What Is Estate Planning

Estate planning is the idea that you need to manage your assets and your wealth to be able to transfer them down to the next generation in the cleanest and most tax efficient way possible. Most problems with estate planning really aren’t even tax related, they’re more to do with dealing with the messiness of inheritance. For example, if you have some older parents and three adult children who don’t like each other, you need to build a well defined will and estate plan that prevents all the money from being wasted on your children litigating each other because they don’t think the inheritance is fair.

Avoiding Probate

If you don’t have some sort of estate plan, you go into probate, and if the estate is more than a certain size, in California I think it’s about 184,000 dollars, probate is very expensive, becomes very ugly, and is a lot of time wasted in the court system. So it’s generally a good idea if you have any meaningful assets to have some sort of estate plan, which is usually a mix of a will and a trust and a variety of other provisions that make sure the money goes to who is supposed to inherit it, in the most tax efficient way possible.

What Is a Trust

A trust can be a lot of things. The most common thing people think of with trusts are trust fund babies, or the idea of people who are so rich they can just live off the assets of a trust. But what is a trust exactly? A trust is the main kind of legal document that an estate planning attorney will construct for you. It’s a legal entity, and there are a bunch of different kinds of trusts. First, they can be broken down in terms of control or revocability.

Revocable and Irrevocable Trusts

A revocable trust is a trust that can be changed or revoked by the grantor during their lifetime, often used for estate planning to avoid probate. The other kind is an irrevocable trust, a trust that cannot be changed once it’s established. It offers asset protection and estate tax benefits.

The reason you want to make it irrevocable is so that it doesn’t count as the assets of the grantor who is passing away, so there’s an estate tax benefit to it, and also if it’s an irrevocable trust and you have some sort of issue, whether it’s a lawsuit or a divorce, where somebody tries to claw assets out of the irrevocable trust, they can’t do it, because you can’t take it back. The money is in the trust and it’s stuck there.

The Legal Definition of a Trust

A trust is a legal arrangement where a trustee holds and manages assets on behalf of beneficiaries and rules set by the grantor of the trust to control distribution of assets, protect wealth, and minimize taxes. There are a lot of stipulations you could put on trusts. There are trusts designed to help pass money down different generations, trusts to protect the grantor or the beneficiary from other forces that might take away the asset, and trusts used for other purposes to be more compliant or estate tax efficient.

Private Placement Life Insurance

Private placement life insurance is a customized, institutionally managed life insurance policy that is designed for high net worth and ultra high net worth individuals to shield investment growth, income, and capital gains taxes, allowing for tax free withdrawals and wealth transfer. So instead of putting your money in a regular brokerage account, you buy a private placement life insurance policy and use your funds to self fund the policy. If you do that, you can get tax free growth and withdrawals on that money if it’s structured properly, so it allows you to compound your investment returns without having to pay taxes in a more conventional way, and it also often avoids estate taxes if the private placement life policy is placed in a trust, and it has a lot of asset protection because it’s in an insurance wrapper.

Cost and Downsides

The main downside is just the cost of setting these things up tends to be rather pricey, so you need to have either a very high amount of assets, generally say like 10 million plus USD, or a very high level of taxable income, or both, for it to make sense. If you’re making less than say 700,000 USD a year, it’s generally not worth considering private placement life insurance, and really, maybe nowadays due to higher costs and higher interest rates, which make life insurance more expensive, you’re going to need maybe more like a million dollars a year in income and about 10 million plus in assets to make this an efficient means that’s worth the cost of setting up.

However, it is an option, and it is a way that higher net worth liquid individuals can be more tax efficient with their investments.

Dynasty Trusts

Dynasty trusts are ones designed to live longer than any of the grantors or beneficiaries, so that they can perpetually pay out certain fixed amounts to different generations of a wealthy family. These are most popular with old money families, or new money families who want to become old money families by making sure everybody is fully provided for. Since the trust owns the asset, the beneficiaries don’t have to pay estate tax every generation it moves down. Instead, the assets in the trust, whether it’s a stock portfolio, real estate, or a bond portfolio, whatever it is, will continually pay out to the beneficiaries of each generation as it was intended and as it was written in the irrevocable trust that set this up.

Other Types of Trusts

Charitable Trust

A charitable trust pays income to the beneficiaries, but then once the beneficiary dies, they donate the remainder to charity.

Special Needs Trust

There are special needs trusts, which provide for disabled beneficiaries without disqualifying them from government benefits.

Asset Protection Trust

There are asset protection trusts, which are trusts designed not for tax purposes, but in a way that the trust owns everything and the human owner who originally owned it does not have legal ownership, so in the case of a divorce or a lawsuit, those assets cannot be claimed by the plaintiff.

Blind Trust

A blind trust is very common for politicians, and it’s why a lot of very high net worth individuals want these cabinet positions. It is a trust where your assets are managed without the beneficiary’s knowledge, and you usually sell whatever you had before and put it into this trust without paying capital gains if you’re appointed to a cabinet position. A lot of people with low cost basis but very valuable assets want cabinet positions for this very reason. The reason the cabinet does this is because of conflict of interest.

If a member of the cabinet owns a bunch of stock in the industry they’re assigned to regulate, say the Department of Energy head owns a bunch of stock in Chevron, they’re not going to work in an objective manner about how they regulate Chevron because it’s in their best interest not to. So you either need to sell it or put it into a blind trust so that the person with the conflict of interest cannot trade on it. There are probably private sector examples of blind trusts too, but this is the most common example.

Testamentary Trust

Then there’s a testamentary trust, which only takes effect after the grantor’s death.

Spendthrift Trust

A spendthrift trust is also very common among wealthier families who want to set these up to protect descendants or heirs who are known to have financial irresponsibility or bad spending habits. It’s basically a trust that disqualifies the beneficiary from reckless spending or creditors. For example, if it’s inheriting real estate, it prohibits the beneficiary from taking a mortgage on the property, or if it’s stock, it prevents leverage. It only pays out a fixed allowance every month, and there’s no way to borrow against it, so that the irresponsible heir cannot spend themselves into bankruptcy.

A lot of old money families, the Phipps family is a notable example based on a video from Old Money Ru, set up these trusts and design them in a way so that the beneficiaries cannot spend themselves back into poverty. That’s why if you have a son or daughter you don’t really trust to be financially responsible, you should probably put their inheritance in one of these spendthrift trusts instead of just giving them a straight lump sum inheritance.

Charitable Foundation

A charitable foundation is an organization designed to give money to a certain special cause. It has to be something for the greater good, and a beneficiary could be education, advocacy, giving money to the poor, or a religious mission. A foundation is really a trust with a company surrounding it, like a nonprofit, and as part of being a trust they have to donate a minimum percentage of the proceeds every year to the stated cause. They don’t have to donate all of it at once, it’s like an investment fund or a series of investments that get returns every year, and a chunk of those returns has to go to the cause the foundation was created for.

The rest of the money can either be reinvested or spent however the beneficiary or owner of the charitable foundation sees fit. This is why you see a lot of wealthy billionaire types create charitable foundations for their heirs or for themselves, because it allows them to have a tax deferred or tax free way to maintain a certain lifestyle without regulatory concerns, and at the same time it’s done for a greater good, which lets a lot of these people sleep at night.