Testamentary Trust vs Direct Inheritance
Testamentary Trust vs Direct Inheritance
Updating my will. DIY investing and personal income tax stuff is pretty simple. Estate and trust issues are so much more complex that I would never consider DIY. However, I do want to be sure I know the right questions to ask when I meet with estate attorney.
Big picture - Three kids, each should get low 7 figure inheritance. One married with kids. Two never married, no kids. A mix of a taxable brokerage account (15%) traditional IRA (50%) and Roth IRA (35%). Current will created before loss of stretch IRA. Assets pass to them in a testamentary trusts. All are responsible adults, off the payroll so they are their own trustees.
My main goals are to make this as easy as possible for them while minimizing taxes. Trusts are a bit of a pain to deal with so considering whether direct inheritance is a better option. Looking for input/opinions on the pros/cons of these two choices. Specifically interested in impact on taxes (income and/or estate) and asset protection (in case of divorce).
Thanks in advance for the help.
Big picture - Three kids, each should get low 7 figure inheritance. One married with kids. Two never married, no kids. A mix of a taxable brokerage account (15%) traditional IRA (50%) and Roth IRA (35%). Current will created before loss of stretch IRA. Assets pass to them in a testamentary trusts. All are responsible adults, off the payroll so they are their own trustees.
My main goals are to make this as easy as possible for them while minimizing taxes. Trusts are a bit of a pain to deal with so considering whether direct inheritance is a better option. Looking for input/opinions on the pros/cons of these two choices. Specifically interested in impact on taxes (income and/or estate) and asset protection (in case of divorce).
Thanks in advance for the help.
"The greatest enemy of a good plan is the dream of a perfect plan" - Carl Von Clausewitz
Re: Testamentary Trust vs Direct Inheritance
The experts usually advise not to leave IRA and Roth assets to a trust, and that’s the bulk of the assets you’re talking about.
If it were me, I’d probably just do it as beneficiary designations on the accounts.
If it were me, I’d probably just do it as beneficiary designations on the accounts.
Re: Testamentary Trust vs Direct Inheritance
They'll each need a co-trustee if they ever want distributions.BigJohn wrote: Fri Jan 24, 2025 7:49 am ... Three kids, .... All are responsible adults, off the payroll so they are their own trustees.
My main goals are to make this as easy as possible for them while minimizing taxes. Trusts are a bit of a pain to deal with so considering whether direct inheritance is a better option. Looking for input/opinions on the pros/cons of these two choices. Specifically interested in impact on taxes (income and/or estate) and asset protection (in case of divorce).
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To the extent there's a tradeoff between easy and asset protection, I think the asset protection is more important.
There's no income tax issue with the Roth.
There's a tradeoff with the traditional. The trustees will have to decide how much, if anything, to distribute each year, and how much to retain, taking into account income taxes and whatever other factors they deem relevant. Roth conversions avoid that tradeoff, though they may or may not be appropriate.
Another possibility is to leave the traditional IRAs to charitable remainder trusts for the children if they're at least age 27. See my article on this in the April 2020 issue of Trusts & Estates: https://www.kkwc.com/wp-content/uploads ... 4_2020.pdf.
At least as to the Roth, I would disagree with anyone calling them experts. It's more complicated for the traditional, but since money in a trust is like toothpaste in a tube (you can always take it out but you can't put it back in), since the value of the traditional is substantial, it may nevertheless be better to leave the traditional in trust rather than outright.lereh wrote: Fri Jan 24, 2025 8:14 am The experts usually advise not to leave IRA and Roth assets to a trust, and that’s the bulk of the assets you’re talking about.
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Re: Testamentary Trust vs Direct Inheritance
Thank for sharing this information and your comments. Only one of our three children are 27 (27, 25 & 24) but I printed the article to read and include in my folder of info. In our case it feels like having the deferred money bypass the trust and going direct to our 3 adult kids is the better way and having the balance go to the trust. We're only using the trust as a speed bump, as it were, in the case of our sudden deaths, inundating them with money on top of the loss of their parents feels like too much, and surprisingly, they agreed. They preferred the idea of a trust to let them kind of grow into the inheritance.bsteiner wrote: Fri Jan 24, 2025 8:41 amAnother possibility is to leave the traditional IRAs to charitable remainder trusts for the children if they're at least age 27. See my article on this in the April 2020 issue of Trusts & Estates: https://www.kkwc.com/wp-content/uploads ... 4_2020.pdf.BigJohn wrote: Fri Jan 24, 2025 7:49 am ... Three kids, .... All are responsible adults, off the payroll so they are their own trustees.
My main goals are to make this as easy as possible for them while minimizing taxes. Trusts are a bit of a pain to deal with so considering whether direct inheritance is a better option. Looking for input/opinions on the pros/cons of these two choices. Specifically interested in impact on taxes (income and/or estate) and asset protection (in case of divorce).
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Interesting stuff.
As an aside, your name came up in a recent boglehead NJ chapter meeting. I'm very grateful for your support and participation here.
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Re: Testamentary Trust vs Direct Inheritance
I am not a lawyer, accountant, or tax expert.BigJohn wrote: Fri Jan 24, 2025 7:49 am Updating my will. DIY investing and personal income tax stuff is pretty simple. Estate and trust issues are so much more complex that I would never consider DIY. However, I do want to be sure I know the right questions to ask when I meet with estate attorney.
Big picture - Three kids, each should get low 7 figure inheritance. One married with kids. Two never married, no kids. A mix of a taxable brokerage account (15%) traditional IRA (50%) and Roth IRA (35%). Current will created before loss of stretch IRA. Assets pass to them in a testamentary trusts. All are responsible adults, off the payroll so they are their own trustees.
My main goals are to make this as easy as possible for them while minimizing taxes. Trusts are a bit of a pain to deal with so considering whether direct inheritance is a better option. Looking for input/opinions on the pros/cons of these two choices. Specifically interested in impact on taxes (income and/or estate) and asset protection (in case of divorce).
Thanks in advance for the help.
My layperson understanding is that the purpose of a trust is generally for "protection" and "control". Protection can be from creditors, probate, etc. Control can be needed because the person cannot manage the funds themselves (spendthrift, minor, disability, etc).
It sounds like if your children are their own trustees, you are okay with them having control over the funds. So it seems like you aren't concerned with that aspect. So I would ask whether you need the protection of the trust for these assets.
As others have pointed out, Traditional IRA's inherited inside of trust can have tax implications, as the RMD's would be taxed at the trust tax rates, which are super compressed. So if the intent is to keep the RMD's inside the trust, a large percentage of those assets are going to Uncle Sam. It is possible that protection you want from the trust overrides the tax downside, but that's for you to decide with your attorney.
Of course, this can be avoided through passing the assets out of the trust to the beneficiary. In that case, the RMD's would be taxed at the beneficiary's tax rate, which is likely more favorable. Of course, you'd lose the protection of a trust. If that's what's going to happen, then I'd question why you'd need the trust in the first place. You can achieve the same thing without the trust by naming your children as beneficiaries directly.
Re: Testamentary Trust vs Direct Inheritance
if asset protection is the goal, then a lot rides on what state you are in. Some states have similar asset protection for IRA and Roth assets, and some states even have that protection for inherited IRAs
Re: Testamentary Trust vs Direct Inheritance
Bruce, thanks for the reply. I'm a long time forum member and know your reputation as one of the experts around here on this topic.bsteiner wrote: Fri Jan 24, 2025 8:41 am They'll each need a co-trustee if they ever want distributions.
To the extent there's a tradeoff between easy and asset protection, I think the asset protection is more important.
Another possibility is to leave the traditional IRAs to charitable remainder trusts for the children if they're at least age 27. See my article on this in the April 2020 issue of Trusts & Estates: https://www.kkwc.com/wp-content/uploads ... 4_2020.pdf.
I appreciate the info on CRTs. Along a similar line, I am currently considering funding DAF's for each with part of the traditional IRA and letting the rest pass to them, I had not considered CRTs. The DAF's would be far easier for the kids to manage but at the cost of loss of control/income. I'll need to consider the pros/cons of each as well as how much they really need to inherit before moving forward.
Two follow ups if you have time...
Can you say more about needing a co-trustee. Current will was prepared by a local estate tax expert (board certified estate lawyer) and does not have co-trustees named.
The balance between asset protection and ease is a tough one. If inherited directly, the t-IRA and Roth would be in their name only. I would advise them to take any withdrawals and put them in an account that is not joint with spouse. I'd advise the taxable account assets be put in the same account (not joint with spouse). If this is done, do I accomplish a level of asset protection similar to a trust?
Thanks to other posters as well. A couple of answers... I live in Louisiana as does one child. The married child lives in South Carolina and the other unmarried one lives in Colorado. The trusts are currently written as pass through trusts were the RMD is required to be distributed to the beneficiary. Again this was before loss of stretch option but I'd intended it to be the same in my new will to avoid high trust tax rates.
"The greatest enemy of a good plan is the dream of a perfect plan" - Carl Von Clausewitz
Re: Testamentary Trust vs Direct Inheritance
Just a bump to get any other input before my meeting with estate attorney later this week.
Thanks
Thanks
"The greatest enemy of a good plan is the dream of a perfect plan" - Carl Von Clausewitz
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Re: Testamentary Trust vs Direct Inheritance
Trusts have better asset protection. But there can be significant costs for anyone not worried about estate taxes. Trust tax rates are extremely compressed. To the extent any income is retained within the trust vs immediately distributed to heirs, the retained income will be taxed at higher rates unless your heirs are in the top tax bracket already. As already pointed out, with a traditional IRA, and the new laws, I think non-spousal heirs have to take the money within 10 years, which will generate significant RMDs and taxable income? When your heirs die, their estate won’t get the step up in basis for any assets in the trust, so you pay more in capital gains. If you go with a corporate trustee like Vanguard, expect to pay a minimum of 0.55% for administrative and investment management fees forever and probably a lot higher with a traditional trust company. By far the biggest asset risk for most people is going to be a spouse during a divorce. If you think some of your kids will never get married, it might be sufficient to tell them to get a large umbrella policy and call it a day.
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Re: Testamentary Trust vs Direct Inheritance
Based on stated goals its probably easiest to set the beneficiaries up in the IRA and taxable accounts as desired, but especially the IRAs. Beneficiary designation overrides a will and skips any probate. This approach keeps it simple and is the most efficient in terms of transfer.
In terms of designating beneficiaries for IRAs (including 401k, etc), most, if not all, brokerages/custodians allow you to set up primary and contingent beneficiaries per stripes, per capita or by name and percentage.
You can also set up taxable brokerage accounts with beneficiaries as described above, although joint accounts may be limited in that way (IRA type accounts are all single accounts). Vanguard does not allow you to list beneficiaries on jointly held accounts. Fidelity does allow you to add contingent beneficiaries to joint taxable accounts. Not sure about other brokerages.
Perhaps most importantly, it's easy change the beneficiary designation on an account...much easier than making changes to a will, including one that establishes a testamentary trust.
Of course, you still need an estate plan, be it a will, revokable trust, or whatever, but using the beneficiary designation is easy and flexible, and does not result in less tax efficiency in transfer of financial assets.
The only caveat I would offer besides some mentioned above, is that one needs to keep in mind any state requirements per wills, trusts, etc.
On a personal note, dealing with my wife's parents revokable trusts after their passings has not been trivial. More specifically, delay in closing out the trusts and delivering the final K-1s has resulted in unnecessary tax complications. This includes having to file amended tax returns.
In terms of designating beneficiaries for IRAs (including 401k, etc), most, if not all, brokerages/custodians allow you to set up primary and contingent beneficiaries per stripes, per capita or by name and percentage.
You can also set up taxable brokerage accounts with beneficiaries as described above, although joint accounts may be limited in that way (IRA type accounts are all single accounts). Vanguard does not allow you to list beneficiaries on jointly held accounts. Fidelity does allow you to add contingent beneficiaries to joint taxable accounts. Not sure about other brokerages.
Perhaps most importantly, it's easy change the beneficiary designation on an account...much easier than making changes to a will, including one that establishes a testamentary trust.
Of course, you still need an estate plan, be it a will, revokable trust, or whatever, but using the beneficiary designation is easy and flexible, and does not result in less tax efficiency in transfer of financial assets.
The only caveat I would offer besides some mentioned above, is that one needs to keep in mind any state requirements per wills, trusts, etc.
On a personal note, dealing with my wife's parents revokable trusts after their passings has not been trivial. More specifically, delay in closing out the trusts and delivering the final K-1s has resulted in unnecessary tax complications. This includes having to file amended tax returns.
Re: Testamentary Trust vs Direct Inheritance
Thanks for the kind words.BigJohn wrote: Fri Jan 24, 2025 12:21 pmBruce, thanks for the reply. I'm a long time forum member and know your reputation as one of the experts around here on this topic.bsteiner wrote: Fri Jan 24, 2025 8:41 am They'll each need a co-trustee if they ever want distributions.
To the extent there's a tradeoff between easy and asset protection, I think the asset protection is more important.
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Can you say more about needing a co-trustee. Current will was prepared by a local estate tax expert (board certified estate lawyer) and does not have co-trustees named.
The balance between asset protection and ease is a tough one. If inherited directly, the t-IRA and Roth would be in their name only. I would advise them to take any withdrawals and put them in an account that is not joint with spouse. I'd advise the taxable account assets be put in the same account (not joint with spouse). If this is done, do I accomplish a level of asset protection similar to a trust?
... I live in Louisiana as does one child. The married child lives in South Carolina and the other unmarried one lives in Colorado. The trusts are currently written as pass through trusts were the RMD is required to be distributed to the beneficiary. Again this was before loss of stretch option but I'd intended it to be the same in my new will to avoid high trust tax rates.
It's permissible to have a child be the sole trustee of his/her own trust, so long as he/she can't make distributions to himself/herself other than for health, maintenance, support and education. If the child ever wants a distribution for some other purpose, he/she could add a co-trustee at that time.
My preference is to have a co-trustee from the inception, to allow distributions for any reason, to prohibit the child from participating in a decision to make a distribution to him/her (so that the co-trustee would decide as to such distributions), and (if appropriate) to give the child the power to remove and replace his/her co-trustee upon reaching an appropriate age (provided the replacement trustee isn't a close relative or subordinate employee). I think this provides greater protection, especially in the Medicaid context, and possibly also in the divorce context. I also think it reduces the likelihood of commingling assets or taking money from the "wrong" place. However, many trusts and estates lawyers do it the other way. It's permissible for estate tax purposes (in other words, it won't cause the trust to be included in the beneficiary's estate).
Requiring RMDs to be distributed to the beneficiary didn't make sense under prior law. It makes less sense now. If the trustees decide each year that the income tax benefit of having the income taxed to the beneficiary at a lower rate outweighs the asset protection of keeping the money (from the traditional IRA) in the trust, the trustees can distribute the amounts received from the traditional IRA to the beneficiary each year. However, if there's a reason not to do so, the trustees will have that flexibility.
If any three other states are to each other like French, Spanish and Italian are to each other, Louisiana is like a language that uses characters rather than an alphabet. There are provisions of Louisiana trust law that are less favorable than those of other states. If the amount involved is enough to warrant the effort, you may want to create trusts for your children during your lifetime and have them governed by a state other than Louisiana where a trustee is located.
Re: Testamentary Trust vs Direct Inheritance
Thanks for the kind words. I live in New Jersey and was able to attend a couple of the New Jersey meetings though I can't always get to them.Kings over Queens wrote: Fri Jan 24, 2025 8:56 am ...
As an aside, your name came up in a recent boglehead NJ chapter meeting. I'm very grateful for your support and participation here.
Re: Testamentary Trust vs Direct Inheritance
What counts as a "close relative"?bsteiner wrote: Sun Feb 02, 2025 5:57 pm My preference is to have a co-trustee from the inception, to allow distributions for any reason, to prohibit the child from participating in a decision to make a distribution to him/her (so that the co-trustee would decide as to such distributions), and (if appropriate) to give the child the power to remove and replace his/her co-trustee upon reaching an appropriate age (provided the replacement trustee isn't a close relative or subordinate employee).
Re: Testamentary Trust vs Direct Inheritance
See Internal Revenue Code Section 675(c):coastal wrote: Mon Feb 03, 2025 1:44 pmWhat counts as a "close relative"?bsteiner wrote: Sun Feb 02, 2025 5:57 pm My preference is to have a co-trustee from the inception, to allow distributions for any reason, to prohibit the child from participating in a decision to make a distribution to him/her (so that the co-trustee would decide as to such distributions), and (if appropriate) to give the child the power to remove and replace his/her co-trustee upon reaching an appropriate age (provided the replacement trustee isn't a close relative or subordinate employee).
(1) the grantor’s spouse if living with the grantor;
(2) any one of the following: the grantor’s father, mother, issue, brother or sister; an employee of the grantor; a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; a subordinate employee of a corporation in which the grantor is an executive.
Re: Testamentary Trust vs Direct Inheritance
Thank you. That's very helpful.
Re: Testamentary Trust vs Direct Inheritance
FWIW
Retired lawyer with spouse of 4 plus decades and three adult kids/families all first marriages.
Not particularly concerned with kids’ asset protection (they can adequately insure against most risks, and as far as divorce goes in our state, if the inheriting person keeps the inheritance in a separate account then it is all theirs). We prefer maximum flexibility for the heirs and avoiding the ongoing administrative matters associated with trusts.
Thus, we choose outright distribution upon our death. I sometimes muse as to whether or not we should be more “conservative, “but at this point continue with the outright distribution choice.
Ymmv.
Retired lawyer with spouse of 4 plus decades and three adult kids/families all first marriages.
Not particularly concerned with kids’ asset protection (they can adequately insure against most risks, and as far as divorce goes in our state, if the inheriting person keeps the inheritance in a separate account then it is all theirs). We prefer maximum flexibility for the heirs and avoiding the ongoing administrative matters associated with trusts.
Thus, we choose outright distribution upon our death. I sometimes muse as to whether or not we should be more “conservative, “but at this point continue with the outright distribution choice.
Ymmv.