Saving for retirement is only one component of your financial plan. Just as important is establishing an estate plan to make loved ones aware of your wishes should you become incapacitated or pass away.
Getting your legal documents in order can ensure your assets are distributed according to your wishes and can minimize taxes, expenses, and unnecessary delays. Whereas everyone should have a will, the suitability of a trust depends on your individual circumstances.
Trusts differ from wills in three key ways:
- A will goes through probate, in which a court reviews the document and ensures its validity. Trusts bypass this process.
- A will takes effect only upon death, while a trust can take effect before death, after death, or in case of incapacitation.
- And finally, trusts come in all shapes and sizes, depending on your needs and those of your heirs.
"Wills can be flexible, too, but many trust types are designed for specific goals, such as charitable giving or providing for an heir with a disability," says Rob Williams, managing director of financial planning at the Schwab Center for Financial Research.
Where to start
A consultation with an estate-planning professional can help you decide if a trust is right for you. "The first step may be to create a revocable living trust," says Tucker Smith, a Schwab senior manager of tax, trust, and estate in Denver.
A revocable trust can be changed at any time and for any reason during the grantor's, or creator's, lifetime. "You're not giving up any control. It's just a different way to hold your assets," Tucker explains. A revocable trust becomes irrevocable when the grantor dies or becomes incapacitated—meaning it can no longer be changed or revoked, depending on how the trust is structured.
A revocable trust is often only a beginning, however. "Think of a revocable living trust as an umbrella under which you can add any number of provisions or supplemental trusts tailored to your specific goals," Tucker says.
Here are six common varieties of trusts individuals and families could consider to establish their legacy.
For blended families
If you've remarried but want to ensure your children from a prior relationship are cared for, a Qualified Terminable Interest Property (QTIP) trust can help. QTIPs provide for the living expenses of the surviving spouse. When that spouse dies, the QTIP distributes the remainder of the estate to the children of the original relationship.
Often these trusts will include provisions that prevent the estate from being excessively drawn down during the surviving spouse's lifetime. When it comes to taxes and QTIPs, estate taxes are deferred until the death of the surviving spouse.
For heirs with a disability
An inheritance can reduce or eliminate the government benefits to which dependents with disabilities may otherwise be entitled. A special-needs trust can help avoid this pitfall by agreeing to pay only those qualified education, equipment, insurance, and medical expenses not covered by federal or state benefits. "If government benefits are paying for housing, but the house needs a wheelchair ramp, the trust can cover that," Tucker says. "The trustee pays such expenses directly so that no money from the trust flows directly to the dependent."
For the prodigal heir
Leaving a lump sum isn't always wise, especially if a loved one lacks financial know-how or struggles with alcohol, drug, or gambling dependencies. This is where a spendthrift trust comes in. This provision appoints a trustee to distribute the assets of the trust on an ongoing basis, rather than giving direct access to heirs themselves.
An independent entity often administers a spendthrift trust to avoid family conflicts. "A good trustee can help educate heirs about budgeting and financial planning," Tucker says.
More to the point, the trustee typically distributes a preset amount based on a budget and may pay creditors and service providers directly. "For example, I have a client whose son is an artist," Tucker says. "He's immensely talented; he's just extremely right-brained and not especially astute at managing money."
What's more, because the beneficiary doesn't control the trust, creditors may not be able to claim a right to its assets.
For the philanthropically minded
Charitable trusts fall into two basic categories, depending on when you want the donations to go to the charity or charities of your choice. One is a charitable lead trust, which provides a predetermined income to a charity for a set number of years, after which the remaining sum passes to your heirs.
A charitable remainder trust does the opposite: It provides a fixed payment to the donor while living, with the remainder going to a charity upon her or his death. For example, if your estate included a rental property with sizable taxable gains, you could transfer ownership to a charitable remainder trust. You would still receive the income from the property for as long as you lived—along with a tax deduction for gifting it to the trust—without having to sell the building and pay capital gains up front. Upon your passing, the remaining trust assets would go to the charity.
It's important to keep in mind that charitable trusts are irrevocable. Once you transfer your assets, you no longer own them, so be sure to think through all your options before making a final decision.
For those concerned about litigation
Attorneys and medical professionals may be especially susceptible to lawsuits. That's why some turn to an asset-protection trust to shield their assets from potential litigation. This type of trust names the grantor as the beneficiary, often with a corporate entity serving as trustee.
By law, these trusts can be established only if you're not aware of a lawsuit or possible lawsuit. Many states—including California, New York, and Texas—prohibit asset-protection trusts, in which case individuals often turn to a corporate trustee in a state that permits them.
For those wishing to maximize life insurance payouts
The IRS considers life insurance benefits as part of an estate, so families with significant assets who also own or are considering purchasing a life insurance policy might benefit from an irrevocable life insurance trust, or ILIT.
If your revocable living trust owns your life insurance policy, the death benefit would be included in the value of your estate. If, on the other hand, an ILIT owns your life insurance policy, it's considered separate from the main estate and, therefore, not subject to estate taxes.1
A helping hand
A basic understanding of the options out there is the first step to establishing a lasting legacy but is no substitute for consulting with the proper professionals.
"Financial consultants often have access to a network of estate-planning specialists who can help clients think through their options before enlisting an attorney to draft any trust documents," Tucker says.
1To be considered separate from the gross estate, existing policies must be gifted to an ILIT, and the insured must live at least three years beyond the gift date.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
Always consult with your legal counsel and tax advisors about your particular circumstances.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.1122-2HDC