A typical trust is designed to distribute its income to one person or a group of people — called the income beneficiaries — and its principal at a later date to another person or group, called the remainder beneficiaries. But there is another approach known as a “unitrust.” A unitrust pays out a fixed portion of the trust’s market value per year— say, 4 percent — to current beneficiaries. Traditional trusts, by contrast, often pay out whatever income happens to be generated in a given year.

The idea of a unitrust is not only to produce annual income but also to invest wisely for the long term so that the size of payments to beneficiaries is more predictable.

As stated before, a typical trust is designed to distribute its income to the income beneficiaries and its principal at a later date to the remainder beneficiaries. This inevitably generates tension between the income beneficiaries, who want the trust’s portfolio skewed toward income-producing assets, and the remainder beneficiaries, who care about long-term appreciation. During some go-go stock market years, equity prices soar, but dividend yields — or income being generated by those assets — fall.

That’s when income beneficiaries get uncomfortable and start saying, “Wait a minute — this isn’t fair. The trust has doubled in size, but my income has stayed the same.”

With a unitrust, trustees invest with an eye toward total return — the cornerstone of modern portfolio theory. Typically, a unitrust agrees to distribute 3 to 5 percent of market value annually. If the actual return in a given year is larger, the surplus gets added to the principal. If the return is below the fixed rate, the payout reduces the unitrust’s principal.

The main strategy of a unitrust is to grow the portfolio, because if the portfolio grows, the payout will grow each year. Thus, a unitrust helps align the interests of current and future beneficiaries. The percentage approach of a unitrust can also greatly reduce the volatility of distributions to current beneficiaries. This is especially so if the trust chooses to base payments on the average market value of the past three years.

But unitrusts aren’t for everyone. In an up market, they are a great idea, but in a down market, especially if the unitrust is using an average market-value approach, there’s increasing risk of eating into principal.

By investing trust assets using total return investment concepts, there’s no requirement in a unitrust to generate income. Trustees can liquidate capital assets as needed to supplement actual income earned from dividends and interest to fund unitrust payments.

The goal of a unitrust is for the remaining assets to grow at a reasonable value for the remainder beneficiaries. There are times when it clearly makes sense to convert to a unitrust: for example, when a trust has appreciated significantly but generates little or no dividends or interest, and more cash is needed by an income beneficiary — an elderly person with increased health care costs, or a young family with a high tuition bill.

The decision to convert to a unitrust often comes down to asset allocation. If a trust is 100 percent allocated to stocks, you are going to be getting a relatively low yield on these equities, and it makes sense to opt into a unitrust so that the trustee can make a payment that is more reasonable to all beneficiaries.

In the past, it was common to name an income beneficiary and a remainder beneficiary. However, making a unitrust election can achieve certain client’s estate planning goals.

Talk to the attorneys at Rochford Langins Jarstad today to see if a unitrust is right for you (507) 534-3119.