One of the most valuable tools for Financial Planning and especially Estate Planning is the Trust.  Trusts can do a lot of different things for you and no, they're not just for rich people.  What I'll do in this article is introduce you to three types of trusts and how they can work in your Financial Plan.  But first, please remember that setting up trusts and estate planning are activities that need to be done with a great deal of precision.  You need to work with a qualified estate planning attorney along with your Financial Planner.  This is not a "do it yourself" project.  So let's take a look at Living Trusts, Irrevocable Trusts and Credit Shelter Trusts.

Living Trusts

Living Trusts are actually a revocable trust.  In a Living Trust you contribute Corpus (assets) to the trust and the trust actually owns the assets.  The key point with a Living Trust is you can change your mind.  If you want to take the assets out of the trust and own them yourself, you can.  So why would you want to set up a Living Trust?

Benefits

Avoid Probate.  The assets in a trust are not subject to Probate.  Assets in a Living Trust pass to beneficiaries without going through Probate.  Probate is the process of distributing your assets in accordance with your will and there are expenses associated with Probate.  Additionally, any assets that pass through Probate are public record and if someone wants to find out about a Probate Estate they can.

Transfer of Control.  A Living Trust can be structured such that if the trustee becomes incapacitated someone else takes over control of the trust.  This can be used to help an aging parent who can currently act as his or her trustee but if cognitive impairment becomes an issue a new trustee can take over administration of the trust without too much of an administrative burden or having to go to court.

Estate Liquidity.  Assets in a trust can be immediately distributed by the successor trustee in the event of death.  There is no requirement to wait for the probate process to run its course.

What It Can't Do

Reduce Taxes.  Since the original donor to the trust maintains a level of control of the assets in the trust both trust income and trust assets can be subject to taxation.  Trust income will normally flow the beneficiary as taxable income.  The income will maintain its same character for the individual as the trustee.  For example, if the trust earns interest then distribution of that interest to the beneficiary will be characterized as interest on the beneficiary's Federal Income Tax return.   In the event of death assets in the trust are considered part of the donor's estate for Federal Estate Tax purposes.  Whether the estate is large enough to be taxed depends on the law in place at the time of death.

Alternatives

Contracts.  Transfer on Death (TOD), beneficiary designations, joint accounts and other contractual agreements can remove assets from the Probate Estate and also provide for estate liquidity.

Power of Attorney.  A General Durable Power of Attorney (POA) can also be used to plan for cognitive impairment.  It is, however, critical that the POA be Durable.  If the POA is not written to be durable it becomes void if the grantor loses the capability to cancel the POA.

Irrevocable Trusts. 

Like the name implies once you put an asset into an Irrevocable Trust you can't take it out.  It is pretty much as simple as that.  In the context of this article Irrevocable Trusts provide the following.

Benefits 

Estate Reduction.  Assets contributed to an Irrevocable Trust are not part of the donor's estate (there are limitations) and not subject to Estate Tax.  A common practice is to place a permanent life insurance policy inside an Irrevocable Trust and gift the premiums to the trust each year.  By doing this the death benefit is paid without being included in the insured estate.  This type of Irrevocable Trust is called an Irrevocable Life Insurance Trust (ILIT). 

Transfer of Control.  Like a Living Trust transfer of control from one generation to the next can be accomplished with an Irrevocable Trust.

What is can't do

Taxes.  An Irrevocable Trust may or may not reduce your Federal Income Taxes.

Alternatives

Transfer Ownership.  By transferring ownership you also remove an asset from your estate.  For instance, a father could transfer the ownership of an insurance policy to a daughter (if the daughter is the beneficiary) and gift the premiums to the daughter each year.  This would remove the insurance death benefit from the estate  (just like an Irrevocable Trust there are limitations...for example you can't do it on your deathbed).

Credit Shelter Trusts. 

Also called By-pass trusts these types of trusts are Testamentary Trusts which means they go into effect in response to instructions in the Last Will and Testament.  Testamentary Trusts are used for two primary reasons.

Use the Estate Tax Credit.  Until this year, if a married individual died and passed all of his or her assets to the spouse it was possible that the estate taxes would be higher on the second death than if the "first to die" had used some of his or her estate tax credit.  At the end of this year the law will revert to the old method unless Congress does something (Did I actually say "Congress does something"?).  By using a Credit Shelter Trust an individual can use the estate tax credit and thus reduce the overall taxation of the married couple's estate.  The trust can be set up to provide income to the spouse (under certain circumstances) without being a part of the spouse's estate.

Control Use of the Funds.  If an individual has minor children or children or other heirs that are not yet responsible with money, the trust can be set up to limit when the child can access the funds and how much of the trust assets the child can have at any given time.

This is, of course, just an introduction to trusts.  But you can see that trusts can have a use in almost anyone's Estate and Financial Plan.  Please remember though, this is not something you can do yourself regardless of what you hear on TV.  Seek competent legal advice before you draft any estate documents. 

If you recently inherited retirement assets from a deceased loved one, it is important to pay attention to IRS rules that govern this type of bequest. Your options in managing this money typically depend on your relationship to the deceased and the type of retirement account (401(k) or 403(b) plan, IRA, or annuity) that you inherited.

Employer-Sponsored Plans

IRAs

Annuities

Because determining the tax status of annuities and other inherited retirement assets can be complicated, you may want to consult an estate planning attorney or a financial advisor to answer any questions you may have.
 
Source/Disclaimer: 

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June 2012 - This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by C.L. Sheldon & Company, LLC, a member of FPA.