What Assets Should Not Be in a Trust?

A trust serves as a legal arrangement where a third party, known as a trustee, holds and manages assets for designated beneficiaries. Establishing a trust ensures assets are managed and distributed according to the grantor’s wishes, often bypassing the probate court process. This probate avoidance can lead to quicker asset distribution, reduced costs, and enhanced privacy, as trust details typically remain confidential, unlike public probate records. While trusts offer considerable advantages, not every asset is ideally suited for inclusion.

Assets with Direct Beneficiary Designations

Certain assets transfer directly to named individuals upon an owner’s death, bypassing probate. This can make placing them in a trust redundant or disadvantageous. These include retirement accounts like IRAs, 401(k)s, and 403(b)s, which allow account holders to designate beneficiaries directly with the financial institution. Upon the owner’s passing, these accounts flow directly to the named beneficiaries according to the established designations, irrespective of a will or trust.

Naming a trust as a retirement account beneficiary can introduce significant tax complexities. The Internal Revenue Service (IRS) generally views a trust as a non-individual entity, which can impact tax-deferred growth and required minimum distribution (RMD) rules. For instance, if an IRA is retitled directly into a trust during the owner’s lifetime, the IRS may consider this a full withdrawal, subjecting the entire amount to immediate ordinary income tax and potentially an additional 10% penalty if the owner is under 59 ½ years old. While it is possible to name a trust as a beneficiary, this strategy requires careful consideration to avoid accelerating income taxes or complicating distributions for heirs, especially concerning RMDs which are calculated based on the trust’s oldest beneficiary.

Life insurance policies also fall into this category, as the death benefit is typically paid directly to the named beneficiary. Similarly, annuities often have designated beneficiaries who receive any remaining payments after the annuitant’s death. For these financial products, the beneficiary designation form filed with the insurer or financial institution dictates who receives the proceeds, superseding instructions in a will or trust. While a trust can be named as a contingent beneficiary for life insurance, or even the primary beneficiary in specific estate planning scenarios, doing so should align with broader tax and distribution goals.

Assets with Automatic Transfer Mechanisms

Beyond direct beneficiary designations, some assets inherently possess mechanisms for automatic transfer of ownership upon death, effectively bypassing the need for probate court oversight. These arrangements simplify the transfer process for specific types of property. One common example is property held in “Joint Tenancy with Right of Survivorship” (JTWROS) or “Tenancy by the Entirety.” When property, whether real estate or financial accounts, is owned this way, the deceased owner’s share automatically transfers to the surviving joint tenant(s). This means the asset passes directly to the co-owner without requiring any probate proceedings.

Another widely used mechanism involves “Transfer-on-Death” (TOD) and “Payable-on-Death” (POD) designations. TOD accounts are frequently utilized for investment assets such as brokerage accounts, stocks, and bonds, allowing the owner to name a beneficiary who will receive the assets directly upon their death. Similarly, POD accounts are typically applied to bank accounts, including checking, savings, and certificates of deposit, enabling funds to be paid directly to a named beneficiary.

Both TOD and POD designations offer a straightforward and cost-effective way to transfer assets outside of probate. The account holder retains full control over the assets during their lifetime, including the ability to change beneficiaries or withdraw funds. Upon the owner’s death, the beneficiary typically only needs to present a death certificate and identification to claim the assets, avoiding the delays and public nature associated with probate. Utilizing these direct transfer methods can often be more efficient than incorporating such assets into a trust, which might add unnecessary layers of administration.

Assets of Minimal Value or Daily Use

For assets that hold relatively low monetary value or are used regularly for living expenses, placing them within a trust may not offer practical benefits and can introduce unnecessary administrative burdens. Tangible personal property, such as everyday furniture, clothing, personal effects, or older vehicles, often falls into this category. The administrative effort and potential costs involved in formally transferring these items into a trust, maintaining records, and then distributing them according to trust terms can often outweigh any perceived advantage. Many jurisdictions have streamlined probate procedures or small estate affidavits that allow for the efficient transfer of such low-value assets without extensive court involvement.

Furthermore, maintaining a primary checking account or funds specifically designated for daily expenses outside of a trust often proves more practical. Immediate access to funds for routine bill payments, household expenditures, and other day-to-day transactions is typically needed without requiring trustee approval or additional administrative steps. While a trust could hold a modest amount of cash for immediate post-death expenses, keeping the main operating account separate ensures seamless financial management during one’s lifetime. The goal for these types of assets is to prioritize ease of access and administrative simplicity, which is generally best achieved by keeping them outside of a formal trust structure.

Assets with Unique Legal or Tax Characteristics

Certain assets possess distinct legal or tax characteristics that can make their inclusion in a standard living trust complex, potentially leading to unintended consequences if not managed with specialized planning. One such asset is S-corporation stock. S-corporations have strict rules regarding who can be a shareholder, primarily limiting ownership to individuals, certain estates, and specific types of trusts. If S-corporation stock is incorrectly titled in a trust that does not meet these specific requirements, the corporation’s S-election could be terminated, resulting in the business being taxed as a C-corporation, which typically involves higher tax rates and double taxation of profits.

To hold S-corporation stock, a trust must qualify as either a Qualified Subchapter S Trust (QSST) or an Electing Small Business Trust (ESBT). QSSTs generally require all income to be distributed annually to a single U.S. citizen beneficiary, while ESBTs can have multiple beneficiaries but are subject to a separate, often higher, tax rate on the S-corporation income within the trust. Establishing and maintaining these specialized trusts demands precise adherence to IRS regulations and ongoing compliance, making it a nuanced area where professional tax and legal guidance is usually necessary.

Foreign assets, such as real estate or bank accounts located in other countries, also present unique challenges when considering trust inclusion. Different nations have diverse property laws, tax systems, and legal frameworks that may not recognize or align with U.S. trust structures. Attempting to transfer foreign assets into a U.S. trust can be administratively difficult, expensive, and in some cases, legally impossible due to local ownership restrictions or transfer requirements. Often, it is more appropriate to engage in separate estate planning within the foreign jurisdiction where the assets are located to ensure compliance with local laws and efficient transfer.

Finally, while trusts can be effective tools for managing wealth, the tax treatment of capital gains within a trust can differ from individual ownership. Trusts generally reach the highest federal marginal income income tax rates at much lower income thresholds compared to individuals. For example, while the top federal income tax rate for individuals is 37%, trusts can reach this rate at considerably lower taxable income levels. Additionally, while individuals may benefit from certain capital gains exclusions, trusts may not always qualify for the same benefits, such as the home sale exclusion. While a trust can avoid capital gains tax if the assets are distributed to beneficiaries, who then pay the tax at their individual rates, direct ownership of highly appreciated assets might offer more flexibility or different tax outcomes depending on the specific circumstances and the type of trust. This area necessitates careful analysis to align asset placement with long-term tax planning goals.