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A TRUly Nice Way to Plan Your Estate!
By Sherwin Lesk CFP, J.D., LL.M.
From Leonetti & Associates. Reprinted with Permission.
ome people give little thought to the financial planning aspects of their estate plan, resulting in unintended consequences. Take, for example, the outdated but still used "live off the income, preserve the principal" trust design.
What happens under that design? Imagine you’re the beneficiary of a $1,000,000 trust and entitled to annually receive all trust accounting income. The trustee opts to maximize income by investing in fixed income securities, for safety’s sake buying only government paper. When you die, the trust passes estate tax free to your children.
There’s nothing wrong with this design, unless you annually need $50,000 pre-tax in today’s dollars to live comfortably. With 5-year Treasury Notes recently priced to yield 3.85%, the trust produces only $38,500 of yearly income before trust expenses. Moreover, investing entirely in fixed income securities held to maturity insures the portfolio will not appreciate, and lets inflation take its toll on your purchasing power. While your children like the potential inheritance, they will be disappointed with a trust invested without regard for growth.
What happens if the trustee instead invests in stocks? Many stocks pay dividends in addition to offering capital appreciation potential, but the dividend yield on the S&P 500 recently has been a paltry 1.38%. Before expenses, that yield produces $13,800 of annual pre-tax income. The children will be happy if the stocks appreciate, but taking capital gains will not help you. Capital gains are not considered trust accounting income.
If the trustee tries to please everyone by investing in stocks and bonds, both the children and you will be unhappy. A stock/bond mix will not produce the income an all bond portfolio would, nor offer an all stock portfolio’s appreciation potential.
Although none of the foregoing outcomes are appealing, many a "Family Trust" is modeled on the "live off the income, preserve the principal" design. That design causes the children and surviving spouse to have competing investment goals. The children want the trust to grow without regard to income; the surviving spouse wants to maintain their lifestyle rather than increase the children’s inheritance. Does your estate plan bequeath similar problems to your family?
Coping with a loved one’s passing is hard enough for those left behind. Don’t make things more difficult for them with an estate plan that fails to adequately address their financial planning needs. Traditional estate planning pays little regard to how much money the survivors need to maintain their lifestyle and how trust funds should be invested in support thereof, focusing instead on reducing
or eliminating estate taxes. A better way to plan your estate and truly make it part of your financial plan is to abandon the "live off the income preserve the principal" approach, and embrace a total return unitrust (TRU) design.
A TRU enables the trustee to invest with a singular goal of maximizing the trust’s total return — the way you would — whether that return comes from interest, dividends, capital gains, or a combination of the foregoing. For example, with a $1,000,000 trust and a surviving spouse having a $50,000 annual pre-tax cash need, a TRU might direct the trustee to annually distribute to the surviving
spouse an amount equal to 5% of the trust’s fair market value determined as of the beginning of the year. Unlike the earlier trust you were asked to imagine, it’s not a problem if the trust’s accounting income is insufficient to cover the required distribution, because the trustee can make up the difference by distributing capital gains.
If the trust grows more than 5%, the following year’s distribution, being 5% of a bigger number, will be greater, permitting the distribution to keep pace with or beat inflation. Conversely, if the trust grows less than 5%, the following year’s distribution will be smaller. Either way, the TRU promotes family harmony by aligning the interests of the trust’s beneficiaries regarding the trust’s investment style and performance. Instead of having competing investment goals, the surviving spouse and children both want the trust fund to grow.
The TRU thus empowers the trustee to concentrate on growing the portfolio rather than avoiding conflict, gives the surviving spouse a fighting chance to stay ahead of inflation, and enhances the surviving spouse’s planning opportunities; the surviving spouse knows at the end of each year the amount of the next trust distribution. The TRU enables you to coordinate your estate plan with your financial plan. It’s truly a nice way to plan for your loved ones.
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