Pandora Papers scandal: Why you don't have to be rich (or evil) to use a trust

You don't need to go to South Dakota to get the most out of a trust.

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Myelle LansatNews EditorMyelle Lansat is a former news editor at Policygenius, where she covered insurance and personal finance. Previously, she was a personal finance writer at CNBC and Acorns, and a reporter for Business Insider.

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Some of the world's wealthiest people are hiding billions of dollars of assets in trusts in South Dakota, according to financial documents leaked to the International Consortium of Investigative Journalists. Rich people are parking their money in the Mount Rushmore state because of its lax tax laws.

The state of South Dakota does not have an income tax, capital gains tax, or estate tax, making it a financially appealing state to wealthy investors. “When you hear ‘tax shelter’ you think of illegal activity, but in reality people are working within the tax system to pay as little taxes as possible,” says Derek Silva, a personal finance expert at Policygenius.

While the Pandora Papers reveal that the wealthy are using trusts to obscure their riches and avoid taxes, there are legitimate reasons for ordinary people to use them, and you don't have to open one in South Dakota to benefit.

How trusts are used

People often combine trusts and wills to make sure their assets and loved ones are taken care of when they die. The main reason to establish a trust is to avoid the probate process, says Patrick Hanzel, certified financial planner at Policygenius. Probate is the legal process of allocating assets when you die. Assets held in a trust are managed and distributed outside of probate courts. Trusts also provide a layer of privacy and protection “if you don’t want all of your information public,” Hanzel says. 

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For example, if you put your home in a trust, ownership can be quickly passed to your beneficiary after you die, Silva says. If you don’t have a trust and want to leave a house, or anything else, to a child it could take weeks, months, or longer to get those assets through the probate process. And it's always possible it still doesn't go to your intended beneficiary, Silva says. 

There are different types of trusts, depending on how you want to disperse your assets and when. The two most common trusts are revocable and irrevocable. A revocable trust is more flexible and can be changed or withdrawn at any time. An irrevocable trust can’t be changed or voided after it's been created. 

In most states, the assets in a trust need to be distributed within 21 years after the youngest beneficiary dies. If you’re looking to keep the wealth flowing for generations, you can create a dynasty trust. Dynasty trusts last longer and can distribute money from generation to generation without getting hit with gift, estate, or generation-skipping taxes.

Trusts have tax benefits

Creating an estate plan will protect your assets when you die. Trusts can help your estate avoid estate taxes. If you transfer assets into an irrevocable trust, that can shield them from estate taxes, since the IRS views the trust as separate from your estate. 

For the most part, states handle estate laws and taxes individually, and a federal estate tax is only applied to high income estates. If your estate is worth $11.7 million or more in 2021, you will be subject to a federal estate tax. If you receive assets from a trust, whether it’s property, investments, or cash, you may be subject to an inheritance tax depending on what state you live in. The tax will kick in if you inherit a property that’s located in a state with an inheritance tax. 

Because of South Dakota’s laws, the assets inside the trust can grow tax-free. The state also doesn’t require you to live there to establish a trust. Hanzel says to consult an estate attorney to understand state and federal estate tax laws. 

“It's generally recommended to have your trust within your primary state of residence. An estate planning attorney [can help] determine what your options are and if there's any solutions that aren't related to your specific state,” Hanzel says. 

Image: Freddie Collins / Unsplash