Trusts can seem like an intimidating tool. They come in an overwhelming variety of names and types and were once seen as an exclusive tool for the ultra wealthy. However, many people in Washington State could benefit from utilizing trusts in their estate plans and they’re often not as complex as they may seem (although a good estate attorney is always helpful).
There are two main distinguishing features that characterize trusts:
- Whether it’s created during your lifetime or after your death
- Whether the trust is revocable/changeable once established
Living (Inter Vivos) vs Testamentary
The first distinguishing feature is simple. Living trusts are created while the creator/grantor of the trust is still alive whereas a testamentary trust isn’t formed until after the death of the grantor. Testamentary trusts are set up in accordance with the last will and testament. The major disadvantage to a testamentary trust is that assets will have to go through probate before entering the trust. Assets in living trusts avoid the probate process.
Revocable vs Irrevocable
Revocable trusts can be changed or revoked. They offer greater flexibility and allow you to move assets in and out of the trust. The primary benefit of a revocable trust is that it allows your assets to avoid probate. However, assets in a revocable trust are considered to still be owned by the grantor. The grantor continues to pay income tax on income generated by assets in the trust such as capital gains and dividends/interest. As such, there is no estate tax advantage to using a revocable trust.
An irrevocable trust generally cannot be modified once it’s created. Assets put into an irrevocable trust are removed from the grantors taxable estate, making them valuable estate planning vehicles. Note that ongoing taxes from income in an irrevocable trust is paid by the trust itself rather than the grantor. Irrevocable trusts can also provide protection from certain creditors.
Trust to minimize estate taxes in Washington State:
Credit Shelter Trust (aka AB Disclaimer Trusts, Bypass Trust)
The credit shelter trust is the go-to trust to help avoid Washington State estate taxes for married couples. Washington estates up to $2.193M per person in 2022 are excluded from estate taxes. However, that $2.193M exclusion amount is not portable, meaning if one spouse simply gives all their assets to the other spouse without utilizing a trust, that exclusion amount is lost. Thus without a trust, the married couple would only be able to exclude $2.193M from their estate, rather than the full $4.386M they can exclude utilizing a credit shelter trust.
Here’s how a credit shelter trust works:
- Each spouse creates an AB trust- each with the potential to create a Trust A and Trust B. Only one trust A ever becomes operational, that of the first deceased spouse. And only one trust B ever becomes operational- that of the surviving spouse
- Surviving spouse is the ‘life beneficiary’ of Trust A and can be given the rights to all income from trust A property, to use that trust’s property, and to spend trust principal for basic needs, like health care. But legally the surviving spouse never owns the property. Assets in this trust will be excluded from the surviving spouse’s taxable estate for both Federal and Washington State purposes.
- Because there is currently portability of federal estate tax exemptions between spouses this trust isn’t necessary for federal estate tax purposes but it is necessary for a state like Washington with no portability
Other common Trust Types:
A basic trust utilized to avoid probate by titling assets in the trusts name during your lifetime. You can move assets in and out of the trust as you see fit.
QTIP– Qualified Terminable interest Property trust
A QTIP trust leaves money and property for the use of the surviving spouse while naming final beneficiaries to receive the trust property at the death of the surviving spouse(often children or grandchildren, including those from a prior marriage)
- Differs from AB trust in that all the property is exempt from estate tax because it qualifies for the unlimited marital deduction. However the property is then included in the estate of the second spouse so estate tax is postponed not avoided
- Oftentimes QTIPs are combined with an AB disclaimer trust. When the first spouse dies, property worth up to the exemption amount is placed into an AB disclaimer trust with the remainder put into the QTIP trust.
Special Needs Trust
A trust designed to ensure a special needs beneficiary preserves their eligibility for government assistance such as Supplemental Security Income and Medicaid. Ordinary inheritance and financial gifts can impact the beneficiaries eligibility to receive these benefits.
As long as the special needs beneficiary is not the trustee and can’t control trust distributions or revoke the trust, social security rules allow a disabled beneficiary to benefit from this type of trust. Special needs trust funds pay for expenses such as out-of-pocket medical expenses, personal care attendants, vehicles, education, home furnishing, recreation, etc.
GST Trust (Generation-Skipping Trust)
A generation-skipping trust is a trust that transfers assets to grandchildren (although technically it’s for a transfer to any non-spouse who is 37.5 years younger than the grantor). A GST is generally set up to avoid estate taxes that would be paid if your children inherited money before passing it along to the grandchildren.
Spendthrift trusts limit beneficiaries access to the trust funds and protects the assets from creditors. Beneficiaries of these trusts cannot take a loan against the value of the trust. The trustee(s) of a spendthrift trust typically has broad discretion in providing beneficiaries with funds. This type of trust is common when there’s concerns about the beneficiary receiving a sudden large influx of money.
Grantor Retained Annuity Trust (GRAT)
A grantor retained annuity trust is an irrevocable trust in which the grantor puts assets into the trust but retains the right to receive a rate of return on those assets set by the IRS. The trust pays that return to the grantor over some predetermined time period before transferring the assets to the ultimate beneficiaries.
Some find GRAT’s an appealing estate planning tool since they freeze the value of assets in the estate when they’re transferred and can shift future appreciation to beneficiaries. A drawback to a GRAT is that if the grantor dies then the assets will transfer back into their estate and the desired freezing of asset value is undone.
Qualified Personal Residence Trust (QPRT)
Grantor puts real estate into the trust while allowing the grantor to live rent-free for a specified period before it’s transferred to beneficiaries. One downside to a QPRT is that your beneficiaries will receive your tax cost basis at the time the residence is transferred into the trust. There is no step up in cost basis upon death as there otherwise would be if the property was outside the trust.
Intentionally Defective Irrevocable Trust (IDIT)
An intentionally defective irrevocable trust moves the value of your assets outside your estate but is set up in such a way that the grantor will continue to pay income tax on trust earnings while alive. The grantor of the trust receives a promissory note from the trust that pays the grantor interest and principal. Upon death, only the value of the outstanding promissory note is included in the estate of the grantor while the assets of the trust are excluded from the estate.
Spousal Lifetime Access Trust (SLAT)
A SLAT trust is similar to a credit shelter in that it removes assets from the estate into a trust for the benefit of a spouse while passing the title of the assets to the ultimate beneficiaries/heirs. The main difference vs a credit shelter trust is that a SLAT is created while the grantor is still alive and is considered a gift rather than part of the estate.
Irrevocable life insurance Trust (ILIT)
An ILIT is an irrevocable trust set up to own life insurance on the grantor. This keeps the death benefits of the policy out of the value of the grantor’s estate. This is sometimes appealing to those with illiquid estates such as those with privately held businesses where the insurance proceeds can help cover outstanding estate taxes.
Charitable Remainder Trust (CRT)
A charitable remainder trust is an irrevocable trust that provides income to a person of the grantor’s choosing while passing the ultimate assets to designated charitable beneficiaries at the end of the trust’s term. A CRT can be established for the grantor’s life or a time period of up to 20 years.
This kind of trust gives the grantor a partial tax deduction when the assets are put into the trust.
Charitable Lead Trust (CLT)
A charitable lead trust is almost the inverse of a charitable remainder trust. The CLT is an irrevocable trust that provides income to a designated charitable beneficiary before passing the assets to a non-charitable beneficiary at the end of the time period of the trust.
As you can see, there are many different varieties of trusts that help people accomplish their estate planning goals. The above list is by no means exhaustive as there are other less common trusts as well. Trusts can be used to accomplish a very broad range of estate planning goals. It’s important to consider what’s best for you and your situation and consult your financial professional in addition to an estate attorney to optimize your situation.
Scott Caufield, CFA, CPA.