Trusts can be valuable tools for managing assets, protecting a family's financial future, and carrying out estate planning goals. They can help individuals determine how their assets will be managed, who will receive them, and when distributions should occur. Depending on the type of trust and the individual's circumstances, trusts may also offer benefits related to probate administration, privacy, and tax planning.
However, creating a trust is only one part of an effective estate plan. It must be properly established, funded, maintained, and coordinated with the rest of an individual's financial plan to accomplish its intended purpose.
Understanding how to avoid these four common trust-related problems can help you avoid complications, protect your assets, and ensure your estate plans continue to reflect your wishes.
Mistake 1: Not Coordinating the Trust With Retirement Accounts and Life Insurance
A trust is usually just one component of a broader estate plan. Retirement accounts, life insurance policies, investment accounts, real estate, and other assets may each have their own ownership and transfer rules. Failing to coordinate these with the trust can create unintended consequences, especially when beneficiary designations and tax rules are involved.
Retirement Accounts
Retirement accounts, such as traditional IRAs and employer-sponsored retirement plans, generally have beneficiary designation rules that determine who receives the account after the owner's death.
Naming a trust as the beneficiary of a retirement account can be appropriate in certain circumstances, such as when the owner wants to provide structured distributions for beneficiaries or address specific family circumstances. However, this can also introduce additional tax and administrative considerations.
For example, distributions from inherited traditional retirement accounts are generally subject to income tax, and the rules governing required distributions depend on factors such as the beneficiary's relationship to the original account owner, the account owner's circumstances, and whether the beneficiary is an individual or a trust.
Certain trusts can qualify for specialized treatment under inherited retirement account rules, but they must meet applicable requirements. Naming a trust as a beneficiary without understanding these rules could limit distribution flexibility or create unintended tax consequences.
Life Insurance
Life insurance can provide liquidity to a family or help support an estate plan. However, the choice of beneficiary can affect how the proceeds are administered and whether additional planning is needed.
For instance, naming an individual directly as the beneficiary generally results in the insurer paying the proceeds according to the policy's terms. Naming a trust may allow the proceeds to be managed and distributed according to the trust's provisions.
In certain situations, specialized irrevocable life insurance trusts may be used for estate tax planning. However, as always, their effectiveness depends on the structure of the arrangement, proper administration, and compliance with applicable requirements.
It is also important to distinguish between who receives life insurance proceeds and whether those are included in the insured person's taxable estate. These are separate questions, and the answer depends on factors such as ownership and retained rights.
How to Avoid This Mistake: Individuals should review retirement accounts and life insurance policies alongside their trust documents rather than treating each asset separately. An estate planning attorney and tax professional can help evaluate beneficiary designations, distribution objectives, tax considerations, and any applicable retirement account rules.
Mistake 2: Assuming Every Trust Provides Tax Savings
A common misconception is that establishing a trust automatically reduces income taxes, estate taxes, or other tax liabilities.
But, trusts are not all taxed the same way. Some are designed primarily for estate planning, while others may be established to accomplish specific tax, charitable, or asset-management objectives.
For example, a revocable living trust is commonly used to manage assets during an individual's lifetime and provide instructions for distributing those assets after death. However, assets held in a typical revocable grantor trust generally remain attributable to the grantor for federal income tax purposes.
As a result, transferring assets into a typical revocable living trust generally does not, by itself, reduce the grantor's federal income tax liability or remove those assets from the grantor's taxable estate.
Certain irrevocable trusts may provide estate tax planning opportunities, but the outcome depends on the trust's provisions, the assets transferred, and the applicable tax rules. Creating an irrevocable trust does not automatically eliminate estate taxes or guarantee income tax savings.
Trusts can also introduce additional tax considerations. For instance, trusts that retain taxable income may face compressed federal income tax brackets, meaning they can reach the highest marginal tax rate at substantially lower income levels than individual taxpayers.
How to Avoid This Mistake: Before establishing a trust for tax purposes, individuals should understand what the trust is intended to accomplish and whether its structure supports those goals.
Mistake 3: Failing to Keep Trust and Personal Finances Separate
When a trust is established, maintaining separation between trust assets and personal finances is important.
This is particularly relevant for irrevocable trusts and trusts with separate legal, accounting, or tax obligations.
Why Separation Matters
Suppose a trustee manages an irrevocable trust that owns an investment account. The trustee uses funds from that account to pay personal expenses without properly documenting or authorizing the transactions. This can create accounting problems, raise questions about whether the payments were appropriate distributions, and potentially create legal or tax complications.
Even when a trustee has authority to make distributions, each transaction should be properly documented and consistent with the trust agreement and applicable law.
Maintaining separate accounts and records also helps distinguish income earned by the trust from income earned personally by the grantor or trustee.
For trusts that require separate tax reporting, this is particularly important when preparing Form 1041 and determining whether beneficiaries should receive Schedule K-1 forms.
How to Avoid This Mistake: Trustees should generally maintain dedicated accounts for trust assets, document transactions, and avoid using trust funds for personal expenses unless a payment is properly authorized and recorded. They should also maintain organized records of income, expenses, distributions, and transfers between accounts. If a transaction involves both personal and trust assets, the trustee should obtain appropriate professional guidance to ensure the transaction is handled correctly.
Mistake 4: Assuming the Trust Document Alone Determines the Tax Treatment
A trust document establishes important instructions regarding how trust assets should be managed and distributed. However, it does not independently determine every federal or state tax consequence. That depends on thing like applicable law, the trust's actual activities, ownership of assets, and distributions.
Why this Matters
A trust agreement may authorize the trustee to distribute income to beneficiaries while retaining principal. However, the tax treatment of the distributions depends on the applicable trust accounting rules and federal income tax provisions, including the rules governing distributable net income.
When a trust distributes taxable income to beneficiaries, the trust may be required to report the appropriate amounts on Schedule K-1 (Form 1041). Beneficiaries may then need to report those items on their individual income tax returns. However, it’s important to note that amount of cash distributed does not necessarily equal the amount of taxable income they report.
Additionally, a trust's classification for tax purposes matters. Many revocable trusts are treated as grantor trusts for federal income tax purposes, meaning their income is generally reported by the grantor rather than taxed separately to the trust. Other trusts may be required to file separate income tax returns and pay tax on income they retain.
How to Avoid This Mistake: Trustees should not rely solely on the trust document when making tax-related decisions. Instead, they should work with a qualified tax professional to determine the appropriate reporting treatment for the trust's income, deductions, distributions, and other activities. Beneficiaries should also review any Schedule K-1 they receive and provide it to their individual tax preparer.
Final Thoughts
Trusts can play an important role in estate planning, but establishing one is only the beginning. To achieve the intended benefits, individuals must ensure that the trust is properly funded, maintained, and coordinated with their broader financial affairs.
By avoiding common mistakes and working with qualified professionals, individuals can better position their estate plans to support their wishes and provide clarity for the people who matter most.
If you are familiar with trusts in any capacity, you probably recognize a few common mistakes with trusts not named here. I wrote an article a few months ago on this topic, which included the five mistakes below. Rather than rewrite these sections in this article, I’ll link the original article which you can read here: https://www.summitwealthandretirement.com/swrp/five-trust-mistakes
Mistake #1: Creating a Trust but Never Funding It
Mistake #2: Forgetting to Update Your Trust
Mistake #3: Choosing the Wrong Trustee
Mistake #4: Ignoring the Tax Implications
Mistake #5: Assuming a Trust Solves Every Estate Planning Problem
This material is purely intended to be general and educational in nature, and should not be construed as specifically-tailored investment, financial planning, tax, legal, or other professional advice. Information and data contained herein is as-of the date of publication, and may be subject to change in the future without notice. Any investment performance referenced is purely past performance, which is no guarantee of any future performance. Nothing contained herein should be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation of any security or other financial product or investment strategy. All investment, tax, and financial planning strategies involve risk that you should be prepared to bear. You are highly encouraged to consult with professionals of your choosing before taking any action based on this material.
