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What Are The Disadvantages of A Trust Fund?
There are some pros and cons of trust funds. It can be used as a gift to a child, grandchild, friend or family member; can be used in case of your disability or death; can be used to pass wealth to generations without estate taxes or probate fees.
While you may already know that trust funds can be an excellent tool for accumulating, safeguarding, and passing on wealth, they do have some drawbacks. You could run into some family trust fund drawbacks, such as:
1) Because of the compressed marginal tax levels, trust fund taxes are sometimes higher than taxes owed on assets not held in trust.
2) Entitled recipients who are unable to maintain themselves as a result of a lifetime of receiving everything on a silver platter.
3) When assets are transferred to an irreversible trust rather than a living trust (also known as an inter-vivos trust) or a testamentary trust, there is a loss of control. It is frequently important to maximize estate tax exemption benefits.
By carefully considering each of these drawbacks, you’ll have a better idea of what you’re getting yourself into if you decide to start using trust funds in your own financial plans, whether to protect your assets or to maximize the amount of wealth you can pass on to your children, grandchildren, and other heirs.
Unfavorable Tax Rates
The tax brackets are updated on a regular basis by Congress to account for inflation. Unfortunately, for decades, the House of Representatives and the Senate have maintained the principle that trust fund tax rates should be reduced when compared to ordinary marginal rates for persons holding the same investments.
According to the IRS, the following federal trust fund tax rates are applied to any income maintained by the trust in tax year 2019:
1) Retained income of less than $2,600 is taxed at a rate of 10%.
2) Retained income over $2,600 but not exceeding $9,300 is taxed at $260.00 plus 24% of the excess over $2,600.
3) Retained income over $9,300 but not exceeding $12,750 is taxed at $1,868.00 plus 35% of the excess above $9,300.
4) Retained income in excess of $12,750 is taxed at $3,075.50 plus 37 percent of the excess.
Unmarried individuals, on the other hand, would not be subject to the 37 percent federal tax rate until their taxable income exceeded $510,300. To make matters worse, most states will impose state taxes on retained trust income, which will be in addition to the federal trust taxes. There are also difficulties like the generation-skipping tax, which might affect trust funds. The income given by the trust to the beneficiaries, including dividends, interest, and rentals, is taxed to the beneficiary at his or her own rate, which is a modest relief. The theory behind this unequal treatment is that it will make it more difficult for families to accumulate aristocratic levels of wealth in a trust, albeit there are simple methods around it.
For example, investment advisors monitoring a huge trust fund’s portfolio as an individually managed account could priorities non-dividend paying equities or firms with low dividend payout ratios, such as shares of Berkshire Hathaway, the holding company founded by billionaire Warren Buffett.
The increase in book value should result in unrealized capital gains over time, thereby creating a deferred tax obligation that permits the trust to have more money working for it than it would otherwise if the trust assets’ look-through earnings were paid out as cash dividends. When all else is equal, this kind of advantage can lead to a considerably greater compound annual growth rate over several decades. It’s one of the reasons why a trust’s investment mandate is so crucial.
On the other hand, if properly designed, an irrevocable trust can save a family money by transferring funds from a wealthy family member’s inheritance to his or her heirs, who are likely to be in lower tax brackets.
Investment income that would have been taxed at considerably higher rates can be taxed at less confiscatory rates on the beneficiary’s personal income tax filing by emphasizing distributions. To pull it off effectively, it takes a lot of planning, many years, and skilled legal, tax, and investment experts, but it can be worth it for families in the top 1%, especially when combined with the annual gift tax exception.
The Problem of Financial Dependence
According to behavioral psychology, most people require meaning in their lives, and money alone cannot offer meaning once fundamental needs are addressed. Consider two imaginary persons named David and John to illustrate this concept.
David is worth a million dollars. He enjoys his life. The clothes he wears, the house he lives in, the furniture he enjoys, the cars he drives, the vacations he takes, the food he prepares, the watches he wears, the fires in his fireplace, the new money added to his investments, and the charitable contributions he makes all come from funds generated by his success. The money is a by-product of his success and achievements. It’s likely based on his coworkers’ respect and appreciation, as well as an understanding of his place in the community and his contributions to his fellow residents.
John also has a $1,000,000 net worth. He enjoys his life. His entire fortune, however, stems from a trust fund established by his grandpa many years ago. The garments on John’s back were made possible by the effort of another man. He lives in a home that was made possible by the achievements of another guy. The furniture, cars, trips, food, and watches he has are all the result of a provision set aside as a result of someone else’s achievement. Because he has done nothing, none of it reflects his contribution to society. John didn’t use the benefits of a trust fund to establish his own life and career for unclear reasons, but instead came to rely on it as a safety net. It prevented him from becoming the man he was capable of becoming.
Affluenza is the word given to the feeling of melancholy and aimlessness that some persons in John’s position experience. There have been books produced on how to break free from the aimlessness or lack of purpose that comes with being born into a trust fund status. When you know, you will never have to work, you may be hesitant to take risks or venture outside of your comfort zone. Many people grow when they are pushed beyond of their comfort zones and compelled to do something they don’t believe they are capable of. While having a lot of money can help people avoid that kind of grief, it can also make them feel worthless.
Avoiding Trust Fund Trap
One approach to avoid falling into this trap is to only offer money to children who have done well on their own. A 35-year-old son who grows up to run a handful of restaurants he established and earns $300,000 per year will not be devastated by a few hundred thousand, or even a million dollars. On the other hand, an 18-year-old who is about to leave home could easily be. Before giving substantial financial presents to your children, consider waiting to see how far the apple has fallen from the tree. Some people can manage it, while others cannot. Some people can handle it at different stages in their lives, while others cannot.
The role of a parent is to assist their children, grandchildren, and other beneficiaries and heirs in becoming self-sufficient, happy, and healthy people. It is not required that you give them money. Sometimes it helps, and sometimes it hurts, and the key to wisdom is recognizing which applies to which situation.
What Is Irrevocable Trust Funds?
It’s a two-edged sword when you transfer your assets to an irrevocable trust fund. You can’t treat those assets as if they were yours anymore because they aren’t. If you chose to name yourself as the trustee, you must now work solely in the beneficiary’s best interests. That’s because you owe the recipient a fiduciary duty, which should not be treated lightly.
Trust funds, on the other hand, are a perfect method for preserving assets from creditors because of this aspect. Money gifted to a trust can frequently be beyond the reach of creditors as long as you don’t engage in a so-called fraudulent transfer, which involves putting money into a trust intentionally in anticipation of a prospective unfavorable legal claim (in which case a judge might reverse the transaction).
If you go bankrupt, lose everything, and end up penniless, your children should not be harmed because you spent decades building up appropriate trust funds for them. Despite losing everything yourself, as a parent, you would have left them an inheritance. If your trust is properly constituted, the same holds true if your child gets into problems and you’ve incorporated phrases like the spendthrift trust protection in your trust papers.
If you have a parent who intends to leave you money, request that the funds be placed in a trust fund that you will not be able to access, with annual dividend payouts that you will know about. You’ll be able to live off the passive income, but your creditors won’t be able to touch the principal because it doesn’t technically belong to you.