A trust can protect your wealth by allowing a third party to hold and manage your assets according to your wishes, even after your death. It also ensures that future generations reap the rewards of your accumulated assets.
Despite their frequent association with the ultra-wealthy, trusts are useful for anyone who wants more control over their assets during life and in determining how they are distributed after death.
In this article, we define a trust, discuss how it works, explain its benefits, and list the different types of trusts you can establish depending on your estate planning goals.
What Is a Trust?
A trust is an estate planning entity that holds assets for an individual or organization. A third party, known as the trustee, manages these assets for the benefit of beneficiaries named in the trust. Trusts can hold different assets, such as real estate, land, businesses, cash, bonds, stocks, jewelry, motor vehicles, and other personal property.
A trust has three parties:
- Grantor: The person creating the trust funds it with their assets and sets the terms for trust management and distribution.
- Trustee: Manages and administers the trust per the grantor’s wishes, including filing tax returns, investing trust assets, overseeing the distribution of assets, and more.
- Beneficiary: Receives some or all the different types of assets in the trust.
A grantor can name more than one trustee as co-trustees and multiple beneficiaries.
Is There a Difference between a Trust and a Trust Fund?
A trust refers to the legal arrangement to hold and manage assets, while a trust fund is an account holding these assets or funds.
How Does a Trust Work?
If you have a limited budget, you can set up a trust without an attorney. However, it’s always best to consult a legal professional to ensure you’re making informed decisions regarding your estate planning. Follow this step-by-step guide to understand how a trust works.
1. Determine What Type of Trust You Need
Finding the right type of trust for you involves understanding your estate planning needs and the benefits you’re seeking.
Do you want to reduce taxes paid on your estate or pass wealth to a loved one with special needs? Are you looking to give legal rights to an unmarried partner or donate some of your wealth to charity?
Take some time to consider your needs and preferences to select the appropriate type of trust.
2. Create a Trust Form
A trust form is the document you fill out to begin officially setting up a trust. List the trust’s purpose and parties. Specify the trustee’s powers, conditions for the change of trustee, and other relevant information.
You can obtain and download an online form to reduce your costs, but it’s advisable to enlist the help of an attorney when filling out this document. This way, a qualified professional can answer your questions and ensure you complete the form properly.
While some states don’t explicitly require notarization of the trust, signing your trust document before a notary public is ideal. This recognition adds legitimacy to the form and reduces the chances of disputes.
3. Open a Trust Account
Open a trust account by transferring different assets you own from your estate into the trust fund. Retitle or change ownership of your property and assets to list the trust as the new owner.
4. Let the Trustee Manage Assets and Distribute Benefits
If you’re not the trustee of your trust account, you must appoint another person or organization to manage your assets and distribute benefits as stipulated in your terms. Trust management includes filing tax returns, investing trust assets, and keeping the beneficiaries updated. However, a grantor can still make changes to the trust and its terms when they’re alive if the trust is revocable.
Benefits of a Trust
Explore some of the benefits of a trust:
- Asset control and allocation: Trusts allow grantors to include specific and tailored asset management and distribution terms, ensuring their wishes are honored. For instance, beneficiaries can receive monthly payments from the trust instead of all assets at once.
- Probate avoidance: Assets in a living trust often avoid probate, meaning the beneficiaries don’t have to wait for the outcome of lengthy probate court proceedings to gain access to the funds. It’s a major benefit, as the probate process is necessary when someone only has a will or dies without a will and no other estate planning tools.
- Potential tax benefits: Irrevocable trusts created during a grantor’s lifetime may minimize estate taxes owed by beneficiaries because the assets belong to the trust (not the grantor). Other specific types of trusts can reduce taxes paid on assets such as a home.
- Privacy: Unlike a will, a trust is not a public record. Therefore, its execution occurs privately, providing beneficiaries with discretion.
- Legacy protection: Irrevocable trusts may shield assets from creditors after the grantor’s death. The ability to specify terms of distribution also protects the wealth and assets from beneficiaries who may not be financially savvy to manage their inheritance wisely.
Revocable vs. Irrevocable Trusts
Trusts can be revocable or irrevocable. This categorization affects different aspects of the trust, such as grantor access and their ability to make changes. Understanding the differences between revocable living trusts and irrevocable living trusts will ensure you’re setting up a trust that matches your estate planning needs.
Revocable Trusts
A revocable living trust allows a grantor to establish and fund a trust during their lifetime to avoid probate and plan for incapacitation.
The grantor remains in control of the revocable trust when they’re alive and mentally competent and can change the terms, remove assets, add beneficiaries, or even dissolve the trust altogether. When the grantor dies, a designated successor trustee takes over the administration of the trust, including the distribution of assets.
Besides avoiding probate, creating a revocable trust allows the successor trustee to take over, and beneficiaries start receiving contributions in the case of a grantor’s incapacitation even before they pass away. Since the grantor remains in control of the assets, the assets are still treated as their own and thus not exempted from estate taxes.
Irrevocable Trusts
Once established or executed, irrevocable trusts are set in stone. Although the grantor sets the terms of asset distribution, they cannot make amendments or dissolve the trust once they fund and execute it.
A grantor transfers their assets from their estate to the irrevocable trust, giving up control and ownership. The appointed trustee manages the trust fund when the grantor is alive and oversees its administration upon a grantor’s death.
An irrevocable trust is established to benefit the beneficiaries, who often receive lifetime distributions from the assets held. Since ownership of assets is fully transferred from the grantor, an irrevocable trust also significantly reduces the amount subject to federal estate taxes and may protect the beneficiaries from debtors and creditors.
Other Types of Trusts
In addition to the basic categories of revocable and irrevocable trusts, several other types of trusts can meet the grantor’s specific needs. They include:
- Generation-skipping: A generation-skipping trust allows a grantor to distribute assets to beneficiaries who are grandchildren, individuals from later generations, or anyone at least 37½ years younger than the grantor while providing tax exemption benefits.
- Spendthrift: A spendthrift trust allows a trustee to limit a beneficiary’s access to assets and release their distribution benefits incrementally. It’s useful for managing beneficiaries prone to reckless spending habits.
- Marital: A marital trust provides distribution benefits to a surviving spouse and is only funded after the death of one spouse. The couple’s heirs often receive the trust’s principal after the surviving spouse dies.
- Special needs: A special needs trust is an irrevocable trust that provides financial support to beneficiaries with special needs without disqualifying them from government benefits such as Medicaid.
- Asset protection: An asset protection trust is an irrevocable trust that protects a grantor’s assets from future claims from creditors.
- Blind: A blind trust gives the trustee total control of the trust fund, with the grantor and beneficiaries having no knowledge of how the assets are managed. Such trusts help avoid conflict of interest among involved parties.
- Family: A family trust names one or more family members as a beneficiary and helps preserve wealth for many generations.
- Charitable: A charitable trust provides benefits to beneficiaries for a certain period and passes assets to one or more charities specified in the trust after it expires.
- Credit shelter trust: Married couples use a credit shelter trust to maximize tax exemptions to their estate. When one spouse dies, the credit shelter trust receives funds up to the federal estate tax exemption limit or the “credit shelter amount.” The surviving spouse can receive the income the trust generates, but the principal amount in the trust isn’t included in their estate when they die.
- Testamentary: A testamentary trust is an umbrella term for trusts that take effect after a grantor’s death through the terms stipulated in a last will and testament.
The Importance of Trusts in Estate Planning
Trusts offer additional benefits, such as probate avoidance and tax reduction, that other estate planning tools like wills lack. They allow a third party to hold ownership and control of a grantor’s assets while empowering them to set terms on things like access and distribution of benefits.
When setting up a trust, it’s crucial to understand your estate planning needs and what type of trust will offer maximum benefits. A financial advisor or attorney who’s an expert in trusts is best suited to provide the professional advice you need to establish any type of trust.
Frequently Asked Questions
Who pays income tax on the money from a trust?
The person who receives the income earned from assets in a trust pays income tax for the trust. Typically, the grantor pays the income tax during their lifetime, and beneficiaries who receive distributions from the income pay the tax after the grantor’s death.
What happens to a trust when the grantor dies?
When a grantor dies, the trustee follows the grantor’s instructions for asset distribution. If the grantor was the trustee, the designated successor trustee would take over the trust’s administration, which involves paying debts and bills and overseeing the distribution of assets as stipulated. The successor trustee manages the trust for as long as stipulated.
Can I be the trustee of my trust?
You can be the trustee of your trust regardless of whether it’s revocable or irrevocable. However, doing so for an irrevocable trust defeats its purposes of transferring assets out of the grantor’s name and control and reducing estate taxes. Revocable trusts in which the grantor is the trustee must have a successor trustee who takes over the trust in case of death or incapacitation.
I’m the beneficiary of a trust. Now that I’m an adult, can I request all the money in the trust and close it?
A trust will have provisions dictating how long it will last. For example, the trust may terminate when a beneficiary reaches a certain age.
You cannot receive all the money in the trust and close it as a beneficiary before the time specified in its terms.
