they owned their home free and clear and had some money in the bank, Medicaid would not pay for long-term care. So they talked to a lot of people and went on some websites (of which there are no shortage) and decided to put all their assets into a Medicade Asset Protection Trust.
The trust, like the one set up by Barbara, above, made Jennifer and her husband the beneficiaries and the children the trustees and remindermen. The idea was, that if either of them had to go to a nursing home, they would be "poor" in Medicaid's eyes, and thus qualify for Medicaid funding.
Sort of cheating of course - telling the government you are poor, when in fact you might be worth millions of dollars, right? And you wonder why medicaid is in crises?
What Jennifer and her husband were protecting was not themselves but instead, their assets, primarily their house. The net beneficiary of all of this is the children, who receive a huge inheritance from Jennifer and her husband, while the taxpayer pays for Mom and Dad in the nursing home.
In effect, the taxpayer is paying for their kid's inheritance.
There are, of course, pitfalls. For example, if Jennifer's husband has a massive stoke only a year after they establish the trust (and has to go to a nursing home) Medicaid will not pay. There is a five-year exclusion rule that must be met - the trust has to be in place for at least five years, before the assets are not counted by Medicaid for determining eligibility.
Also, for married couples, Medicaid will not come after your house, provided the spouse is still living in it. Until after the spouse dies, of course.
In addition, even if neither of them go into the nursing home, there are consequences of the trust - they have to file a trust tax return, and their use of the trust may be limited (e.g., they can use it to pay for utility bills for the home, but not the phone bill. They can buy a new furnace, but not a new car). Improper use of the trust may void it, for Medicaid purposes. Tying up too much money in the trust may make living difficult.
For example, suppose Jennifer and her husband put all their money in the trust? They will have nothing left to live on. So the trust, by definition, cannot shield all of their assets. And to qualify as a Medicaid trust, it has to be irrevocable.
There are alternate approaches to use, other than a trust, such as a life estate in the home. Consult an elder law attorney for more details. And of course, one approach is to worry less about "leaving an inheritance" to your kids and just living life and let the chips fall where they may. Or, you could transfer money inter vivos (while living) in small amounts, which would be tax-free to them and tax-free to you (under the Gifts and Estate tax).
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The point of this posting is not to exhaustively examine trusts, or advise you one way or the other on whether to set one up. That is a fact-specific situation, depending on your level of wealth, income, your family situation, what State you live in, your general health, and a number of other factors. You should consult an Attorney in your State and examine carefully all of these factors and decide whether it is right for you.
The point is, a trust is not a cure-all for whatever it is you are trying to insulate in life. For most people, trusts just are not really necessary - or the benefits are de minimis.
Before you rush off to put everything into a Trust, based on what a neighbor said at a cocktail party, think it over carefully, as to what you are trying to do and why. In many situations, particularly for middle-class people, a trust is not really going to achieve much except to complicate your life and increase your expenses.