Understanding how a trust works can help you become more comfortable using them to achieve your estate planning goals. Think of a trust as a bucket holding water (money) with a spigot that is either closed or open. A trustee is in charge of turning that spigot. The trust beneficiary receives the water (money).
A trust is often created with a “closed spigot” and is used where there is a possibility of either an outside risk (divorce, creditors, taxation) or inside risk (a troubled beneficiary). If a trust beneficiary has limited or no access to the funds, it makes it difficult for a potential creditor to gain access to the trust assets. The application of state law is very important as to the effectiveness of this technique and should be researched prior to creating a trust. When estate tax planning is the main goal, several types of trusts with a closed spigot may be used. This may maximize the assets remaining for heirs. One common trust is a Credit Shelter Trust (CST) which will typically hold the federal estate tax exemption ($5.45MM in 2016) of the first spouse to die and of which the surviving spouse is a lifetime beneficiary. The trustee in this type of trust may often have absolute discretion over trust distributions. Anytime a discretionary trust is created, it is good practice to provide the trustee written guidelines for making distributions in varying circumstances. Remember, the trustee’s primary job is to follow the instructions given by you, the grantor.
A trust created with an “open spigot” may be used to comply with estate tax requirements or personal management preferences. Mandatory income distributions are a requirement for a Qualified Terminal Interest Property (QTIP) Trust. This trust is created for the benefit of a surviving spouse but ensures the assets pass according to the wishes of the first spouse to die. Mandatory income distributions and discretionary principal distributions may be set up for a beneficiary where support is the main goal.
Beyond income distributions, there are two additional common options for opening the spigot more. First, distributions may be permitted for health, education, maintenance, and support. These are called ascertainable standards. An example of maintenance and support might be buying a new car similar to the one you are now driving. This could be a permissible distribution whereas upgrading to a new Rolls Royce would be a more challenging request. Additionally, a beneficiary can be given a right to access 5% of the principal annually without providing justification to the trustee. It all depends on the terms of the trust.
Trusting the Trustee
The trustee clearly has a critical role in making a trust work. Financial responsibility is probably the most important consideration in choosing a trustee as well as the ability to get along with the beneficiary. Making sure you name at least one successor trustee is also a prudent move. A beneficiary can often be named a co-trustee and given rights to administer the trust with all powers except discretionary distributions of income or principal of the trust.
A trust can be tailored to your individual needs and is a helpful technique in meeting estate planning and wealth transfer goals.