Wealth Management by 4Thought Financial Group
"The comprehensive wealth management we provide involves the coordination and execution of four different types of financial planning: Investment Planning, Estate Planning, Business Succession Planning and Fringe Benefit Planning."
(Co-authored by 4Thought Financial Group CIO Jesse Mackey)
Most individuals that either now have or expect to have substantial wealth in the future prefer to plan in advance of their own death to minimize estate taxes to the extent possible.
While the federal estate tax exclusion in 2019 is relatively high compared to history ($11.4 million for an individual), the amount above that left to beneficiaries on death may be taxed at a maximum rate of 40%. This could be a huge tax bill in some cases if the proper planning is not done beforehand. In addition, some states have their own lower estate tax exclusion (in New York for example, it’s $5.74 million), so more people need to consider doing such planning than one might think.
So how exactly can one reduce estate taxes?
While there are several potential answers to this question (and the appropriate ones depend on the specifics of the situation), one possible solution is the Irrevocable Living Trust.
An Irrevocable Living Trust can be created today, while the grantor is still alive (as opposed to a Testamentary Trust, which is created at the death of a grantor), and transfers asset ownership from an individual to a legal entity with its own rules of operation, but it requires that the grantor surrender some control and access to assets (hence “Irrevocable”).
Relinquishing this control may be acceptable to the individual for several reasons, such as to protect assets from creditors and lawsuits, or to circumvent the often lengthy and expensive estate probate process, but a prime objective is often to reduce or eliminate estate taxes.
With an Irrevocable Living Trust, the grantor must make a “completed gift” to the trust. This means that the gift must be permanent, and that the grantor cannot also be the trust beneficiary. However, there is potentially some minor flexibility in the ability of the grantor to access the assets afterwards, in that most documents are written so that the grantor can take a secured loan if necessary. Assets must be transferred into the trust after it is created and before the death of the grantor in order to be shielded from estate taxes.
Taxation of the trust and its assets is important to understand. The Irrevocable Trust must pay income taxes at the highest individual tax rate. If the trust pays income to beneficiaries, these recipients will pay taxes on the income at their own personal rate. Also, there is no step-up in cost basis for capital gains tax purposes on the death of the grantor with an Irrevocable Living Trust.
There are also some considerations from a set up and maintenance standpoint:
- An attorney must draft the document, usually costing $2,000-$5,000, and it must be coordinated with the Wills and any other estate planning documents utilized by the grantor and his/her spouse. (While the Irrevocable trust typically takes precedence over a Will and may include some of its typical features, it does not replace it.)
- The trust document should acquire its own tax identification number at the time it is created, otherwise this will add an additional step to the operational process at death, in which the accountant will have to apply for a tax ID at that point, delaying the disposition of the trust assets. It’s usually recommended to get this done in advance.
- A gift tax return must be filed in any year a gift to the trust is made in excess of the “Annual Exclusion” (which is $15,000 in 2019), or if the gift would cause the grantor to exceed the total lifetime “Unified Credit” amount ($11.4 million in 2019). There is no significant negative to filing this, as it helps to document the gift and protect the grantor. The gift tax return should be filed any time money is “gifted” to a trust.
- The trust must annually file an IRS form 1041, which is a trust tax return.
There are additional specialized subcategories of the Irrevocable Living Trust as well. One of these is called an “Intentionally Defective Grantor Trust” (IDGT). As mentioned earlier, the Irrevocable Living Trust will pay income taxes at the highest individual tax rate, unless it is made “intentionally defective.” With an IDGT, the grantor makes a gift to the trust and then pays all of the trust’s income taxes at his/her individual tax rate. Paying the taxes for the trust allows the assets held by it to grow without the drag of taxation, which is an indirect way of allowing the grantor to make a larger gift to the trust (and ultimately the beneficiaries) than they’d be able to if the trust was not “defective.”
Another subcategory of the Irrevocable Living Trust is the “Irrevocable Life Insurance Trust” (ILIT). This is a way to remove a life insurance death benefit from the estate for estate tax purposes. In this case the trust is made the owner and beneficiary of a life insurance policy (with the grantor as the insured), and the individuals (usually the spouse, and then the children) are made beneficiaries of the trust itself.
On the grantor’s death, the ILIT would be funded by the death benefit from the life policy, allowing the influx of cash to remain safe from estate taxation, and allowing it to bypass the probate process. The primary beneficiary of the trust (typically the surviving spouse) may then take income from the trust to cover living expenses during their lifetime. At the second spouse’s death, the remaining assets would typically initially remain in trust for the contingent beneficiaries (the children) until they reach a predetermined age written into the document, after which point they may receive the assets outright (they become individually titled). But often it may make more sense to instead leave the assets permanently in trust for the children for their entire lives (and potentially multiple future generations), thereby indefinitely protecting the assets from any creditors or unexpected future claimants.
Importantly, for grantors that are concerned about eating into their lifetime Unified Credit amount by paying the annual insurance premium, a “Crummey Letter” will be needed. This is a letter that goes to each beneficiary of the trust each year, in which they must sign that they waive the right to withdraw the premium amount.
While an Irrevocable Living Trust is certainly not for everyone, it can be a valuable tool for alleviating estate taxes and for preparing a smooth transition for heirs. If you are considering an Irrevocable trust, make sure to discuss it in full detail in advance of implementation with your financial advisor, estate attorney, and accountant.
4Thought Financial Group
Concerned about estate taxes and the potential reduction in the value of the assets to be passed to your heirs? Contact 4Thought Financial Group to find out whether an Irrevocable Living Trust or other estate planning techniques could help you.
Financial Planning and Investment Advisory Services are offered through 4Thought Financial Group Inc., an SEC Registered Investment Adviser. This document is for informational purposes only and does not constitute a complete description of our services or performance. This is in no way a solicitation or offer to sell financial planning or investment advisory services except, where applicable, in states where we are registered or where an exemption or exclusion from such registration exists. This information is not to be construed as legal or tax advice. Consult with an attorney and/or an accountant before taking any action on the information provided.