Asset Location When a Trust Is Involved

By Dr. James M. Dahle, WCI Founder

Proper asset location is an important aspect of financial planning. However, most people only consider income tax when doing tax planning. Even thinking about the tax bill for the next generation is beyond the scope of most articles and advice given on the subject. Things become even more complicated when an irrevocable trust has been put in place as part of a plan to reduce estate tax. Today, though, let's talk about it.

 

IDGTs and Tax Planning

Consider an estate plan (like ours) involving an Intentionally Defective Grantor Trust (IDGT) such as a Spousal Lifetime Access Trust (SLAT). With this technique, rapidly growing assets (such as a business) are gifted using up the estate tax exemption (and/or sold in exchange for a promissory note) into the IDGT relatively early in life, removing the growth on those assets from the estate and thus reducing the estate tax due.

Reducing the estate tax (mostly applied in the top bracket of 40%) becomes the most important aspect of tax planning and, thus, tax location becomes key. This is primarily done by preferentially spending and giving away the assets that are outside of the trust but can also be affected by the placement of the investments in the portfolio.

 

2 Portfolios or 1?

The first question is whether you should be managing two portfolios (one in the trust and one outside the trust) with two sets of asset allocations and asset locations. If you decide on two, then the rest of this discussion becomes easier. If you are still going to look at all of your assets together as one big portfolio (as purists would argue you should), it becomes more complicated.

 

How to Minimize the Estate

The IDGT helps you reduce the size of the taxable estate by using the personal side preferentially for your income taxes, spending, and gifting.

 

Paying Taxes

An IDGT is a pass-thru entity for tax purposes. All the taxes generated by the businesses, investments, or other assets in the IDGT are paid on the personal side. That's a good thing, as it allows a huge opportunity to reduce the estate tax bill. Imagine a business in the IDGT that makes $10 million in profit a year. The tax bill on that may be $4-$5 million. By using the IDGT and then paying taxes using personal funds, the value of the IDGT goes up by $10 million a year and the value of the personal assets goes down by $4-$5 million a year. A single year of doing this would reduce the total estate tax due by $10 million x 40% + $4.5 million x 40% = $5.8 million! And that process repeats every single year!

The same tax arbitrage occurs with spending. The order of spending when it comes to an IDGT may be as follows:

1. Spending all salary, Social Security, pensions, and investment income on the personal side
2. Spending interest from any promissory notes
3. Selling personal taxable assets
4. Spending retirement account assets
5. Spending principal from promissory notes issued by the IDGT
6. Spending distributions from IDGT

However, it is not entirely clear that steps 3-5 above are in the right order. There are inherent conflicts here.

 

Conflict with Capital Gains Taxes

If you spend taxable assets before having the trust pay the principal on the promissory note, you are likely to incur capital gains taxes that you would not otherwise. However, the amount of those taxes depends on the basis of the asset. If you can sell high basis shares, then the savings on estate tax is almost surely going to outweigh the additional income tax paid. However, if the shares sold have low or zero basis, the right move is not entirely clear. Is paying tax at 23.8% now better than the estate paying tax at 40% later? You would think so, but remember that the assets in the trust do not get a step-up in basis at death. If you can't reduce that basis in the trust between now and death via charitable giving of the most appreciated shares, the estate may be paying more income tax later. It looks like this:

Spending appreciated assets

• Income tax: 23.8%
• Estate tax: 0%
• Money stays in trust and may owe 23.8% in lost step-up in basis at death
• Total tax due: 47.2%

Spending promissory note principal

• Income tax right now: 0%
• Estate tax: 40%
• Income tax later: None
• Total tax due: 40%

Is paying up to 23.8% now and up to 23.8% later better than paying 40% later? Of course not, but depending on who the trust beneficiaries are and how charitable giving is managed, it's entirely possible that the “23.8% later” can be reduced or eliminated completely. It's a dilemma, for sure. Personally, we give a lot to charity now and plan to give a lot to charity later, so we lean toward spending appreciated assets first. But a family less charitably inclined should probably spend the promissory note before liquidating taxable assets, especially if the basis is low.

 

Conflict with Retirement Accounts

If you thought the conflict between paying capital gains taxes now or estate taxes later was difficult, consider the conflict between losing the benefits of retirement accounts vs. paying more in estate tax later. Retirement accounts eliminate the tax drag as investments grow. They also provide additional asset protection. If you spend down retirement accounts prior to spending the principal of a promissory note owed to you by your trust, you lose those benefits. However, you also reduce any estate tax due. Which is more valuable?

Well, the promissory note clearly receives less asset protection than the retirement accounts, but in many states, it can be placed into an asset protection trust. Plus, it's not that attractive of an asset for a creditor to receive since it typically earns a low interest rate. A $10 million promissory might only be earning $200,000 a year in interest. The creditor might have thought they were getting $10 million, but if it is going to take five decades to actually get it, they are likely to settle for much less than the $10 million. Asset protection techniques like these are also rarely needed, so I don't put too much value into the asset protection aspects of this decision.

The tax protection, however, is much more significant. For simplicity's sake, let's consider that it is all coming from a Roth IRA. How much is that avoidance of tax drag worth? Imagine a $1 million Roth IRA and a $1 million taxable account. Let's say it can sit in that account for twenty years before it is spent. While it could be longer, it could also be shorter. We'll ignore the potential 10-year stretch with the Roth IRA for the heirs since it is at least partially offset by the fact that the taxable account would get a step-up in basis at death if left to heirs. We'll just go 20 years and withdraw the entire sum and pay any taxes due.

• $1 million Roth IRA after 20 years at 8% = $4.7 million
• $1 million Taxable account invested tax efficiently after 20 years (0.5% tax drag and 23.8% on gains at withdrawal) = $3.5 million

So, the benefit of leaving the Roth IRA intact is about $1.2 million. But the estate tax cost of leaving it intact would be between $3.5 million x 40% = $1.4 million and $4.7 million x 40% = $1.9 million, depending on how you look at it. Those numbers are not that different, and differences in assumptions (such as tax-efficiency or tax brackets) could easily swing the verdict one way or another.

It gets even more complicated if you consider a tax-deferred account. When making tax decisions, it is generally best to think of a tax-deferred account as a combination of a tax-free account plus an account you are investing on behalf of the government. When it comes to estate taxes you are paying on both “your” tax-free account and the government account. So, the decision leans even more heavily toward spending retirement account assets prior to spending the principal of a promissory note, at least once you are past age 59 1/2. Unless, that is, you are very charitably inclined. In that case, you can leave your entire tax-deferred account to your favorite charities, gradually via Qualified Charitable Distributions (QCDs) while alive and the rest at death (immediately by setting the charity as a beneficiary or after 10 years of stretching if you set the trust as a beneficiary).

 

Spending

You want to do all your spending on the personal side. Every dollar you spend from the personal side reduces your estate tax by 40% compared to spending a dollar from the trust. Even if you're not actually making trust distributions, just spending the promissory note reduces the ratio of trust-to-personal-assets and increases the estate tax that will be due.

If the trust includes a business, minimizing family salaries from that business increases the trust-to-personal-assets ratio. Don't just increase salaries willy-nilly thinking you're coming out ahead. You may be better off spending down personal assets. Just like with an S Corp, keep your salaries as low as you legally can while also considering the benefits of additional retirement account contributions and the 199A deduction.

 

Giving

You also want to do your giving from the personal side rather than the trust. Giving to family and friends will reduce your estate tax bill. It gets even better with charitable giving. Every dollar you give to charity provides a tax deduction this year (likely worth 40%-50% of the amount given); PLUS it reduces future estate tax by 40% of the amount given. That's a win-win! Your contribution almost reduces your tax bill 1 for 1, a much higher value than you typically get for charitable donations. You know what is even better? If you donate appreciated shares instead of cash, neither you nor the charity pays capital gains taxes. However, this introduces yet another conflict.

 

Conflict with the Donation of Appreciated Shares

The most appreciated investments with the lowest basis are likely now in the trust. If you donate them from the trust, you certainly get the tax deduction (it's passed through), but you are also reducing your trust-to-personal-ratio and thus increasing your estate tax. This is an even bigger deal when you consider that the assets in the trust do not get a step-up in basis at death. Ideally, you want to donate from the personal side, but you want to donate the assets that are in the trust. This can be done, but you first must swap cash into the trust in exchange for the low basis assets. Then, donate the assets. That means additional paperwork and hassle, and that's assuming you actually have the cash without having to liquidate assets and pay capital gains taxes to get it. One could swap similarly valued assets with the trust and perhaps save some capital gains taxes. Either way, the process is far more complicated than it used to be before you had the trust.

 

The Hassle Factor

Now that we have talked about how important it is to increase the trust-to-personal-asset ratio by preferentially paying taxes, spending, and giving from the personal side, let's talk about another factor that may affect your asset allocation inside the trust. When you have a trust, there are trustees. With an IDGT, at least one of those trustees is going to be someone besides you and your spouse. They're going to have to sign and do paperwork for every new account you open, close, or transfer assets from. That can be a major pain, especially if that trustee lives out of state.

Keeping your asset allocation simple, at least within the trust, reduces that hassle significantly. Hassle-wise, there ideally is just one brokerage account and one bank account in the trust. But if you have enough assets to have an IDGT, your mix of assets is likely more complex than just one brokerage account. You probably have a small business or two. Maybe some rental properties, syndications, or private real estate funds. Maybe some cryptocurrency or precious metals. Complicated asset allocations always increase your hassle factor, but when there is a trust involved, it goes up by at least a factor of three.

 

Risk

Since it is unlikely that the assets in the trust will ever be spent by you (remember trust distributions are at the bottom of the spending list), you can take a lot more investment risk with them. This might argue for a separate asset allocation (the two-portfolio solution) rather than one. Whichever route you go, you certainly want your highest returning assets in the trust to increase the trust-to-personal-assets ratio as much as possible. With a two-portfolio solution, that means you have a more aggressive asset allocation in the trust. With a one-portfolio solution, that means the risky, higher returning assets go in the trust and the less risky assets go outside the trust. You probably don't want a trust full of bonds, CDs, or even life insurance.

Irrevocable Life Insurance Trusts (ILITs) are popular because they simplify trust tax accounting. But with an IDGT, the taxes are all paid on the personal side anyway. Better not to have low returning cash value life insurance in there (although you can put your term policies in there if you still have any since they use up little estate tax exemption when sold to the trust.) Unfortunately, risky, higher returning assets usually involve the most hassle. There is a trade-off to everything.

 

Trust vs. Retirement Accounts

When discussing asset location, normally the big discussion is what goes in the retirement accounts and what goes in taxable. When the taxable account is owned by an IDGT, it gets way more complicated. Consider the normal asset location advice:

 

 

Once you insert a trust into the mix, it starts to look more like this:

 

 

As you can see, the dominating factor here is more the return than it is the tax-efficiency. High-returning assets go in the trust, and low-returning assets go elsewhere, even if it means they're filling up your Roth retirement accounts.

 

A Case Study

Let's consider a case study. In this situation, the asset locations look like this:

• Trust: 60%
• Retirement accounts: 20%
• Personal taxable account: 20%

Let's say the desired asset allocation looks like this:

• 30% Total Stock Market
• 10% Total International Stock Market
• 15% Small Value
• 15% Nominal Bonds
• 10% Inflation-Indexed Bonds
• 5% REITs
• 5% Private equity real estate
• 5% Private debt real estate
• 5% Cryptoassets

What asset classes are you going to put in which locations? Here is what I would do:

• 30% Total Stock Market: 25% Trust, 5% into personal taxable (high returning, tax-efficient, low hassle)
• 15% Total International Stock Market: Trust (high returning, tax-efficient, low hassle)
• 15% Small Value: 15% into trust (high returning, somewhat tax-efficient, low hassle)
• 10% Nominal Bonds: Personal taxable, as muni bonds (low returning, tax-efficient, low hassle)
• 10% Inflation-indexed Bonds: Retirement accounts, as TIPS (low returning, tax-inefficient, low hassle)
• 5% REITs: Retirement accounts (high returning, tax-inefficient, low hassle)
• 5% Private equity real estate: Personal taxable (high returning, tax-efficient, high hassle)
• 5% Private debt real estate: Retirement accounts (high returning, tax-inefficient, moderate hassle)
• 5% Cryptoassets: Trust (high returning, tax-efficient, moderate hassle)

There is no perfect solution, but this is a reasonable approach weighing the three main factors of return, tax-efficiency, and hassle. As the trust-to-personal-assets ratio increases, I would move assets to the trust in the following order:

1. Total Stock Market
2. REITs
3. Equity real estate
4. Debt real estate
5. Nominal bonds
6. Inflation-indexed bonds

Looking at this complexity, the investor likely will simply choose a less complex asset allocation to maintain! Dropping 2-5 asset classes will simplify life immensely.

 

As you can see, the use of an IDGT for estate plan purposes has important effects on asset location decisions. You should preferentially pay taxes, spend, and give from the personal accounts to maximize the trust-to-personal ratio of assets. However, it is also important to consider expected rates of return when deciding which assets go into the trust and which do not. Expected return matters more than tax-efficiency, but you should also consider the hassle factor.

 

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What do you think? If you use an IDGT, what asset classes did you place into it? Do you treat the IDGT as a separate asset allocation or group it together with your other assets? Comment below!