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Estate 101

When you die, the default outcome is that you and your loved ones pay for the privilege for all your finances to become public record for anyone to view. You can easily avoid this by simply using a trust. Otherwise, your estate is submitted to a process called probate, where the state judicial system will publically gather your holdings, pay your creditors, and distribute the remaining assets (per your will, if you left one; to family members, per the state’s default rules if you did not). This process costs roughly 2-7% of your total probatable assets and delays the inheritance process by 12-18 months. Trusts allow you to bypass the entire probate process and have control over the distribution of your assets after death.

The two most common categories of trusts are revocable and irrevocable.

All assets transferred into revocable trusts are exempt from the probate process and transfer to beneficiaries without public disclosure. Revocable trusts are pass-through entities, meaning they provide no tax incentive whatsoever (assets inside a revocable trust are still considered part of your estate). As the name implies, they are also mutable—you may change things at your sole discretion (e.g., move assets in-and-out) at any time.

Irrevocable trusts are not mutable—anything you put in, stays in. Furthermore, when you transfer assets into an irrevocable trust, you must relinquish control and assign a trustee other than yourself to be the legal owner of the assets. While you are alive, you may manage the assets, but you must appoint beneficiaries who may receive distributions. Why would you do this? Moving assets outside of your estate may provide two major benefits:

  1. Estate tax advantage—assets outside of your estate are not subject to estate tax upon death. As of 2021, the estate tax exemption is $11.7 million ($23.4M for couples). Anything above this threshold is subject to the 40% federal estate tax. Gifting assets into an irrevocable trust uses your lifetime exemption by the value of the assets at the time of gifting—any future growth is not subject. Waiting to do this will make it harder to move assets outside of your estate.
  2. Income tax advantage—any tax obligations (e.g., capital gains) from assets outside of your estate are the responsibility of the trust, not you. The trust is a separate entity with its own taxpayer identification number (this means the trust must file taxes annually (if there is no additional income, this is a very simple exercise)). Further, you may set up an irrevocable trust in a state with no state-income tax.

Assets inside of an irrevocable trust are outside of your estate.

Planning techniques leverage both estate and income tax advantages to optimize your estate.

To make things simpler:

  1. The only urgency to setting up a revocable trust is “cleaning up your finances.” (It’s “what happens if I get hit-by-a-bus?” insurance).
  2. If you think you will use all of your lifetime exemption (i.e., you think your estate will one day surpass the limit of ~$11.7M), you have an incentive to move assets outside of your estate earlier. It’s possible, but harder to move things when you’re operating above the exemption. Reminder—growth of assets does not count against your exemption so long as the asset is outside of your estate. Growth company executives may want to contribute stock when it is worth a low amount, using a small portion of their exemption, and the subsequent growth will not be subject to estate tax (the growth will still be subject to capital gains tax).
  3. You broadly do not want to over-optimize too early in your career as the administrative overhead is non-zero. Tax accountants do not rule the world—your own mental clarity is more valuable than a small percentage of savings. Things will naturally get more complicated over time, so there is an advantage to keeping things as simple as possible. What you are optimizing for is yourself (and the people you care about), and you have to do what is best for you.
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