Estate Planning Essentials: The Living Trust

First, the nuts and bolts. A trust is an arrangement where a trustee holds the right to property for the benefit of a beneficiary. The person who establishes and funds the trust is the grantor (also called the “trustor” or “settlor”). The person who controls the property in the trust for the benefit of a beneficiary is the trustee. The trustee has a fiduciary duty to always act in the grantor’s best interest. The person who the grantor appoints to manage the trust assets during their lifetime or distribute the trust assets after their death is the successor trustee. Commonly in a living trust, the grantor, trustee, and beneficiary are all the same person.

Probate is the legal process that takes places after someone dies. It includes validating the will, identifying, inventorying, and valuing the decedent’s property, paying debts and taxes, and distributing the remaining property as the will or state law directs. If the decedent had a will, then the will determines the transfer of property; if the decedent didn’t have a will, then the laws of intestate succession determine the transfer of property. In California, intestate succession is determined by the state legislature and set forth in the Probate Code. As such, the decedent has no choice but to leave their property to the persons in the order listed in the Probate Code, even if it’s not what they would have wanted.

Enter the living trust. A living trust is a type of trust that the grantor establishes during their lifetime (as opposed to a testamentary trust which takes effect at the grantor’s death) and one that they may amend, revoke, or terminate at any time (as opposed to an irrevocable trust). A living trust essentially acts in place of a will, and trust assets pass to beneficiaries outside the probate process. This works because probate only includes property held in the decedent’s name, whereas property in the living trust is held in the trust’s name. The number one reason people create living trusts is to avoid probate.

Probate fees are a significant concern. As of April 1, 2022 in California, probate is required if someone dies owning $184,500 or more worth of assets. Excluded from this $184,500 are financial accounts with designated beneficiaries, transfer-on-death (TOD) accounts, or any assets owned in joint tenancy or as community property with the right of survivorship. California has the following statutory fee schedule set forth in the Probate Code for the attorneys and executors representing the estate, which cover the probate duties mentioned above.

  • 4% of the first $100,000
  • 3% of the next $100,000
  • 2% of the next $800,000
  • 1% of the next $9,000,000
  • 0.5% of the next $15,000,000

The probate fee calculations may have to be done twice, once to calculate the attorney’s fee and once to calculate the executor’s fee. Here are example probate fee calculations based on the gross value of an estate.

  • $500,000             $13,000 x 2 = $26,000
  • $600,000             $15,000 x 2 = $30,000
  • $700,000             $17,000 x 2 = $34,000
  • $800,000             $19,000 x 2 = $38,000
  • $900,000             $21,000 x 2 = $42,000
  • $1 Million            $23,000 x 2 = $46,000
  • $5 Million            $61,000 x 2 = $122,000

The gross value of the estate is the full market value of the assets of the estate, and the probate court does not use debts or encumbrances to offset this. For example, if a house is appraised at $900,000 but has an outstanding mortgage of $400,000, the house is still valued at $900,000 for the purposes of calculating probate fees. Furthermore, if the house is sold during probate, the attorney and the executor may be entitled to receive extra compensation for their time and the costs incurred in the sale.

The probate process is slow and can drag out the distribution of the estate, which is undesirable for obvious reasons. Probate can easily take a few years and most beneficiaries would prefer not to wait that long. By contrast, a living trust can be distributed in accordance with trust instructions at any time after the grantor’s death, without having to get permission from the probate court. This is a much more expedient and straightforward process.

Privacy may be an additional worry. All documents related to the transfer of the decedent’s property must be filed with the probate court and as such become a matter of public record. This includes assets and their values, identification of beneficiaries, and any conditions on the receipt of assets. By contrast, a living trust is a private document, and nothing becomes part of the public record. This is how a living trust can protect the decedent’s privacy and the privacy of their beneficiaries.

Outside of avoiding probate, there are ancillary benefits of a living trust. A living trust can protect the grantor if they become incapacitated, as the successor trustee can step in and manage or distribute the trust assets for the grantor’s benefit. This is particularly important for people who are single or who don’t have children. A living trust can also provide management of property for young beneficiaries by naming custodians and including instructions for the creation of subtrusts. These provisions can protect minor children until they are old enough to manage their inheritance themselves, or protect adult children who are not responsible from themselves.

If you live in California and own a home, the math is irrefutable. As of August 31, 2022, Zillow lists the typical home value in California as over $775,000. If a living trust costs approximately $3,000, then establishing one will save you over $30,000 based on that asset alone. While talking about estate planning with an estate attorney may be a gloomy prospect, paving the way for beneficiaries to receive more of their inheritances efficiently, privately, and responsibly makes complete sense.

ESPPs: Employee Stock Purchase Plans (Easy Street Pretty Please?)

Are you lucky enough to be an employee who receives benefits in the form of equity? There is a mélange of ways companies can incentivize and reward their employees via equity, and employee stock purchase plans (“ESPPs”) are a well-known perk. This discussion will focus on qualified ESPPs, or Section 423 ESPPs, as they must meet regulatory requirements to offer tax advantages. In contrast, non-qualified ESPPs are more flexible regarding regulatory requirements but do not offer tax advantages. It is always prudent to check which type of plan you have before making any investment decisions.

ESPPs are relatively simple as far as contributions go. They are funded by after-tax payroll deductions and there is no withholding, not even for Social Security or Medicare. The deductions are held in the plan until a specified purchase date, at which point they are invested in company stock. Participants state the amount they want to contribute to the plan, which the IRS limits to $25,000 of the stock’s market value per year, and plans generally allow participants to elect deductions between 1% and 15% of a participant’s compensation.

ESPPs offer discounts and lookbacks. Most ESPPs build in a 10-15% stock price discount below market value. Then the lookback provision bases the purchase price not on the stock price at the time of purchase but on the price either at the beginning of the offering period or at the end of the purchase period, whichever is lower.

The tax treatment is a bit more complicated, but stay with me. When you sell the stock, you either pay ordinary income tax (called a disqualifying disposition) or long-term capital gains tax (called a qualifying disposition) on the gain, and you pay ordinary income tax on the discount. To receive the favorable long-term capital gains treatment, you have to hold the shares for more than one year from the purchase date and more than two years from the offering date. If you hold the shares according to these guidelines, you receive a lower percentage of ordinary income taxes and a higher percentage of capital gains taxes, which means you pay less in taxes overall.

Here’s an illustration of the tax treatment for both disqualifying and qualifying dispositions for those who are inclined.

Assumptions:
Offering date price $10 
Market price on purchase date $12
Purchase price @ 10% discount with lookback = $9
Sell price = $14

Disqualifying disposition:
< 2 years from offering date and < 1 year from purchase date
Market price on purchase date – purchase price = ordinary income
$12 – $9 = $3 ordinary income
Sell price – tax basis* = short-term capital gain
$14 – $12 = $2 short-term capital gain

Qualifying disposition:
> 2 years from offering date and > 1 year from purchase date
Offering date price – purchase price = ordinary income
$10 – $9 = $1 ordinary income
Sell price – tax basis* = long-term capital gain
$14 – $10 = $4 long-term capital gain

*Tax basis = ordinary income + purchase price

In both examples, the tax burden is the same, a total of $5. However, the disqualifying disposition is broken down into $3 taxed at ordinary income rates and $2 taxed at short-term capital gains rates. The qualifying disposition is broken down into $1 taxed at ordinary income rates and $4 taxed at long-term capital gains rates. Therein lies the savings from observing the hold periods.

Let’s not forget about the discount either. While the 10% discount in the above examples may not seem like a significant amount, it can add up with share volume and is basically free money. What would you do if I offered to give you $10 in return for you giving me $9?

Accumulating shares over time through an ESPP can help build wealth. Still, you need to be careful not to end up with a concentrated position that exposes you to unnecessary risk should your company encounter adverse circumstances. You also need to account for your access to other stock-related benefits, including stock awards, restricted stock units, and stock options, and how this might add additional exposure. The key with all investing is diversification, so any ESPP holdings should be appropriately allocated within your global portfolio, which in and of itself should be rebalanced as your company holdings increase over time.

Your Next Healthy Habit: The HSA

One of the top 10 questions I get from clients is should I open an HSA (Health Savings Account)? It is open enrollment season and HSAs have risen in popularity over the last few years, so let me take the opportunity to address the question here.

First, what are HSAs?

HSAs are personal savings accounts that can only be used for qualified health care expenses and out-of-pocket costs not covered by health plans. They offer tax benefits, spending flexibility, and portability.

Second, who is eligible?

To contribute to an HSA, you must be enrolled in a qualifying high-deductible health plan (HDHP). For 2022 the HDHP for individuals must have a deductible of at least $1,400 and an out-of-pocket medical expense limit of $7,050, and the HDHP for families must have a deductible of at least $2,800 and an out-of-pocket medical expense limit of $14,100.

Third, how do I get one?

You can enroll in an HDHP and an HSA through your employer if available, or find an HDHP on the health insurance marketplace and an HSA through a financial institution.

Here is a summary of the advantages and disadvantages of HSAs:

Advantages:

  • If you make contributions with pre-tax dollars, they are excluded from your gross income.
  • If you make contributions with after-tax dollars, you can deduct them from your gross income on your tax return.
  • Contributions can earn interest and be invested.
  • Your investments can grow and compound on a tax-deferred basis, which means there are no capital gains taxes on earnings.
  • Withdrawals are tax-free for qualified health care expenses.
  • You don’t have to make withdrawals in the year that the expenses are incurred (just save the receipts for the year in which you do make the withdrawals).
  • Any unused money at the end of the year rolls over to the next year (unlike Flexible Spending Accounts (FSAs)).
  • The account is always owned by you even if you change employers or terminate employment.
  • When HSA money is used to pay for health care costs in retirement, it has more buying power than money from retirement plans like 401ks where you will owe income taxes on withdrawals.

Disadvantages:

  • It can be challenging to budget how much to save as medical expenses are often unpredictable.
  • HSAs have low contribution limits – the 2022 contribution limit is $3,650/year for individuals with additional catch-up contributions of $1,000 between ages 55 and 65. (This amount is reduced by any employer contributions excluded from gross income.)
  • Once you enroll in Medicare at age 65 you can no longer contribute.
  • If you withdraw funds for nonmedical expenses before age 65, you will have to pay income taxes on the money and an additional 20% penalty. If you withdraw funds for nonmedical expenses after age 65, you don’t have to pay a penalty but you will have to pay income taxes on the money.

For an HSA to be worth it, you should be relatively healthy and good with recordkeeping. If this describes you, consider adding HSAs to your financial to-do list. “I don’t like tax savings” said no one ever.