By ERIN MCCARTHY
Updated Nov. 9, 2014 4:46 p.m. ET
For many investors, trusts are an ideal way to keep portfolios safer for the long term.
The hard part is knowing what kind of trusts to set up and how to do it.
Trusts can protect assets from taxes and legal threats, and provide income for family and descendants for years to come. But if a trust isn’t set up correctly, it can be ignored by the courts. Safeguards set up for family members may no longer exist, or planned tax savings may no longer be in effect.
Here’s a look at several kinds of trusts, which ones work best for whom, and mistakes to avoid.
Irrevocable Life Insurance Trust What It Is: This is used to buy life insurance on behalf of the person establishing the trust. The trust owns the insurance and pays the premium, and the benefits are paid into the trust. That way, the death benefit is isolated from estate tax, says Joan Crain, wealth strategist at BNY Mellon Wealth Management.
Life-insurance payouts can raise the risk that the insured’s estate will be taxable. And if the estate is already taxable, the payouts make the taxes worse, says Robert Weiss, the global head of J.P. Morgan Private Bank’s Advice Lab.
With a trust, the payouts won’t increase the beneficiary’s estate. The death benefit can be paid immediately or stay in trust for generations. The insured can put more than one policy into a single trust, or create multiple trusts for different beneficiaries. Policies in a trust also have some creditor protections.
Best for: The trusts are ideal for someone younger, who can obtain life insurance at affordable rates, and wants to protect any large insurance benefits from facing estate taxes.
Mistakes Often Made: Mr. Weiss says he has seen people set up a trust but never put the policy into it; others pay the premiums from their personal assets rather than from the trust. In such cases, those payments are not protected from any wealth-transfer taxes.
Granter Retained Annuity Trust What It Is: Also known as GRATs, these trusts are typically short term, most commonly two to five years, and allow people to transfer their wealth to family members with little to no exposure to wealth-transfer taxes.
The granter places assets—such as cash, stocks or bonds—into the trust and each year receives an annuity payment. At the end of the trust’s term, if the trust’s assets have outperformed a “hurdle rate” set by the IRS—also known as the 7520 rate—those excess returns are distributed to the trust’s beneficiaries or into another trust, free of gift and estate tax, J.P. Morgan says.
In recent years, low interest rates have resulted in an especially low hurdle rate, giving people more confidence their assets will outperform.
Best for: GRATs are ideal for granters who want to pass on assets to their own children while avoiding a hefty wealth-transfer tax. Through these short-term trusts, investors often try to take advantage of market volatility, placing assets in the trust that are expected to perform well in the next few years.
Mistakes Often Made: One critical point: The granter must survive the term of the trust. If the granter dies before the trust reaches the end of its term, the trust collapses and the assets are returned to the granter’s estate.
Dynasty TrustWhat It Is: These trusts allow families to use wealth-transfer tax exemptions of up to $5.34 million per person to place assets into trust and let them grow untouched. “The idea there is that you’re creating a family resource that’s a pool for future generations,” says Carol Kroch, managing director of wealth and philanthropic planning at Wilmington Trust Co.
Best for: They are for individuals thinking very, very long term. Then later, the trust can make tax-free distributions to the granter’s children, grandchildren or future generations. The trust can specify whether beneficiaries will have access to its income or principal, and when. Such trusts can provide a great deal of tax savings.
Mistakes Often Made: Not all states allow dynasty trusts. Delaware, Pennsylvania, Rhode Island, Idaho and Louisiana are among the states that do.
Also, granters should use the trusts for assets they are confident will appreciate. If they use a wealth-transfer tax exemption to fund a trust with a stock that falls in value, the exemption ends up being wasted, Mr. Weiss says.
Qualified Personal Residence TrustWhat It Is: A homeowner can place a residence in this trust—often a second home—to transfer the property later without paying full transfer taxes. The granter pays gift tax when the home goes into the trust, but on a reduced value of the house, since they reserve the right to live in it for the term of the trust, according to BNY Mellon Wealth Management. The value of the home for gift-tax purposes is the fair market value minus the present value of the granter’s right to use it during the length of the trust (calculated using an IRS formula), J.P. Morgan says.
The trust lasts a certain number of years, and when it ends, the beneficiaries—often children—will own the residence. Any appreciation of the home since being placed in the trust is transferred to beneficiaries free of gift and estate tax. If the granter dies before the trust’s term ends, the home is transferred back to the granter’s estate.
Best for: People with vacation homes who know they want to give them away to their children or other family members down the line.
Mistakes Often Made: These trusts are most beneficial when interest rates are higher, since that results in a lower gift-tax value on the residence when it is placed in the trust.
Revocable Living TrustWhat It Is: This is a trust created to hold and protect assets during an individual’s lifetime. While it doesn’t provide any tax savings, it does protect assets from probate. The individual creating the trust can also assign a successor trustee in the case of his/her death or incapacitation, which is a critical benefit, says Ms. Crain.
Best for: A revocable living trust makes sense for someone middle-aged or older who has money or investments that “they wouldn’t want the court to take over if there’s something that happens to them,” Ms. Crain says. It also could be a good fit for someone seeking privacy, as a living trust is shielded from public scrutiny, rather than the estate being settled through probate, she adds.
Mistakes Often Made: Some investors don’t put all the assets they should in the trust, so those assets are not protected from probate, Mr. Weiss says.
Charitable Remainder TrustWhat It Is: Here, a granter puts assets into a trust and takes at least a 5% income interest, or assigns it to another beneficiary. What is left at the end of the trust’s term goes to charity, and the granter receives an income-tax deduction for that amount, says Ms. Kroch of Wilmington Trust. The beneficiaries pay income taxes on the distributions.
Best for: These trusts are ideal for an investor who has assets that have already grown, since assets in the trust can be sold without incurring capital gains taxes, advisers say.
Mistakes Often Made: Ms. Kroch advises working with a trusted professional, as the rules are very detailed.
Ms. McCarthy is a reporter for The Wall Street Journal in New York. Email firstname.lastname@example.org.