Trusts are useful but complicated. Here are some basics

Financial planner Barbara Bilello likens wealth management to a car, in which an estate plan is part of the body and investment or portfolio management is the engine, she said.

"That engine is going to fuel the car. That body of the car is your financial plan, said Bilello, a partner in the Morristown, New Jersey-based office of registered investment advisory firm Corient. "I use that as an analogy because the body of the car, for example, should offer you protection."

Trusts that slash taxes for the owners and their heirs, while avoiding potential probate court cases, can form a crucial part of that security for many financial advisors and their clients. With the higher estate-tax exemptions under the Tax Cuts and Jobs Act of 2017 set to expire at the end of next year, Bilello and other experts who spoke with Financial Planning said there is an added incentive to set aside assets before the level of inherited assets that can be taxed reverts to lower levels. 

However, tapping into trusts requires knowledge of an increasing array of entity types with the typical industry acronym jargon and, often, collaboration with an estate attorney and a trust company.

"Trusts are these very flexible arrangements, and you can make of them what you will," said Jose Reynoso, the director of personal financial planning and the director of advanced tax and estate planning with Citizens Private Wealth. "It starts with, what are the client's objectives and what are they trying to accomplish."

For example, a spousal lifetime annuity trust can shield up to $13.61 million — the current exemption amount for individuals — from estate taxes while giving the partners "comfort and a safety net" if one passes away, he noted. 

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Other couples may wish to launch a bypass trust, also known as a credit shelter trust, or a marital disclaimer trust, according to a 2022 guide to estate planning for spouses in the Journal of Accountancy. More than 50 of the 100 richest people in the U.S. have used a grantor retained annuity trust or similar entities to get around estate taxes, ProPublica reported as part of a 2021 investigation.

Charitable remainder trusts cater to clients seeking to maximize their deductions through donations of certain assets, and a qualified personal residence trust removes homes from customers' estates with a steep discount on any gift taxes. A testamentary trust that is part of a will could reduce the size of the estate and shelter assets, Bilello noted.

The irrevocable life insurance trust can help its owner send the proceeds of the policy to heirs at their death tax-free following the payment of estate duties, and a special needs trust enables families to provide dependents with living means while managing the outlays for people with disabilities or bad money habits, noted Michael Chuah, the principal attorney of Paxterra Law.

To begin with, advisors and their clients should understand how state-specific the rules can be for trusts and estates, he said. Some clients may fit various states' formulas for a "small estate" that won't need any trusts to stay out of probate. The probate process could take anywhere from two to five years, and, "unfortunately, it does lay bare the decedent's life" in a way that could draw claims on a client's assets from family members, according to Chuah.

"The reason why those numbers are important is because they trigger probate. Probate is just something that nobody wants to find themselves in," he said. "The avoidance of probate is the big thing when it comes to trusts, because trusts don't undergo the probate process. … That's why trusts are very attractive."

Another key basic choice in trust planning starts with whether to use a revocable or irrevocable structure, with the latter cordoning assets off from taxes or creditors permanently and the former allowing for flexibility with possible changes and a means for its owner to instruct loved ones on "what to do on their behalf in the event they became incapacitated," Bilello noted.

Most advisors won't be equipped to answer all of these questions on their own. The need for official documents combined with the intricacies of state laws explain why the decision around the location of the entity is "a conversation that needs to happen with a trust and estate attorney," she said. Also, the clients will likely want to use a corporate professional to administer the terms rather than appointing a family member. Otherwise, there may be situations like a younger relative asking a trustee for, say, a half million dollars to buy a sports car.

"It basically takes the emotion out of it," Bilello said of hiring a corporate trustee. "You just know that Aunt Judy isn't going to pull out the checkbook and write the check, but boy is it going to be awkward."

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When thinking about referring clients to particular lawyers for trust services, advisors ought to ensure "there's a good professional relationship where they can bounce ideas off the attorney," Chuah said. In addition, they'll want the client to hire the lawyer rather than the advisor putting themselves in charge of the estate by paying the attorney to draw up the documents, he said.

"It's always best to handle it that way, which means that you can maintain the attorney-client privilege," Chuah said.

The many kinds of entities and laws involved with trusts may seem daunting at first, but "reading reading, reading" news and practitioner articles and cultivating advisory practices in which there is "a philosophy of lifetime learning or you fall short" can bring a lot of knowledge, Reynoso said. At a time in the profession marked by the convergence of wealth and tax-related services, such expertise is "how you differentiate" as an advisor, he said.

"Now we have so much access to information," Reynoso said. "You just accumulate knowledge and you never stop learning. You're never going to learn it all."

Advisors who are focusing only on clients' investments without considering how to mitigate the tax impact of passing down their wealth are "missing an opportunity to be more helpful to your clients," Bilello said. In that regard, the clients' wealth management vehicle and the safety offered by their estate plan may be ready for a tuneup or a trade-in.

"Maybe over time you get a different car," Bilello said. "The car that you started with might not be the car that is the most effective for you today, the most productive for you today."