Jacqueline Gabbidon, JD, LL.M, CPWA®, AEP®
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Key Highlights
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A trust often serves as a foundational component of a comprehensive estate plan, offering key benefits like transferring wealth to beneficiaries, facilitating tax planning, or protecting assets from creditors. Different types of trusts have distinct advantages and considerations. The structure of your trust, even between trusts of the same type, may vary based on individual goals and circumstances. Your wealth management team can evaluate your unique goals and prepare you for conversations with your estate planning attorney.
Revocable or living trust
Revocable trusts, also known as living trusts or revocable living trusts, allow the grantor (the person who creates and funds the trust) to make changes to the terms of the trust or revoke the trust during the grantor’s life. Many revocable trusts, however, become irrevocable when the person with the power to revoke the trust (usually the grantor) dies. The grantor and the initial trustee for a revocable trust are often the same person, which can simplify trust administration and provide grantors with more control over trust assets.
The flexibility to alter the terms of the trust document is a key benefit to establishing a revocable trust. Grantors can typically change beneficiaries, alter distribution instructions, or remove assets from the trust as they see fit. The grantor also has the option to revoke the trust if it no longer serves the purpose for which it was originally created. This allows grantors to respond to changes in life circumstances or family dynamics when necessary.
One of the main benefits of a revocable trust is the avoidance of probate. Probate is the administrative process of settling a person’s estate through a court proceeding and distributing assets to the beneficiaries of the estate. The probate process can be costly and time-consuming, so avoiding it may preserve more wealth for beneficiaries and ensure a smoother transfer of assets.
Settling the estate usually requires hiring a probate attorney and, since probate filings are typically available to the public, the privacy of the beneficiaries could be jeopardized. If this is a concern, proactively establishing a trust, like a revocable trust, may help bypass the probate legal process.
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Revocable versus irrevocable trusts Many estate plans use a revocable trust as a means for the grantor to retain control over the assets and simplify the transfer process upon the grantor’s passing. However, a revocable trust does not reduce estate taxes or provide much creditor protection as the assets remain under the grantor’s control and in the grantor’s taxable estate until they pass away. By contrast, since grantors generally relinquish control and ownership of the assets they transfer into an irrevocable trust, many irrevocable trusts can provide a level of asset protection against creditors. If administered correctly, the trust assets will not be included in the grantor’s taxable estate, which can lower their estate tax liability. In other words, the grantor of an irrevocable trust trades control and ownership of the trust assets to reduce the value of their taxable estate at death and minimize their estate taxes.
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Irrevocable life insurance trust (ILIT)
An irrevocable life insurance trust (ILIT) is an irrevocable trust structured to hold one or more life insurance policies that typically insure the life of the grantor. In contrast to a revocable trust, an ILIT is generally irrevocable and unamendable. Like many other irrevocable trusts, an ILIT holds assets outside of the grantor’s taxable estate, which can potentially lower their estate tax liability if the trust is structured properly. In the case of an ILIT, the trust holds the proceeds of a life insurance policy outside the grantor’s taxable estate.
Generally, an ILIT takes ownership of the grantor’s life insurance policy. Premiums for the policy are paid by the trust, not the grantor. Upon the grantor’s death, the life insurance proceeds are distributed to the trust and then to the trust beneficiaries in accordance with the terms of the trust. Since the grantor had no ownership interest in the policy, the proceeds of the policy will not be included in the grantor’s taxable estate. This can result in significant estate tax savings.
In addition to the potential estate tax savings, an ILIT may also allow the grantor to provide their heirs with a regular income stream. Through an ILIT, the grantor can ensure proceeds from their life insurance policy can be distributed across a defined timeframe, which differs from naming a beneficiary directly on the insurance policy and having them receive a lump sum distribution of the policy proceeds.
Utilizing an ILIT requires careful planning and execution, as certain actions may unintentionally cause the policy proceeds to be included in the grantor’s taxable estate.
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What is the lifetime exemption amount? Understanding the federal lifetime estate and gift tax exemption is important to consider when choosing a type of trust because it helps determine how much wealth can be transferred tax-free, allowing for more effective estate planning and potential tax savings when using a trust. The IRS requires payment of a federal estate tax if the value of an individual’s estate exceeds a specific dollar amount that includes any taxable gifts that occurred during the decedent’s life. For the federal lifetime estate and gift tax exemption, the value of any assets over the exemption amount will be subject to estate taxes. Conversely, if the value of transferred assets and lifetime taxable gifts is lower than this threshold, no estate tax would be incurred. The current federal lifetime exemption amount is $13.61 million in 2024 and is expected to be reduced to $5 million indexed for inflation pursuant to the sunset of certain provisions of the Tax Cuts and Jobs Act on December 31, 2025. Note that some states impose their own estate and gift tax which may have a lower threshold than the federal estate and gift tax exemption.
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Spousal lifetime access trust (SLAT)
A spousal lifetime access trust (SLAT) is another type of irrevocable trust that can reduce the taxable estate of both spouses without completely losing access to their assets as they would with other irrevocable trusts. A SLAT can be created by just one spouse for the benefit of the other, but a more typical SLAT technique involves each spouse creating a SLAT for the benefit of the other spouse.
In this strategy, each SLAT is funded with all or a portion of each spouse’s lifetime exemption amount. In doing so, each spouse reduces his or her estate by the amount funding the trust. Since each spouse is also the beneficiary of the SLAT created by the other spouse, the couple still has access to the full value of their estate. Use of the assets is governed by the trust agreement for each SLAT. Since each SLAT is an irrevocable gift to the other spouse, divorce or the death of one spouse can fundamentally change the dynamics of the couple’s estate plan and may impact the efficacy of this strategy.
Typically, a SLAT is structured as a “grantor trust” for income tax purposes. This means the grantor is generally responsible for paying all income taxes and capital gains taxes associated with the trust’s investments. Otherwise, as is often the case in a “non-grantor trust,” the tax responsibility would be borne by the trust itself or its beneficiaries. By paying income taxes on the trust assets, the grantor is effectively reducing their taxable estate and indirectly benefitting the beneficiaries without involving a taxable gift.
Another attractive feature of the grantor trust is that the grantor retains the right to remove assets from the trust and substitute in other assets. This flexibility allows for adjustments to the assets held in the trust if market conditions or other changing circumstances affect the value of the assets.
In addition, when drafting the SLATs, the provisions of each SLAT should not be identical to avoid violating the concept known as the reciprocal trust doctrine. If certain provisions of each trust are too similar or identical (for example, having the same beneficiaries or distribution terms), it may result in the trust assets being included in each spouse’s taxable estate, meaning the couple would forfeit a key estate tax planning benefit that SLATs can provide. If you and your spouse are considering creating SLATs for the benefit of each other, you should take care in working with your estate planning attorney to ensure the trusts are materially different and the estate tax benefits are preserved.
Credit shelter trust
A credit shelter trust, also commonly called a family trust or a bypass trust, provides a vehicle for married couples to fully utilize their federal lifetime estate tax exemptions. In order to minimize estate tax exposure, the credit shelter trust is funded up to the decedent spouse’s remaining lifetime exemption amount upon their death. The surviving spouse is typically the beneficiary of the trust, and trust assets can be used for his or her health, education, maintenance, and support during life.
Upon the death of the surviving spouse, the trust assets are transferred to the remainder beneficiaries per the terms of the trust free of estate taxes in most circumstances. In other words, the exemption remains with the trust, meaning federal estate taxes will generally not be incurred even if the assets appreciate over time.
A credit shelter trust is typically created as a continuing trust under the grantor’s revocable trust, but may also be part of the grantor’s last will and testament as a testamentary trust. There are requirements and restrictions to ensure that the credit shelter trust functions to provide the estate tax benefits for which it is created. As with any trust and estate planning, it is critical to proactively consult with your wealth management team, including estate planning professionals, to ensure that the trust is properly created and will fulfill the goal of estate tax minimization.
Specialized estate planning and trust guidance
Choosing the right trust to support your estate plan requires a thorough understanding of your goals. By partnering with a wealth management team at Commerce Trust, a team of specialists across multiple disciplines will coordinate to identify the logical next steps. Proactive estate planning ensures experienced advisors get to know you and your objectives before your plan is put into motion. If your estate plan involves establishing a trust, our professional advisors will provide the necessary information to facilitate the process and partner with your estate planning attorney at your request to help you successfully achieve your goals.
Contact Commerce Trust today to learn more about our estate planning capabilities. Through a team-based approach, our financial planning, investment management, and tax management* professionals will deliver a comprehensive wealth management strategy under one roof.
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Investments & Wealth Institute™ (The Institute) is the owner of the certification marks "CPWA", and "Certified Private Wealth Advisor." Use of CPWA, and/or Certified Private Wealth Advisor signifies that the user has successfully completed The Institute's initial and ongoing credentialing requirements for wealth advisors.
The opinions and other information in the commentary are provided as of August 9, 2024. This summary is intended to provide general information only, and may be of value to the reader and audience.
This material is not a recommendation of any particular investment or insurance strategy, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified tax advisor or investment professional. While Commerce may provide information or express opinions from time to time, such information or opinions are subject to change, are not offered as professional tax, insurance or legal advice, and may not be relied on as such.
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