The Assets That Should Stay Out of Your Living Trust

The standard advice about funding a living trust is to put everything into it. That advice is wrong in both directions. Some assets cannot legally be transferred to a trust at all, and attempting it creates an immediate tax bill. Others can be transferred but should not be, because California already provides a cheaper route or because the transfer costs a tax benefit worth more than the probate it avoids.

At the same time, two of the most common reasons people give for leaving an asset out of a trust are simply incorrect, and both of them regularly result in the family home sitting outside the trust it was supposed to be in.

Here is what genuinely does not belong in a California revocable living trust, what belongs there only after a specific step is taken, and which widely repeated cautions are myths.

Retirement Accounts: The One That Cannot Go In at All

This is the clearest rule in the entire subject. Individual retirement accounts and employer plans require individual ownership—section 408 of the Internal Revenue Code for IRAs, section 401 for 401(k) plans. There is no mechanism for retitling one into a living trust while you are alive.

Attempting it is not merely ineffective. Taking the account out of your own name is treated as a full distribution: ordinary income tax on the entire balance in the year of transfer, plus a 10 percent early withdrawal penalty if you are under 59 and a half. A large IRA can generate a six-figure tax bill in a single stroke. Health savings accounts have the same individual-ownership requirement and the same problem.

What you can do is name the trust as the beneficiary, and that is a real decision rather than a default. To preserve favorable treatment, the trust has to qualify as a see-through trust, and the structure then matters. A conduit trust must pass distributions straight through to the beneficiary as it receives them, which means the SECURE Act ten-year rule empties the account into that beneficiary's hands within a decade regardless of what the trust says. An accumulation trust lets the trustee hold the money back, preserving control, but income retained inside the trust is taxed at the compressed trust rates that reach the top bracket at a very low threshold.

For deaths on or after January 1, 2020, section 401(a)(9)(H) requires most non-spouse beneficiaries to empty an inherited account within ten years in any event. Naming an individual directly is often the better answer. Naming a trust makes sense when the beneficiary is a minor, has creditor or addiction problems, receives needs-based benefits, or when a blended family makes it important to control where the remainder goes.

Vehicles: California Already Has a Cheaper Answer

Cars and boats are commonly listed on trust schedules, and it usually accomplishes nothing but friction with the DMV and with insurers, who sometimes take issue with a titled owner that is not a natural person.

California already provides a direct route. Under Vehicle Code sections 5910 and 9916, a successor can transfer a California-titled vehicle or vessel without probate using DMV form REG 5, the Affidavit for Transfer Without Probate, once 40 days have passed since the death.

There is a second point that surprises people. Vehicles are excluded from the small estate value computation under Probate Code section 13050, which means a car does not count toward the $208,850 small estate affidavit threshold that applies to deaths on or after April 1, 2025. A valuable vehicle will not push an otherwise modest estate over the line, and it does not need to sit in a trust to stay out of probate.

Life Insurance and Annuities

Putting a life insurance policy into a revocable living trust does not do the thing people usually hope it will do. Under Internal Revenue Code section 2042, the death benefit is included in your gross estate if you hold incidents of ownership in the policy, and a revocable trust you created and can amend at will is still you for that purpose. The proceeds remain in the taxable estate.

If removing the proceeds from your estate is the objective, the instrument for that is an irrevocable life insurance trust, which is a different structure with different consequences—you give up the ability to change it, and transferring an existing policy into one starts a three-year lookback under section 2035, so the proceeds come back into the estate if you die within three years of the transfer. Where estate tax is not a concern, and at the 2026 federal exemption of $15 million per person it is not for most families, a straightforward beneficiary designation naming individuals is cleaner than either option.

Annuities are a separate problem. Changing ownership of an annuity contract can trigger immediate recognition of the deferred gain, converting a tax-deferred asset into a current tax bill. The beneficiary designation is the right tool, and the contract should be reviewed before anyone changes anything on it.

Business Interests: Not So Much Do Not, as Not Without Checking

Business interests belong in the trust often enough, but each type carries a condition, and one of them fails silently.

S corporation stock is the dangerous one. A revocable living trust is a permitted shareholder while you are alive, because it is a grantor trust and no election is required—so the transfer itself is fine. The problem arrives at death. Under Internal Revenue Code section 1361(c)(2), the trust has two years from the date of death to distribute the shares out, qualify as a qualified subchapter S trust, or elect to be an electing small business trust. Miss that window and the S election terminates, and the company is taxed as a C corporation. Nothing announces the deadline; it simply expires, usually while the family is focused on other things.

LLC and partnership interests are governed by their operating or partnership agreements, which frequently require the consent of the other members before any transfer, including a transfer to your own revocable trust. Assigning an interest without that consent can breach the agreement or trigger a buy-sell provision that forces a sale at a formula price.

Professional corporations are the most restricted. California limits ownership of a professional corporation to licensed persons, so shares generally cannot be held by a trust whose beneficiaries are not themselves licensed in that profession. Succession for a professional practice has to be planned within those rules rather than around them.

Custodial Accounts and Anything You Do Not Actually Own

A custodial account created under the California Uniform Transfers to Minors Act, Probate Code section 3900 and following, cannot go into your trust for a simple reason: it is not yours. The transfer to the minor was an irrevocable gift, and you hold the account as custodian, not as owner. It passes to the child at the termination age regardless of what any trust says.

The same logic covers a few other categories that show up on funding checklists by mistake. Property already held in an irrevocable trust is owned by that trust. Property you hold with others in joint tenancy can only be transferred as to your own interest, and doing so severs the joint tenancy—which may be exactly what you want, or may accidentally undo the survivorship arrangement the co-owners were relying on. Assets held in another person's name, however informally you regard them as family property, are not yours to fund.

The Two Myths That Keep Homes Out of Trusts

Both of these come up constantly, and both cause real damage, because the asset they keep out of the trust is usually the house.

The first is that a mortgage prevents you from transferring your home into a trust, or that doing so lets the lender call the loan. It does not. The Garn-St. Germain Depository Institutions Act, 12 U.S.C. section 1701j-3(d)(8), prohibits a lender from exercising a due-on-sale clause on a transfer into an inter vivos trust in which the borrower is and remains a beneficiary, provided the transfer does not change the rights of occupancy. An ordinary revocable living trust, where you are both the settlor and a beneficiary and you continue living in the home, fits squarely inside that protection. This is federal law and it is not discretionary with the lender.

The second is that a revocable trust is pointless if Medi-Cal is a concern. That is half right, and the wrong half is the one people act on. A revocable trust does nothing for eligibility—assets in it remain countable, because you can take them back at any time. But recovery is a separate question. Since SB 833, codified at Welfare and Institutions Code section 14009.5 and effective January 1, 2017, California limits Medi-Cal estate recovery to the decedent's probate estate. Assets in a properly funded revocable trust avoid probate, and therefore fall outside what the state can recover against.

The practical consequence in California is the reverse of the folk wisdom. Funding the trust is precisely what keeps the family home out of reach of Medi-Cal recovery. A home left out of the trust, passing through probate, is exactly what the state can claim against.

The California Detail That Lives in the Drafting, Not the Funding

One issue for married couples is not about which assets go into the trust, but about how the trust describes them once they are there.

California is a community property state, and Internal Revenue Code section 1014(b)(6) gives married couples an advantage available almost nowhere else: when the first spouse dies, both halves of community property receive a stepped-up basis, not just the decedent's half. For a couple who bought a Truckee or Tahoe City home decades ago, that full step-up can eliminate hundreds of thousands of dollars of capital gain if the survivor later sells.

Community property can keep its character inside a revocable trust, and a properly drafted California trust preserves the double step-up while also avoiding probate at both deaths. But the result depends on the drafting. Trusts prepared in a separate property state and carried into California, older documents, and deeds that recharacterize community property as separate property or as a tenancy in common can quietly cost the surviving spouse half of that step-up. Nothing about the trust will look wrong; the consequence only appears when the survivor sells.

This is a drafting and titling question rather than a funding question, and it is one of the more valuable things to have reviewed if your documents were prepared elsewhere or a long time ago.

When to Get Legal Help

Funding mistakes are cheap to prevent and expensive to unwind, and most of them are found in a single review of the trust against what you actually own.

It is worth getting advice before transferring a business interest of any kind, before naming a trust as beneficiary of a retirement account, when a spouse has died and an S corporation interest is held in a trust, when a trust was drafted outside California or more than a decade ago, when long-term care planning is on the horizon, or when a home has been left out of the trust because someone was told the mortgage prevented it.

Andrews Law Firm reviews trust funding and drafting for families in Truckee, Tahoe City, and throughout the Sierra Nevada region—confirming that what belongs in the trust is actually in it, that what does not belong is handled another way, and that the community property language is doing what it should. Contact us to schedule a consultation.