Bogleheads style portfolio for a Trust?

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Bogleheads style portfolio for a Trust?

Postby charles_shaw » Tue Jan 29, 2013 10:38 pm

Hello all,

I want to present a scenario that may unfold for me in the near future and tap into the collective wisdom here on these forums. It's not exactly the standard nest egg portfolio check I'm used to reading on this forum.

A wealthy relative is establishing a generation-skipping trust (skipping me) that will eventually have my children as beneficiaries (I currently have no children). The trust would be turned over to my children when they are 30 years old (so let's assume a 40 year investment horizon for assets in trust). Obviously the assets will have an even longer investment horizon, but they basically have 40 years to grow unadulterated. The amount of the assets today is about $500,000.

My mother will be the trustee, and we are discussing what investment options are appropriate for the trust. We have a few questions out to our tax advisor, but our understanding is that income tax brackets for trusts are brutal. Basically the trust hits the highest income tax bracket after about $12,000 of income. With that in mind we are trying to find the most tax-efficient way to invest.

Our current plan is to follow a simple Bogleheads-style portfolio of index funds: 30% muni-bonds / 70% equity, with the equity split about 50/50 US/international.

We have discussed a small/value tilt for extra return. However, I'm questioning the "need" to take extra risk and part of me says not to overweight SCV. On the other hand, this is a very generous 'gift' to my future children. I don't want to raise "trust fund kids" and want them to be able to provide for themselves and their own families without this money. As this isn't retirement money or a nest egg like most of us are saving and investing for on this forum, I'm beginning to think about risk a little differently in this case. There is a substantial time horizon and it isn't a retirement fund, so part of me says it is okay to take on the extra risk with a SCV tilt to get a few extra points of return in the long run.

We are also discussing diversifying outside of the markets -- perhaps putting a portion of the money into real-estate or land so everything isn't tied up in one place.

I was wondering if any other Bogleheads have been in this situation or had any input to share.

Particularly, I want to validate my gut reaction that a DIY Bogleheads style portfolio is just as good in this situation as any. Others have suggested "professional wealth management", but that term just conjures horrible images of active management and absurdly high expenses that make me reel.

Also, since there is no tax advantaged space in the trust, all the fixed income would need to be in CDs and tax-exempt bonds like Munis (and I believe the trust can purchase I-bonds also). Is there any downside to being "all munis" in your fixed-income allocation? Are there any tax-exempt fixed-income options that I'm not aware of?

Thanks all for the feedback.
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Re: Bogleheads style portfolio for a Trust?

Postby Gill » Tue Jan 29, 2013 10:51 pm

Answering only one part of your question, but which goes to the heart of your concern. There is a very easy way to avoid tax on the income earned in a trust - pay it out to a beneficiary. Income earned by the trust is only taxed in the trust when it is accumulated. Also, I would not invest the trust in land or real estate. The trust is not really large enough for this kind of diversification nor is it needed.
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Re: Bogleheads style portfolio for a Trust?

Postby Grt2bOutdoors » Tue Jan 29, 2013 11:22 pm

What happens if you don't have children for one reason or another? What becomes of the generation skipping trust?

If you were going to select an investment - either Balanced Index Admiral or Lifestrategy Growth; an all in one indexed portfolio, self-balancing, low er.
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Re: Bogleheads style portfolio for a Trust?

Postby Leesbro63 » Tue Jan 29, 2013 11:26 pm

Grt2bOutdoors wrote:What happens if you don't have children for one reason or another? What becomes of the generation skipping trust?

If you were going to select an investment - either Balanced Index Admiral or Lifestrategy Growth; an all in one indexed portfolio, self-balancing, low er.


But this type of fund will automatically rebalance every year, creating potentially large taxable events. At least with a two (or more) asset class fund portfolio, the trustee can weigh the taxation issues against the asset allocation issue and manually select to rebalance or not.
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Re: Bogleheads style portfolio for a Trust?

Postby Grt2bOutdoors » Tue Jan 29, 2013 11:29 pm

Leesbro63 wrote:
Grt2bOutdoors wrote:What happens if you don't have children for one reason or another? What becomes of the generation skipping trust?

If you were going to select an investment - either Balanced Index Admiral or Lifestrategy Growth; an all in one indexed portfolio, self-balancing, low er.


But this type of fund will automatically rebalance every year, creating potentially large taxable events. At least with a two (or more) asset class fund portfolio, the trustee can weigh the taxation issues against the asset allocation issue and manually select to rebalance or not.


I made the suggestion on the basis that trustee will not take an active management role.
Here's another alternative - Tax-Managed Capital Appreciation + Intermediate Tax-Exempt.
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Re: Bogleheads style portfolio for a Trust?

Postby bsteiner » Wed Jan 30, 2013 10:40 am

During the lifetime of the grantor (the person creating the trust), the trust can be (and usually would be) a grantor trust. In other words, the grantor would pay the income tax on the trust's income and gains. This allows the trust to grow faster. The grantor would take this into account in deciding how much to contribute to the trust.

After the grantor's death, the trust has to pay its own taxes. However, its income will probably be mainly qualified dividends, long-term capital gains, and tax-exempt income, so the cost of the compressed tax brackets for trusts will probably be tolerable.

Different states have different ways of determining when a trust is taxable as a resident trust. Depending on where the grantor resides, it may be possible for the trust not to be subject to state income tax in any state after the grantor's death. This may ameliorate the cost of the compressed Federal income tax brackets for trusts.

Instead of requiring payout when the beneficiaries reach age 30, we would divide the trust into separate shares for each beneficiary, and have the trusts continue, with each beneficiary getting control of his/her trust at that point. In other words, each child could become a trustee, could remove and replace his/her co-trustee (provided the replacement trustee is not a close relative or subordinate employee), and have the power to appoint (give or leave) the trust assets to anyone he/she wants (other than the beneficiary or his/her estate or creditors). This will protect the assets against the beneficiaries' potential creditors (including spouses), and will keep it out of the beneficiaries' estates for estate tax purposes.
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Re: Bogleheads style portfolio for a Trust?

Postby assumer » Wed Jan 30, 2013 10:49 am

MBMiner wrote:Answering only one part of your question, but which goes to the heart of your concern. There is a very easy way to avoid tax on the income earned in a trust - pay it out to a beneficiary. Income earned by the trust is only taxed in the trust when it is accumulated.


Can you explain this better? What's the difference between a trustee and a beneficiary?
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Re: Bogleheads style portfolio for a Trust?

Postby willardx » Wed Jan 30, 2013 12:28 pm

assumer wrote:
MBMiner wrote:Answering only one part of your question, but which goes to the heart of your concern. There is a very easy way to avoid tax on the income earned in a trust - pay it out to a beneficiary. Income earned by the trust is only taxed in the trust when it is accumulated.


Can you explain this better? What's the difference between a trustee and a beneficiary?


He was saying that the trustee could pay out the income from the trust to OP's unborn children. Someone might have suggested opening 529 college accounts, if that's allowed, or you'd just have to wait until the children are born to take the income out of the trust and put it into each children's own accounts (bank accounts or minor accounts at VG or the like). If you were to do that, you'd still face low income thresholds before you get into the parents' income tax rates, but that might be preferable over the the trust's tax rates.

The trustee is the one who is charged with taking care of the assets in the trust, and in this case the trustee is not the grantor ('grantor' is the one who creates and funds the trust). The beneficiaries are the ones identified in the trust to receive the assets and/or income from the trust, the OP's children.

I'm no expert on this stuff so if I am off base on it, I'd appreciate correction/clarification, but I think that's pretty much it.

As to OP's original questions about AA, I wonder the same thing. But I've read enough threads to understand that some bonds actually improve returns, even with a super-long investment horizon. I would also agree not to get into alternative investments like land, at least not until the children get older and might take an interest in handling some of their own investments. By that time the assets should have grown considerably to make such alternatives more attractive, perhaps.
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Re: Bogleheads style portfolio for a Trust?

Postby Van » Wed Jan 30, 2013 12:51 pm

If a trust holds tax-free municipal bonds (as the OP is considering) and pays out the tax-free income generated to a beneficiary, is the income still tax-free to the beneficiary? What I'm concerned about is that it might be tax-free to the trust but not to the beneficiary.
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Re: Bogleheads style portfolio for a Trust?

Postby 555 » Wed Jan 30, 2013 1:28 pm

I had never heard of these compressed tax brackets for trusts. They seem so unfavorable it makes me wonder why anyone would have a trust. Why would they? (It may be a silly question since I've never thought about it.)
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Re: Bogleheads style portfolio for a Trust?

Postby sscritic » Wed Jan 30, 2013 1:55 pm

555 wrote:I had never heard of these compressed tax brackets for trusts.

Instructions are good sources of information:
Code: Select all
Over      But not over—   Its tax is:   Of the amount over—
$0            $2,400         15%              $0
2,400          5,600    $360.00 + 25%       2,400
5,600          8,500   1,160.00 + 28%       5,600
8,500         11,650   1,972.00 + 33%       8,500
11,650         -----   3,011.50 + 35%      11,650
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Re: Bogleheads style portfolio for a Trust?

Postby 555 » Wed Jan 30, 2013 2:18 pm

Yes, I found the tax brackets for trusts using Google. They seem so unfavorable it makes me wonder why anyone would have a trust.
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Re: Bogleheads style portfolio for a Trust?

Postby Leesbro63 » Wed Jan 30, 2013 6:25 pm

555 wrote:I had never heard of these compressed tax brackets for trusts. They seem so unfavorable it makes me wonder why anyone would have a trust. Why would they? (It may be a silly question since I've never thought about it.)


Perhaps you are asking the wrong question. Perhaps the question should be "why would anyone accumulate income in a trust and not pay it out yearly"
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Re: Bogleheads style portfolio for a Trust?

Postby bsteiner » Wed Jan 30, 2013 7:36 pm

In response to 555 and Leesbro63: there's a tradeoff between retaining income in the trust and paying tax at the trust's compressed brackets but keeping the assets in the trust where they're not included in the beneficiary's estate for estate tax purposes and protected against the beneficiary's , including spouses, and distributing the income so it's taxable in the beneficiary's tax bracket but included in the beneficiary's estate and subject to the beneficiary's creditors, including spouses.

Since trusts mainly invest for qualified dividends, long-term capital gains and tax-exempt income, the cost of incurring tax at the trust's rates isn't as much as it might appear. However, since trusts are now subject to the 20% tax rate on qualified dividends and long-term capital gains, plus the 3.8% Medicare, at a low level, the cost of incurring tax at the trust's rates is higher than it was before this year.

The trustees' job is to consider the benefits of either distributing or accumulating the income, and deciding what they think is best each year.

Note that it's sometimes but not always possible to distribute capital gains to beneficiaries.

Also note that the trust and the beneficiary may be subject to state income tax (or not) in different states.
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Re: Bogleheads style portfolio for a Trust?

Postby charles_shaw » Wed Jan 30, 2013 7:40 pm

Thanks for the input about real-estate/land. I agree that for simplicity's sake, it's best to stick with a typical bond/equity fund portfolio. The trustee (mother) will be managing the portfolio, so we would want to keep it as low maintenance with an AA defined in an IPS, and stick to it as while being as tax-efficient as possible.

bsteiner wrote:Instead of requiring payout when the beneficiaries reach age 30, we would divide the trust into separate shares for each beneficiary, and have the trusts continue, with each beneficiary getting control of his/her trust at that point. In other words, each child could become a trustee, could remove and replace his/her co-trustee (provided the replacement trustee is not a close relative or subordinate employee), and have the power to appoint (give or leave) the trust assets to anyone he/she wants (other than the beneficiary or his/her estate or creditors). This will protect the assets against the beneficiaries' potential creditors (including spouses), and will keep it out of the beneficiaries' estates for estate tax purposes.


I believe this may be how it will be structured. I will double check with the estate attorney we've been talking with to verify.

Leesbro63 wrote:Perhaps you are asking the wrong question. Perhaps the question should be "why would anyone accumulate income in a trust and not pay it out yearly"


Thanks for framing it that way, Leesbro. I hadn't thought of it in those terms.

Possibly a dumb question: Is it possible to set up a 529 or UTMA for an unborn person? (I would guess NO).
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Re: Bogleheads style portfolio for a Trust?

Postby Leesbro63 » Wed Jan 30, 2013 7:46 pm

Actually yes. Just name a living person as the beneficiary and change it to your child just after it is born. Very uncomplicated actually
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Re: Bogleheads style portfolio for a Trust?

Postby archbish99 » Wed Jan 30, 2013 9:04 pm

Leesbro63 wrote:Actually yes. Just name a living person as the beneficiary and change it to your child just after it is born. Very uncomplicated actually

Not quite. That's how you can open a 529 you intend for an unborn child. However, it doesn't actually "belong" to the unborn child. For that matter, it doesn't belong to the child even after they're the beneficiary -- the owner of the account can change beneficiaries at any time, because it still belongs to them.

You might phrase it such that the trustee has discretion to pay out any taxable income to you (if you have no children), the child's legal guardian (born, under age 18), a UTMA account in the child's name (including a UTMA 529, where the child is both owner and beneficiary), or directly to the beneficiary. Within those choices, the trustee can then decide what's most tax-appropriate in a given year.
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Re: Bogleheads style portfolio for a Trust?

Postby Leesbro63 » Wed Jan 30, 2013 11:48 pm

archbish99 wrote:
Leesbro63 wrote:Actually yes. Just name a living person as the beneficiary and change it to your child just after it is born. Very uncomplicated actually

Not quite. That's how you can open a 529 you intend for an unborn child. However, it doesn't actually "belong" to the unborn child. For that matter, it doesn't belong to the child even after they're the beneficiary -- the owner of the account can change beneficiaries at any time, because it still belongs to them.


Nothing belongs to an unborn child! That's implied and assumed. The idea of the 529 plan is to be like special purpose trust with less hassle than a regular trust. For all practical purposes starting a 529 with a "placeholder" beneficiary accomplishes this poster's goal pretty well.
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