Chapter 13
Saving for College in Trust Accounts
In This Chapter
Understanding the basics of trusts
Using different types of trusts
Figuring out taxes on trusts
Looking at how well trusts work for college savings
If you’re like most people, you may immediately associate the word trusts with a picture of great wealth and privilege. After all, the only people who set up trusts are those who can afford to fund them, and the only people who have trust funds set up for them do things like play polo and wear blazers with little crests on the pockets. Right?
Wrong. Trusts come in all sizes and shapes, and they may serve your needs. Because of their amazing flexibility, the protections they offer you and your family, and the fact that you determine how the trust will operate, saving for all or a part of future college expenses inside of a trust may suit you better than relying totally on other forms of college saving, including a Section 529 plan or a Coverdell Education Savings Account (ESA). You may also discover that augmenting other savings you have with those in a trust gives you the control and the safeguards you’re looking for.
In this chapter, you find out what trusts are and what they can do for you. You see how they can provide you with the assurance that the money you save today will be used only for purposes that you approve of down the road. You discover ways to be certain that your children or grandchildren receive the education they deserve (and you want to pay for) even if you’re not around to see it happen. And you find out how to structure your trust(s) so that you pay the least tax possible while gaining the greatest advantage.
Getting the Definitive Word on Trusts
A trust is a legal entity that is able to hold assets of one person for the benefit of any other person or people (including the person whose assets the trust holds).
You may put as much money into a trust as you want, know that the money is always invested, and then have the trustee make distributions when the time comes for whatever expenses, educational or otherwise, you want. You have no limitations on contributions if you make over a certain amount of money, and no restrictions (other than the ones you impose) on the size of the distributions when they are made. None of the rules that govern what expenses you may pay using tax-free or tax-deferred distributions from Section 529 plans, Coverdell Education Savings Accounts, or Series EE or Series I savings bonds apply to trusts. Depending on the rules contained in the trust instrument (which you create when you create the trust), the trustee may make distributions to the beneficiary, or on the beneficiary’s behalf, to pay for any of that beneficiary’s expenses, whether directly for educational expenses or for any other purpose.
When you hear people talking about trusts, they generally throw around a lot of terms that sound impressive but that really only define clear roles and relationships within this legal entity. Here are a few of those terms:
The grantor (or the donor): This person (or people) actually creates and funds a trust.
The beneficiary: This is the person (or other being) who is entitled to receive payments from the trust. You’re not at all limited here. When you create a trust instrument, you must define who the beneficiary is (either by name or by class of people, such as your children or your grandchildren), as well as a whole slew of contingencies if that beneficiary can’t or doesn’t use up all the money. Your contingent beneficiaries, however, don’t have to be related to the original beneficiary in any way. Not only do you not need to name specific names, but beneficiaries (and contingent beneficiaries) don’t even need to be alive yet when you set up your trust. You choose.
The trustee (or fiduciary): This person or institution (accountants, attorneys, banks, and trust companies are very popular choices here) is responsible for the assets in the trust and for making sure that the assets are used in the manner you indicate when you set up the trust.
The trust instrument: This legal document governs how your trust works. Have an attorney who is very knowledgeable about trusts and how they function draft this document for you, and be certain you understand its provisions before you sign it.
No two trusts are identical, and there is no one, perfect trust that will solve everyone’s needs. When creating your trust, be as specific as you can about what you’re trying to achieve. Only then will the attorney drafting your trust instrument be certain to include all the provisions you feel are important.
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Because the trust is its own entity, it enjoys its own set of legal protections. Depending on what type of trust you create, you may be able to completely separate the affairs of the trust from your own, providing your student with adequate funding for those important college years even if your personal affairs suffer from declines and setbacks. When you look at the initial sticker price to create a trust and the costs associated with running it, think of this as a way in which you can protect your children from the financial fall-out of a major family disruption such as death, divorce, or remarriage.
Looking at Types of Trusts and How They Work
No two trusts are alike in every respect. Different grantors, beneficiaries, and fiduciaries make sure this is the case. Individual provisions make the variations even more pronounced. And that doesn’t even begin to touch the wide variety of types of trusts that are available: living trusts, grantor-type trusts, irrevocable inter vivos trusts, testamentary trusts, and so on. The list is lengthy, and each serves a particular purpose. Still, some basic types of trusts may be particularly appropriate for you when saving for your children’s college education.
Investigating inter vivos trusts
If you’re so fortunate as to remember some of the Latin you learned in school, you know that “inter vivos” refers to a period during life. In the case of these trusts, it’s during your life. Inter vivos trusts are created by you (the grantor) during your lifetime, to hold assets for another person. These trusts can be revocable (you can change your mind at any time and do away with it, taking back all the assets that you’ve placed in it) or irrevocable.
Living and other grantor-type trusts
A so-called living trust is probably the most talked-about trust variety in the media these days. Everyone and his brother is touting these trusts as a way to avoid probate and even estate taxes, and they’re generally being sold as the greatest thing since sliced bread. In reality, a living trust is an entity that you set up, fund, and then retain total control over. You have the right to revoke the trust at any time as long as you’re still alive — once you die, all bets are off. All trusts become irrevocable at the death of the grantor. Because you retain control over the assets, you’re taxed on any income earned by this trust just as if you never put it into the trust.
When the financial aid folks come around counting your assets, whatever is in this trust is counted as your asset and a maximum of 5.6 percent of the value will be included in the federal formula for the expected family contribution outlined in Chapter 17. You haven’t successfully removed it from the mix.
Even if you make a distribution to your child to pay for his college expenses, you still have to pay the annual income tax bill on the income you’ve earned in the current year (just like you’ve been paying every year since you set up the trust).
If you’re the type of parent that wants your child to really understand how much this education is costing, and you hand your child a check and tell him to use it to pay his expenses (fortunately for you, he’s a good kid and does what he’s told), you’ve just made a gift to him that may have gift tax consequences (see Chapter 3).
Irrevocable inter vivos trusts
Although many financial planners use the term inter vivos trust interchangeably with living trust or grantor trust , you can create an inter vivos trust that is irrevocable. And it’s with irrevocable trusts that you begin to see some benefits of using trusts to save for future events.
With an inter vivos irrevocable trust, any assets that you put into the trust represent a gift to the person for whose benefit you’ve created the trust, even though that person may not receive any benefit from the money either now, or ever. And here begins the tricky legal waltz you’ll dance, because, in order to receive annual exclusion treatment for the gifts you’re making (see Chapter 3), you have to make a completed gift of a present interest.
A completed gift of a present interest contains two essential aspects: First, it consists of property over which you’ve given up all dominion and control, and second, the person to whom you’ve given the property must receive immediate benefit from that property (a present interest). Because, in the case of a trust, you’re not actually putting the money into the beneficiary’s hands, most contributions to ordinary irrevocable inter vivos trusts don’t qualify as annual exclusion gifts (see Chapter 3) and become subject to gift tax (and Generation-Skipping Transfer Tax for gifts to grandchildren) rules and regulations. Even though your control over the gift is severed, your beneficiary doesn’t receive any current benefit from it.
Crummey trusts
The name of this particular type of trust isn’t a reflection on whether it’s a good trust or a bad trust. It’s actually named after the poor soul who invented it who was blessed with an awkward last name.
Crummey trusts are irrevocable and must contain so-called Crummey powers, or specific instructions regarding what must happen every time you make a contribution to the trust. And what must happen, in order for the gift to be deemed completed and a present interest, is that your trustee must notify all the beneficiaries that a gift has been made. The trust must then give them the opportunity to withdraw the value of the gift (within a specific period of time, usually 30 or 45 days from the date the gift is made) from the trust and take the cash or other property. The beneficiary’s ability to cash out the gift to the trust is what makes it a gift of a present interest and therefore eligible for annual exclusion treatment.
Here’s how it works. Aunt Jane decides to set up a Crummey trust for her nieces and nephew (she has three), and names her sister as trustee. Each year, Aunt Jane makes a gift of $33,000 (3 x $11,000 — the current annual exclusion gift per child) into the trust. After her sister receives the check, she sends letters (certified mail and with return receipts, so she can prove to the Internal Revenue Service (IRS) that the notices went out should they decide to ask) to each of the children (or their parents, in the case of minor children), notifying them that a gift has been made into the trust and that they each have the right to withdraw $11,000 within the next 45 days.
Not surprisingly, no one decides to withdraw their share of the money, and their right to ask for the money expires with all the money still sitting in the trustee’s possession. Now the trustee is free to invest the money, and Aunt Jane is perfectly within her rights to show she made three annual exclusion gifts on her gift tax return. Meanwhile, the money remains invested in the trust, growing until that time when the beneficiaries need distributions to pay for college expenses (or to buy that first house, pay for a wedding, or whatever other good reason the beneficiary needs the money for).
Section 2053(c) and 2053(b) trusts for minors
The only way a minor child can own securities outright is through a Uniform Gift to Minors Act (UGMA) account (see Chapter 12). One of the great drawbacks of this account, however, is that, at age 18 (or 21, depending on the state), the no-longer minor child now controls the account and everything in it to use as he or she determines.
To give parents and grandparents more control over the situation, you may also create trusts under Internal Revenue Code Section 2053(c) or (b), which allows you to save for that child until he or she reaches the age of 21. Unlike the Crummey trust, this trust doesn’t require that you maintain the rather elaborate fiction of providing an opportunity for that child to take money out every time you put money in.
Instead, Section 2053(c) and (b) trusts to minors allow the grantor to create the premise of making annual exclusion gifts (as described in Chapter 3) in the following ways:
Section 2053 (c) requires that the trust (all contributions plus all accumulated income) become completely payable to the beneficiary on his or her 21st birthday.
Section 2053 (b) requires that all income earned (but none of the contributions received from the grantor) is paid to the minor child every year that the trust is in effect.
Tackling testamentary trusts
As the name suggests, these trusts are created under, and through, your last will and testament. Because these trusts are governed by terms contained in your last will, and because your last will doesn’t become truly effective until you die, a testamentary trust comes into being and is administered after your death. Beyond that, it functions in all ways exactly the same as an irrevocable inter vivos trust does. You may include the same provisions in your testamentary trust as you might in any other, especially regarding how, when, and to whom distributions are made.
If your priority during life is being sure you have adequate resources for your own needs, and you haven’t made lifetime gifts of significant pieces of wealth to your family, a testamentary trust may be the ticket. Rather than making specific bequests of money to your children, grandchildren, or other relatives, the terms of the trust govern how your money will be used, preventing your descendents from frittering away their legacies. Because you define what that money may be used for (education is always a nice choice) before you die, you ensure that your money is actually used for those purposes.
Paying Tax on Your Trust
As you’ve no doubt figured out by now, putting money into a trust doesn’t mean that you don’t pay any tax on the income. Quite the contrary — all taxable income earned by a trust, in whatever form, is subject to applicable federal, state, and local income taxes. What you have to figure out is who pays the tax, how much has to be paid, and what you can do to make the taxes as minimal as possible.
Figuring out who foots the bill
What makes trust taxation interesting is figuring out who gets to pay the tax. If the trust is a revocable trust, or otherwise falls within the grantor rules (where the grantor retains at least some of the benefit of the assets inside the trust), the grantor includes the income on his income tax return and pays the tax. In certain situations, the trust may need to file its own income tax return, but in such cases, it shows only that the income will be reported on the grantor’s return.
For all other trusts, the rules are more complex. Irrevocable trusts, such as Crummey trusts, Section 2053 (c) or (b) trusts for minors, and testamentary trusts, must file their own income tax returns. For trusts that make no distributions to beneficiaries, the tax return preparation is roughly the same as it is for an individual.
If a trust makes distributions to a beneficiary during the year, though, things change. A trust is an entity that the IRS refers to as flow-through or pass-through. Just as the income comes into the trust (in the form of interest, dividends, rents, business earnings) and then flows out of the trust to the beneficiary in the same form, the income tax liability that travels with the income flows into the trust and out to the beneficiary, who then has the responsibility to pay the tax. In every year in which a distribution is made, the trustee must provide to the trust beneficiary a copy of Schedule K-1 from the trust’s income tax return, which provides the beneficiary with the breakdown into the various types of income he received during the year.
Running through the trust tax brackets
Although most trust tax laws do follow the individual tax rules very closely, there is one place with a huge discrepancy: where the tax bracket changes occur. Trusts aren’t a very popular area with the IRS, and Congress generally considers trusts fair game when trying to balance its checkbook — after all, trusts don’t vote.
Accordingly, the amount of income you need to go from the lowest income tax rate to the highest (the bracket ride ) for non-grantor trusts is short, not-so-sweet, and very much to the point. For example, in 2003, a trust begins to pay income tax at the highest rate with only $9,350 of income (as compared to $311,950 for single individuals and married couples filing jointly). There is some relief, though — the new 15 percent top dividend and long-term capital gains rates created by the Jobs and Growth Tax Relief Reconciliation Act of 2003 and explained in Chapter 12 apply to trusts as well as to individuals.
Kiddie tax: Making the children pay
If you fund a trust for a minor child and you determine that he should receive a distribution from the trust, if he is under age 14, the trust distribution may trigger the kiddie tax.
The kiddie tax was inaugurated in 1986 as a way to prevent high-income taxpayers from shifting their income to their children, who were presumably in a lower tax bracket. The rules and forms are somewhat complicated, but the net result is this: In any year, a child under age 14 who has investment income in excess of a pathetically low base amount, which is looked at annually and adjusted periodically ($1,500 in 2003) will pay tax on the excess amount at his parents’ highest bracket. In other words, if in 2003 you paid in a 35 percent tax bracket, your child also paid at that rate for all investment income over $1,500.
Unless you’re making trust distributions to a young child, the “kiddie tax” shouldn’t be a cause for concern for you. Because you’ve probably created the trust to deal with future college expenses, you probably don’t need to fret over this particular provision unless you’re living with Einstein reincarnated, who’ll be starting college when he’s twelve.
Identifying the Pros and Cons of Trusts in Relation to College Savings
Clearly, funding trust accounts has some very real benefits when saving for your kids’ future education expenses. Trusts also have a very strong downside. You have to decide whether the balance tips positive or negative for your own financial and family situation.
You have absolute flexibility in funding, choosing beneficiaries, investing, and deciding how much, when, and for what distributions may be made.
These accounts keep control out of the hands of your kids but give them the benefit of your savings.
A properly drafted trust protects you, and your family, from personal catastrophes and financial disruptions. Funds that are segregated in an irrevocable inter vivos trust (and your intentions when you put that money there) will survive your death, a divorce (either your own or one of your beneficiary’s) or a remarriage, to name a few issues.
You pay no penalties for failing to use the money for its intended purpose, and you can use what you don’t use for education expenses to help purchase that first home, pay for your kid’s wedding, or even start funding his retirement. You really have no limitations.