As a Certified Private Wealth Advisor who has been trained in advanced estate and tax planning, I often get the question of whether one should get a trust or a will. There are many questions that must be answered before I can give a recommendation on that issue. However, the one area I stress is the importance of keeping your trust updated on a regular basis. Now is as important as ever.
Before I get to a clause that could save you significant money, let’s review the latest estate and gift tax laws. The Bush tax cuts were made permanent which means that as of 2015, the estate tax exemption is $5.43 million per person, indexed for inflation. However, there is another very important part of the current tax rules and it is called Protective Portability. This means a couple really has $10.86 million in estate tax exemptions.
How it works is that whatever amount one person in a couple doesn’t use, goes to the surviving spouse. It can’t go to kids or friends, just the surviving spouse. As a hypothetical to illustrate this, if a couple in a community property state (such as Texas) has a net worth of $6M million and the husband passes away, each person’s estate is divided equally (in theory and assuming no separate property). That would be $3 million for both the husband and wife. The husband would use his $3 million exemption and the remaining $2.43 million would port to the wife. She now has $7.43 million to use when she passes away.
This is great but causes a huge risk in many older estate plans. Let’s break it down to couples with less than $5.43 million in net worth, couples between $5.43 million and $10.86 million, and then those with over $10.86 million.
Net Worth Less than $5.43 Million
There might be a big risk for couples with less than $5.43 million and that have an AB*, ABC*, or living trust (technically called a grantors trust). The one issue with a trust is it does not provide a step up in cost basis. For example, a couple has real estate (not a home) that they have a $500,000 unrealized gain. Keep in mind, they receive no estate taxes benefit of the first to die’s assets going into a trust. Thus, if the total net worth was $4 million then each spouse would show $2 million in their estate net assets. In total both are under the exemption so there isn’t any estate tax liability. However, since the highly appreciated real estate went into the trust, they just lost $250 thousand (half of the total gain) in a potential step up basis. If they didn’t have the trust, half of the real estate cost basis would step up to today’s value and they save the taxes on that gain, which in this case would be approximately $50,000 ($250,000 multiplied by a 20% tax rate).
Here is where Power of Appointment is important. A power of appointment is a clause that allows the surviving spouse to exclude an asset from the trust. For example, the wife could exclude the real estate from the trust, the asset now goes to her outside the trust, and the cost basis just increased by $250,000. Another means to protect your family is a Disclaimers Trust, both accomplish the same.
One may not need a trust if they have less than $5 million in net worth, unless they are concerned about creditors, kids from previous marriages, or special needs children. However, if you have one, please ensure that it doesn’t cost you due to being inflexible.
Net Worth Between $5.43 and $10.86 Million
In theory, there shouldn’t be an estate tax liability here if it is in a community property state. If one doesn’t live in a community property estate, there may be an estate tax liability based on how the assets are split between a couple. Even if a trust might not be needed for an estate tax liability, there might be other reasons one wants a trust such as creditors, young beneficiaries, privacy, etc. However, the issue mentioned above becomes greater because asset sizes are larger, which means capital gains should be larger.
Couples in this situation might consider two options. There are more than two, but let me highlight the following two options. The first is a Power of Appointment, which we discussed earlier. The second is a Clayton Trust. The Clayton Trust allows the same flexibility, relatively speaking, but has one major difference. The executor decides on which assets will be excluded, not necessarily the surviving spouse (could be the same).
Net Worth Over $10.86 Million
A trust is typically needed in many cases. However, it is usually a very complex trust that might include a Generation Skipping Trust (GST), a QTIP, and/or several other options. Depending on how the entire estate plan is established, a Power of Appointment may or may not be needed.
The above is just a high level summary of when a trust may or may not be needed, and If needed, when a Power of Appointment or some form of flexibility is beneficial. Please note, it is critical that the trustee is aware of the appointment and why it may be used.
If we can help you by reviewing your estate plan, please feel free to call. As a Wealth Management firm, we believe it is important to focus on your estate planning, tax planning, risk management and investment needs.
* An AB trust is two trusts created at the first to die. Part of the assets, usually equal to the estate tax exemption goes into a trust for the first to die while the remainder goes into a trust for the surviving spouse. An ABC trust adds a layer so now you have 3 trusts created after the first to die. The A and B are the same as an AB trust but an added layer for a QTIP (Qualified Terminable Interest Trust) or a GST (Generation Skipping Trust) is created.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual, nor intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor. Tax laws and provisions are subject to change. No strategy assures success or protects against loss. Examples provided are hypothetical for illustrative purposes, and are not representative of any individual experience. Individual results will vary.
LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.