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Knowing how to avoid estate taxes with a trust is paramount to successfully transferring your hard earned wealth to your heirs.
The estate tax is a significant barrier if you are an accredited investor or successful business owner who wants to leave a legacy for your family members. While only a small percentage of U.S. residents are impacted by the federal estate tax, the levy impacts more than just the ultra wealthy.
For example, if you are a farmer, family business owner, or successful career professional, you may want to reduce the size of your estate as well. After all, the tax is on net-worth, not just investable assets.
Of course, you could avoid the tax altogether by moving to Canada, New Zealand, or one of the other countries that has no federal estate taxes. But for most people, reducing the size of your estate is the most effective way of reducing or eliminating the estate tax.
There are several ways you might reduce your estate, including spending assets, giving assets away, buying life insurance and putting assets in trusts.
For most people who are impacted by the estate tax, trusts are integral to reducing an estate’s size and may help to reduce estate taxes.
Estate Taxes Reduce Individual’s Abilities to Leave Legacies
Estate taxes are a final tax bill that’s assessed on estates exceeding a certain size. They’re one of the final payments made when an individual passes away (along with probate fees and final income taxes).
Since the 2018 tax reforms, the federal estate tax exemption will be $11,180,000 for individuals and $22,360,000 for married couples filing jointly in 2018.
Estates exceeding these values are subject to a 40-percent tax bill on the excess amount, for the tax is no longer graduated. In most cases, the estate tax must be paid in a timely fashion after death and it must be paid in cash.
If you’ve ever calculated your net worth, you can easily estimate the current value of your estate. Simply add up the value of your assets and subtract all your liabilities.
Assets may include, but aren’t limited to:
Personal residence
Bank accounts
Investments
Properties
Business interests
Life insurance death benefits
Any other assets that would be passed on to heirs
Spouses can pass on all of their assets and any unused estate tax exemption to their surviving spouse tax-free if one spouse dies. In the past, A/B trusts or marital trusts were utilized to accomplish the same task. Luckily, this is no longer necessary.
A strategy for reducing the value of an estate is still needed in this situation, however, because death is impossible to predict with certainty. It’s possible your estate will still be taxed if it exceeds the allowed exemption by growing over time.
The estate tax exemption is actually a unified gift and estate tax exemption, so any gifts exceeding the annual allowed amount generally counts against the exemption. Exemptions and rates may change again in the future, and all of this is in addition to any individual state’s estate tax.
Virginia doesn’t currently have a state-assessed estate tax.
Trusts Can Effectively Reduce the Taxable Size of Estates
As mentioned, trusts are one of the most reliable and effective ways to legally reduce the size of an estate. When set up properly, trusts can either greatly reduce how much of an estate is taxed at the 40-percent rate or eliminate the estate tax burden altogether.
A trust is essentially a financial arrangement between three parties in which assets are held for a beneficiary. The assets are turned over by the trustor and managed by the trustee. The trustee has a fiduciary responsibility to manage the trust assets for the advantage of the beneficiary.
For the purposes of reducing your estate, trusts are effective because they take assets out of your name and put them in the name of the trust.
Every dollar that’s moved from your name to a trust matters. For every dollar moved, that’s a dollar that either doesn’t count toward the exemption or isn’t taxed at the 40-percent rate. The process is legal and can result in a major reduction of your end-of-life taxes.
You Have Multiple Trust Options Available for Use
There are several types of trusts, including living trusts and irrevocable trusts, that you might use to reduce the size of your estate. Often, people use a combination of the various options.
Qualified Personal Residence Trust for Your Home
Qualified personal residence trusts (QPRTs) are primarily used to eliminate the value of a personal residence from the total value of an estate. Assuming you have a nice home, this single move could greatly reduce how much your estate is worth.
A QPRT works by transferring your residence from your name to the trust’s. The home remains in the trust for a predetermined amount of time, after which it goes to the trust’s beneficiaries. The beneficiaries would be your chosen heirs.
Successfully setting up a QPRT requires forethought and honest conversations, but it’s certainly a viable option. Should you pass away before the trust expires, the residence goes back to your estate and the transfer is for naught.
Usually, people who establish this type of trust make it so that they can live in their house while the trust is in effect. Then, they either accept that a move will be in order after the trust expires or set up a rental arrangement with the beneficiaries who receive the residence.
Irrevocable Life Insurance Trust for Your Death Benefits
Irrevocable life insurance trusts (ILITs) typically help reduce the value of life insurance policies’ death benefits from an estate.
Do you have permanent life insurance? If so, transferring your policy to an ILIT could reduce your estates’ value by a seven-figure sum or more depending on the value of your policies.
An ILIT moves your life insurance into the trust and makes the trust the beneficiary of any death benefits that the policy will pay. The payments are then distributed to your heirs, usually over time. As long as you live at least three years after the transfer to the trust is completed, the death benefits aren’t included in your estate.
If relevant to your situation, an ILIT can have the added benefit of disbursing funds over time to discourage irresponsible spending. It also may shield death benefits from creditors whom you owe.
Grantor Retained Annuity Trusts for Income Generating Assets
Grantor retained annuity trusts (GRATs) and grantor retained unitrust (GRUTs) are very similar to one another. They’re both used to shelter income producing assets such as business interests, stocks, bonds, or real estate. GRATs are used when assets produce consistent incomes, and GRUTs are for when the assets’ income fluctuates.
Either of these trusts works, similar to how a QPRT functions. The income-producing asset is placed into a trust for a set amount of time, and you receive the asset’s income during that time. When the trust expires, the asset (and it’s income) go to the heirs who are named as beneficiaries.
This strategy doesn’t fully reduce your estate by the value of the asset. However, it does reduce the taxable value of the asset by delaying when the transfer to heirs occurs.
Charitable Remainder Trusts for Appreciated Assets
Charitable remainder trusts (CRTs) are often used for highly appreciated assets, because they help divert capital gains taxes as well as estate taxes. They may be a good choice for real estate, stocks, mutual funds or other assets that have been in a portfolio for some time.
A CRT transfers your asset into an irrevocable trust and by doing so, removes your asset from your estate. The trust then sells the asset at fair-market value. The proceeds from the sale can be used to provide you with income during your lifetime, and the trust principal is given to the charity upon death.
In addition to reducing your estate’s value, a CRT has two other tax benefits. It provides an immediate charitable tax deduction when assets are transferred, and no capital gains are paid on the assets that the trust sells.
It’s the capital gains benefit that makes this a particularly attractive option for highly appreciated assets.
Charitable Lead Trust for Good Will
Charitable lead trusts (CLTs) are used to direct funds toward charities without detracting from heirs’ future inheritances. These trusts function almost opposite of how CRTs work.
A CLT transfers your asset to a trust and thereby, reduces your estate by the value of the asset. The trust then makes payments to one or more chosen charities, either for a set amount of time or until your passing. When the trust terminates, the asset is given to heirs who are the trust’s beneficiaries.
A CLT may be an appropriate choice if you want create an income stream for your favorite charity during your lifetime. Just know that your heirs won’t receive the principal until after your death.
Intentionally Defective Grantor Trust for Appreciating Assets
Intentionally defective grantor trusts (IDGTs) are normally used when assets are expected to appreciate significantly. One of their main purposes is to let an asset grow outside an estate so that the appreciation isn’t included in the estate’s value.
An IDGT transfers your asset to a trust, but it’s set up so that you continue to pay income tax on whatever income the asset generates. The trust will provide some payments for a defined amount of time, and the assets are transferred to beneficiaries upon termination. The payments, of course, must be listed on your income tax return.
Without income tax eating away at the asset’s value, the asset in this type of trust can see significant growth. None of that growth is included in your estate since it occurs in a trust.
Explore the Trusts Available to Help You
These are just some of the trusts that you might use to reduce the size of your estate and future estate tax liability.
If you are a high-net-worth individual, a trust can be a great tool for tax reduction.
However, for individuals with less than $11,180,000 or married couples with less than $22,360,000 you may be at risk too! After all, if invested prudently, your net-worth should grow over time, and potentially surpass these numbers for many.
That's why it's so important to have a wealth advisor who understands trusts while also specializing in tax-managed investing.
Ultimately, in order to be effective, trusts must be properly identified, established, and funded. You should also project the growth of your wealth over time to ensure your estate plan is built for today and tomorrow.
Mark Fonville, CFP®
Mark has over 18 years of experience helping individuals and families invest and plan for retirement. He is a CERTIFIED FINANCIAL PLANNER™ and President of Covenant Wealth Advisors.
Disclosure: All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Diversification does not eliminate the risk of market loss. Investment risks include loss of principal and fluctuating value. There is no guarantee an investing strategy will be successful. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. This article is not advice and you should always consult with a financial advisor, tax advisor, or estate planning attorney.
Registration of an investment advisor does not imply a certain level of skill or training.