While you may already know that trust funds can be a great tool for building, protecting, and passing on wealth, like all things in life, they also have a few downsides. Specifically, you might encounter certain trust fund disadvantages, such as:
- Trust fund taxes that are often effectively higher than the taxes owed on assets not held in trust due to compressed marginal tax brackets.
- Entitled beneficiaries who aren't able to support themselves due to a lifetime of having everything handed to them on a silver platter.
- A loss of control that comes with transferring assets to an irrevocable trust, as opposed to a living trust (also known as an inter vivos trust) or a testamentary trust. It is often necessary to achieve the maximum estate tax exemption benefits.
By taking a moment to examine each of these disadvantages, you can gain a better understanding of what you're getting yourself into should you choose to begin using trust funds in your own financial plans, whether to protect your assets or maximize the amount of wealth you can transfer into the hands of your children, grandchildren, and other heirs.
Trust Funds Have Unfavorable Tax Rates
Congress routinely updates the tax brackets to adjust for the inflation rate. Unfortunately, for decades, the House of Representatives and the Senate have maintained the policy that the tax rates applied to trust funds should be compressed compared to the ordinary marginal rates applied to individuals holding the exact same investments.
For example, according to the IRS, in the tax year 2019 the following federal trust fund tax rates are applied on any income retained by the trust:
- Retained income of under $2,600 is taxed at 10%
- Retained income of over $2,600 but not over $9,300 is taxed at $260.00 plus 24% of the excess over $2,600
- Retained income of over $9,300 but not over $12,750 is taxed at $1,868.00 plus 35% of the excess over $9,300
- Retained income of over $12,750 is taxed at $3,075.50 plus 37% of the excess over $12,750
An unmarried individual, in contrast, wouldn't hit the 37% federal tax rate until taxable income reached more than $510,300. To make it worse, State taxes on the retained trust income are going to be owed in most states, as well, which would be in addition to the Federal trust taxes. Then, there are other issues such as the generation-skipping tax, which can apply to trust funds.
There is a small respite, in that income distributed by the trust to the beneficiaries, including dividends, interest, and rents, is taxable to the beneficiary at his or her own rate. The philosophy behind this unequal treatment is that it will make it less attractive for families to amass aristocratic levels of wealth in a trust, though there are easy enough ways around it.
For example, the investment advisors overseeing the portfolio of a large trust fund as an individually managed account could arrange the equity investments to emphasize non-dividend paying stocks or stocks with low dividend payout ratios, such as shares of Berkshire Hathaway, the holding company built by billionaire Warren Buffett.
The increase in book value should, over time, result in unrealized capital gains, effectively creating a deferred tax liability that allows the trust to have more capital working for it than it otherwise would if the look-through earnings generated by the trust assets had been paid out to the trust as cash dividends. Over many decades, this sort of advantage can lead to a much higher compound annual growth rate, all else equal. It is one of the reasons the investment mandate of a trust is so important.
On the flip side, structured correctly, an irrevocable trust can lower taxes for a family by moving money from the estate of a wealthy family member to his or her heirs, the latter of which are likely to be in lower tax brackets. By emphasizing distributions, investment income that would have been taxed at much higher rates can be, instead, taxed at less confiscatory rates on the beneficiary's personal income tax filing. It takes a lot of planning, many years, and good legal, tax, and investment advisors to pull it off correctly, but for families that are in the top 1%, it can be worth it, especially when used with the annual gift tax exclusion.
Trust Funds Can Create Financial Dependence
Behavioral psychology tells us that most people need meaning in their life and that money alone cannot provide meaning once the basic necessities have been met. To demonstrate this point, imagine, for a moment, two fictional men, David and John.
David has a net worth of $1,000,000. He lives well. The clothes on his back, the home in which he lives, the furniture he enjoys, the cars he drives, the vacations he takes, the food he puts on the table, the watches he wears, the fires in his fireplace, the new money added to his investments, and the donations he makes to charity, all come from funds generated by his success. The money is a by-product of his achievement and accomplishments. It likely comes with the respect and admiration of his colleagues and a sense of how he fits into the community and his contributions to his fellow citizens.
John also has a net worth of $1,000,000. He lives well. However, all of his wealth comes from the trust fund his grandfather set up for him years ago. For John, the clothes on his back were provided by another man's labor. The home in which he lives was funded by another man's accomplishments. The furniture, cars, vacations, food, and watches he has are only there because of the provision set aside due to the success of someone else. None of it reflects his contribution to society, for he has done nothing. For unknown reasons, John didn't use the benefits of a trust fund to launch his own life and career, but, rather, came to rely on it like a security blanket. It kept him from growing into the man which he was capable of becoming.
The sense of depression and aimlessness that afflicts some people in John's position has been given a name: Affluenza. Books have been written about how to escape the aimlessness or lack of purpose that comes from being born into a trust fund situation. When you know you will never have to work, it can cause you to avoid taking chances and going outside of your comfort zone. For many people, growth comes when they are forced outside of their comfort zones and made to do things they don't yet think they are ready to do. While large financial resources can allow people to avoid that kind of pain, it can also destroy their sense of self-worth.
Avoiding the Trust Fund Trap
One way to avoid this trap is to only give money to offspring who have been successful on their own. A 35-year old son who grows up and is earning $300,000 per year running a couple of restaurants he founded is not going to be ruined by a few hundred thousand, or even a million, dollars. On the other hand, an 18-year old just leaving home easily could be. Consider waiting to see how far the apple has fallen from the tree before making major financial gifts to your children. Some individuals can handle it; some can't. Some people can handle it at certain times in their life and other people can't.
A parent's job is to help their children, grandchildren, and other beneficiaries and heirs develop into self-sufficient, happy, healthy adults. It is not necessarily to give them money. Sometimes it helps, sometimes it hurts, and wisdom is knowing which applies in a specific situation.
Irrevocable Trust Funds: The Assets Are No Longer Yours
When you transfer your assets to an irrevocable trust fund, it is a double-edged sword. You can no longer treat those assets as if they belong to you because they don't. You must now, by law, work solely in the interest of the beneficiary if you opted to name yourself as the trustee. That is because you have a fiduciary duty to the beneficiary, which is not to be taken lightly.
On the other hand, it is this very fact that makes trust funds an ideal mechanism for protecting assets from creditors. As long as you don't engage in a so-called fraudulent transfer, which means specifically moving money into a trust in anticipation of a potential adverse legal claim (in which case a judge might reverse the transaction), money gifted to a trust can often be beyond the reach of creditors.
If you go bankrupt, lose everything, and find yourself destitute, but you spent decades building up legitimate trust funds for your children, they shouldn't be hurt. As a parent, you would have provided an inheritance for them despite losing everything yourself. Properly structured, the same is true if your child gets in trouble and you've included clauses in your trust documentation such as the spendthrift trust protection.
If you have a parent that plans on leaving you money, ask for the cash to be put into a trust fund that you cannot access, with specific annual dividend distributions. That way, you can live off of the passive income, but your creditors should not be able to touch the principal since, technically, it doesn't belong to you.