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Why a Total Return Trust?

November 05, 2021
By Patrick V. Masso, CFA

Among the reasons clients utilize trusts as their estate planning tool of choice are: avoiding probate, maintaining privacy, or minimizing income and estate taxes. The primary attraction, typically, is the desire to maintain direction and control over assets after they pass.

As a corporate fiduciary charged with the investment management and administration of trusts, Heartland Bank Wealth Management encounters many scenarios that were not anticipated when the documents were originally drafted. One such situation is what happens in a prolonged low interest rate environment.

A traditional trust invests the trust corpus (or principal), for creation of current income, which is paid out to the income beneficiaries, AND for growth of principal; growth in a typical trust is not distributed to the income beneficiary rather growth is retained in the trust for benefit of future “remainder” beneficiaries.

Here is a common trust scenario: After the death of the husband who created a trust, the wife becomes the income beneficiary, with discretion to invade principal for her health, maintenance, and support. Once the wife passes, the children become the income/discretionary principal beneficiaries. Upon the passing of the children, the trust principal will be distributed out of trust to the grandchildren of the trust creator.

In the scenario above, especially in the current economic environment, there is a natural tension between the income beneficiaries and remainder beneficiaries. While the remainder beneficiaries (grandchildren) are well-served by growth-oriented investments that are expected to appreciate, the income beneficiaries (widow/children), whom the trust creator intended to receive a dependable source of support, are left wanting.

How can both the income beneficiaries and the remainder beneficiaries WIN? A “total return trust” may be the solution in the new normal of low interest rates. This means that an income beneficiary will receive a relatively consistent and predictable fixed amount of income from the trust, even as the trust corpus appreciates for the future benefit of the remaindermen.

At the time of drafting, the trust creator may exercise broad discretion to establish the total return formula to establish the income distribution. If the trust creator did not originally elect to base the income distribution on the total return of the trust assets, all is not lost; the trustee or beneficiaries still have options to provide for the income beneficiary.

If the trust is irrevocable (either by its terms or due to death of the trust creator), trustees and beneficiaries may seek to “amend” the trust. Under Illinois law (and under the laws of most other states) a trust can be converted into a “total return” trust. Conversion may be accomplished by the trustee with notice to and agreement by all beneficiaries. If the trustee and beneficiaries cannot find common ground, either party may seek court approval to convert to a total return trust. Illinois law dictates what percentage and calculation method is applicable, depending on the method of conversion. It should be noted that the statutory conversion method provides less flexibility than a trust originally drafted as a total return trust, so converting by mutual agreement is generally the better option.

At Heartland Bank and Trust Company Wealth Management, we are happy to discuss these concepts and possible solutions with you and your attorney.

Please send an email to pvmasso@hbtbank.com* or give us a call to recommend topics you would like presented in future issues of Investment Insights.

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Securities and insurance products are NOT deposits of Heartland Bank, are NOT FDIC insured, are NOT guaranteed by or obligations of the bank, and are subject to potential fluctuation in return and possible loss of principal.

Legal, Investment and Tax Notice: This information is not intended to be and should not be treated as legal advice or tax advice. Readers should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel.