Note: This video is part of Morningstar's October 2014 5 Keys to Retirement Investing special report.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. What is a trust and do you need one? Joining me to discuss that topic is estate-planning expert Deborah Jacobs.
Deborah, thank you so much for being here.
Deborah Jacobs: Thank you for having me.
Benz: Deborah, a lot of people hear the term trust and they think maybe they need one. Let's talk about the basic need for a trust--what trusts do--and then we'll get into who might actually need and benefit from a trust.
Jacobs: Maybe first we should talk about how trusts work. There are many people who are reluctant to admit that they really don't understand what these things are. So, I like to explain that a trust is an invisible legal wrapper created by a document that looks a lot like a contract. Title to the assets passes to someone called the trustee, who manages the assets and then gives them out according to the wording of the trust document.
Benz: So, that's the basic framework for trusts. What are some of the most commonly used trusts? And when people are thinking about their retirement plan and how it intersects with their estate plan, what are the trusts that will tend to be the most common and the most helpful for people to contemplate?
Jacobs: The one that is most commonly used and most helpful for planning for later in life is what's called the living trust. This is a trust that can serve two purposes: one is to pass assets after you die, but it also takes effect while you are alive to hold assets for your benefit--for example, in the case of dementia. Previously, before the estate tax exemption amount went up to now more than $5 million, people used to use trusts. A very garden-variety trust was the life insurance trust, which would buy the policy and hold it for the benefit of beneficiaries, so that when the proceeds were paid out, they would not be considered part of the estate of the person who was insured under that policy. Those trusts, although many of them are still in existence from life insurance policies that were bought in the past, will no longer be necessary for many people and they are somewhat cumbersome to run.
Benz: Backing up to the idea of living trusts, Deborah, you mentioned that they can be helpful in case of dementia, say, which is an increasing problem in the elderly population. Let's talk about how such a trust would interact with the power of attorney that someone might have--that durable power of attorney. On the surface, it might seem that those two things would serve the same goal.
Jacobs: Well, first of all, a living trust only applies to assets that you put into the trust. So, you still might want to have a durable power of attorney for anything that you have neglected to put into the trust. The other thing is that some financial institutions would much rather you have a living trust then a durable power of attorney. And another thing to consider is that if you owned real estate in more than one state, real estate is subject to probate--that is, court oversight of the distribution process after you die. So, it is subject to probate in the state in which it's located. So, if you have a home in New York and you also have a home in Massachusetts, for example, ordinarily your estate would need to be probated in both of those states; however, if you put one or both of your homes into the living trust, that would avoid the need for probate in two states in that way. So, that's another really important reason that people might want to consider having a living trust.
Benz: Now, how about for people who are looking to do some planning? They want to set assets aside for, say, children or grandchildren. In what situations would a trust be appropriate and in what situation is it overkill? Would other ways of passing those assets to heirs perhaps be more cost-effective or just simpler all around?
Jacobs: A trust can provide protection against creditors, and that is one of the most important benefits of having a trust--and "creditors" doesn't just mean that you don't pay your bills, it can also mean the people who get judgments against you. So, say, in a car crash or someone who falls in your home and injures themselves seriously or divorcing spouses really are one of the big categories of creditors that trusts are designed to protect against. All that said--and those are all selling points that lawyers use to encourage clients to setup trusts--there are enormous expenses and inconveniences associated with them. They can be expensive to set up; it's not unusual for a relatively simple trust to cost anywhere from $1,500 to $5,000 to set up, depending on where you are located and the size of the firm of the lawyer who you are dealing with.
In addition, the income on a trust, if it's not being distributed out to the beneficiaries, is typically taxed as income of the trust. And the trust reaches the highest tax bracket much sooner than individuals do. Then, you need someone who you trust to run this operation, and that trustee may expect to be paid, especially if you are dealing with a financial institution rather than an individual. Although there are plenty of individuals who you might find who are qualified to run the trust, many people for smaller trusts turn to family members who don't know what they are doing and don't want to spend the money to get the necessary advice. So, typically, if the assets going into the trusts are not worth $200,000 or more, you might find it's extremely inefficient from a cost perspective to even have a trust.
The other thing I like to warn people about this year is to beware lawyers pitching trusts to be the beneficiaries of IRA assets. There was a Supreme Court case earlier this year in which the court said that inherited IRAs are not protected in bankruptcy and the workaround for that is to, rather than leave IRA assets to people directly, is to leave them to a trust for their benefit. But there are many, many problems that surround this particular type of trust. And so, although there is a small industry springing up around this now, I would warn people to be very careful whether they go this route.
Benz: I'd also like you to touch on bypass trusts: First, say what they are. They were estate planning 101 even five years ago, but perhaps they are less necessary now. Maybe we can talk about that?
Jacobs: The bypass trust used to be a routine estate-planning mechanism to protect each person's exemption amount in marriages when the first spouse died. The reason this was necessary was that in the past--this is no longer true--in the past when the first spouse died, their exemption amount, which used to be much lower than the current amount which is over $5 million, would be lost if they left everything to their spouse directly in what is called an "I love you" will. In other words, "I die; I leave everything to my husband." In the past, those assets then became part of his estate. And when he died, there was no way to use my exemption amount, and it could be subject to tax. If it was worth enough, there would be taxes on the assets.
So, instead of leaving everything to the spouse in an "I love you" will, people would leave something to the spouse, because assets left to the spouse are never taxed, provided the spouse is a U.S. citizen. Instead of doing that, people would do what was called AB planning. A was what went to the spouse, and B was everything else that would go into this trust called the bypass trust, or sometimes called the credit shelter trust, because it sheltered the estate tax exemption. And the assets would remain in the trust. Income or principal could be paid out to benefit the surviving spouse while he or she was alive, but it was not considered part of his or her estate. The exemption amount of the first to die would be applied to the assets going into the trust, and then after the second spouse died, they could be paid out to the kids or to anybody else. That's no longer necessary for tax reasons. So, a lot of people are rethinking the necessity of bypass trusts.
Benz: So, it may be necessary in situations with very high net worth people; they may reap some benefit from having this setup. But you're saying that for people who don't expect to have, say, $10 million as a couple that this might not be necessary.
Jacobs: That's right. There are other good reasons to use bypass trusts--the main one being to protect assets from creditors. Many people don't think that those reasons apply to them and would much prefer to have a simpler estate plan. Lawyers are correct that there are plenty of good reasons for bypass trusts, but many clients much prefer simplicity.
Benz: Deborah, thank you so much. Trusts can be a very confusing subject. We really appreciate you being here to shed some light on the topic.
Jacobs: Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.