A trust is an estate planning tool to transfer assets to your heirs, also known as beneficiaries, upon your death. Once you’ve established a trust, you can designate an individual or institution, a trustee, to manage the trust to benefit your beneficiaries.
Established correctly, a trust can:
- Transfer your assets to your heirs easily;
- Keep your property away from the probate process;
- Eliminate or reduce estate taxes on the assets you list in the trust.
There are two basic categories of trusts: living trusts and testamentary trusts. Most trusts are living trusts, meaning they are set up during your (creator’s or grantor’s) lifetime. Living trusts can be either revocable or irrevocable.
On the other hand, testamentary trusts are set up after your death according to your last will and testament and are only enforceable after death.
Let’s take a look at the different types of trusts together and find out which one is the best for your estate plan.
Good for: People looking for flexibility in managing their assets during their lifetime
A revocable trust can be changed or canceled by the grantor at any time as long as the grantor is mentally competent at the time of the decision. If you expect certain life changes (e.g., birth of a child) that can prompt the need to amend a trust, consider making your trust revocable for flexibility.
Keep in mind that the grantor still owns the assets in a revocable trust; therefore, they must report any revenue generated by the trust on their taxes.
Revocable trusts become irrevocable trusts when the grantor dies.
► READ MORE: Setting Up a Trust: Living Trust Cost & Checklist
Good for: High-net-worth individuals looking for estate tax benefits and greater protection
An irrevocable trust cannot be modified or revoked without its beneficiaries’ permission or the court’s interference. Once it is established, the grantor relinquishes ownership and control of the assets listed in the trust, which are transferred out of their estate. Unlike a revocable trust, an irrevocable trust pays its own taxes and files a separate tax return.
Despite its lack of flexibility, irrevocable trusts offer asset security and tax advantages, making them an attractive type of trust for people with large or complex estates.
However, the tax implications of irrevocable trusts can be complex. Consult an attorney before deciding what type of trust is right for you.
Good for: Married couples who want to manage and distribute assets together
A joint trust combines the assets of both spouses or committed partners for easier management and distribution. This type of trust is revocable before the second spouse passes away; both parties have the ability to manage and control the assets, often with the aim of passing them seamlessly to beneficiaries upon death.
One key advantage is administrative convenience, as there’s only one set of documents to manage. However, this type of trust can be inflexible, particularly when it comes to tax planning or if the spouses have different beneficiaries in mind.
When creating a joint trust, couples should carefully discuss their individual wishes for asset distribution and consider consulting a tax advisor to understand any potential tax implications.
Good for: Blended families for control over the disposition of assets after both spouses’ death
A bypass trust, also known as an AB trust or credit shelter trust, is designed for married couples. It aims to protect and shield assets for beneficiaries while offering flexibility to a surviving spouse. In the context of blended families, a bypass trust could prevent the surviving spouse from altering the original allocation of assets.
Upon the first spouse’s death, the trust splits into two parts: an A Trust (survivor’s trust) containing the surviving spouse’s share, and a B Trust (bypass trust) containing the deceased spouse’s share. The B Trust becomes irrevocable, thus safeguarding the inheritance for the deceased spouse’s children. Any income generated by the trust does not have to be paid to the surviving spouse.
Bypass trusts offer protection to both the surviving spouse and the children from the deceased spouse’s previous marriage. It’s also off-limits in cases of remarriage and divorce. However, the trust requires careful legal structuring and consideration of potential tax implications.
Qualified Terminable Interest Property Trust (QTIP Trust)
Good for: Married individuals with significant estates seeking to minimize estate taxes
A QTIP trust allows couples to optimize tax benefits while ensuring that assets are distributed according to their wishes. This type of trust is designed to qualify for the unlimited marital deduction, thereby sidestepping gift and estate taxes, while providing financial support to the surviving spouse.
The advantages of a QTIP Trust include tax benefits on top of the ability to control the final distribution of assets. However, the trust has rigid guidelines that must be strictly followed, including that:
- Only the surviving spouse can be the beneficiary of the trust during their lifetime; and
- The trust must distribute all income generated to the surviving spouse at least annually (which is different from a bypass trust).
Failure to adhere to these rules can forfeit the tax benefits.
When establishing a QTIP Trust, work with an experienced attorney to ensure all guidelines are met. Special attention should be given to the documentation and tax filings needed to qualify the trust for the marital deduction.
Special Needs Trust
Good for: Families with disabled dependents
A special needs trust is established to meet the financial needs of a dependent with special needs and appoints them as the beneficiary. It funds the beneficiary’s medical care or day-to-day needs while retaining the dependent’s qualification to receive government benefits such as Supplemental Security Income (SSI). There are two main types of special needs trusts: first-party and third-party.
Asset Protection Trust
Good for: High-net-worth individuals looking to protect assets from creditors or litigation
As the name would suggest, asset protection trusts (APTs) are the best type of trust to protect your assets against creditors, legal disputes, or judgments against your estate. This trust is irrevocable and allows the trustee to hold your assets to protect them from taxation, divorce, bankruptcy, and other judgment creditors.
It’s essential to set up this trust well before any legal claims arise; otherwise, it might be considered a fraudulent transfer.
Good for: Those wishing to shield assets from a financially irresponsible beneficiary
A spendthrift trust is helpful if you believe your heirs will squander their inheritance. It allows you to specify when and how your beneficiaries may access assets designated to them.
For example, you could state that beneficiaries may only receive income from the assets rather than access the entire principal amount. Doing so ensures the beneficiary has a stable, long-term source of financial support. However, it takes away financial control from the beneficiary and can be complicated to manage.
If creating a spendthrift trust, the grantor should carefully consider the choice of trustee, who will have significant control over how the assets will be distributed to the beneficiary.
Good for: High-net-worth individuals who want to leave assets to later generations while avoiding estate taxes
You can set up a generation-skipping trust if you prefer your estate to go to your grandchildren (or later generations) rather than your children. By transferring the assets to your grandchildren instead of your children, the assets enjoy estate tax exemption. However, you can give your children access to income generated by those assets.
Generation-skipping trusts can be complex and may trigger the generation-skipping transfer tax. Grantors should be aware of tax thresholds and consult tax professionals when setting up this type of trust.
Life Insurance Trust
Good for: Individuals looking to exclude life insurance proceeds from their taxable estate
A life insurance trust, often called an irrevocable life insurance trust (ILIT), is designed to hold the proceeds of your life insurance policy. It is irrevocable and allows your life insurance payouts to be invested and distributed by the trustee without incurring taxes for the beneficiaries.
Note that this kind of trust requires relinquishing ownership rights to the policy. This means that the insurance policy is owned by the trustee but not the insured (grantor). When the insured dies, the trustee collects the policy proceeds. Those proceeds can be distributed to the trust’s beneficiaries, who can use them to pay estate taxes.
Qualified Personal Residence Trust (QPRT)
Good for: Homeowners wanting to reduce taxable estate but retain temporary residence rights
A Qualified Personal Residence Trust (QPRT) allows a homeowner to transfer their home to an irrevocable trust while retaining the right to live in it for a certain period. The QPRT can effectively remove the home’s value from the taxable estate, possibly saving on taxes.
However, one downside is the loss of flexibility; once the property is in the trust, it’s challenging to undo the arrangement. Moreover, if the grantor outlives the term specified, the tax benefits might be nullified.
Good for: Philanthropists
A charitable trust is established during the grantor’s lifetime (i.e., a living trust). It distributes assets to the chosen non-profit or charitable organization upon the grantor’s death. This irrevocable trust allows the charity to avoid or reduce estate or gift taxes.
There are two popular types of a charitable trust: charitable lead trusts (CLTs) and charitable remainder trusts (CRTs). CLTs provide income to a charity for a set period of time, after which the remaining assets go to the grantor or a designated beneficiary. On the other hand, CRTs provide income to the grantor or another beneficiary to start, and then the remaining assets go to a charity.
Both types aim to benefit charities but differ in their approach to tax advantages, income distribution, and the eventual recipient of the trust’s principal assets.
Charitable trusts can also be incorporated into a standard trust so that the trustor’s heirs receive part of the estate and the charity receives the remainder.
Good for: Correcting unjust enrichment or fraud
A constructive trust is created through a court’s power when the court determines that a party secured possession of assets unfairly (i.e., unjust enrichment) or by fraud. The purpose is to correct the situation and transfer the assets to the rightful owner(s). Therefore, a constructive trust doesn’t have a trustee.
There’s no set formula for when a constructive trust should be established, but common scenarios involve stolen property, fraudulently acquired assets, or items mistakenly given to the wrong person.
If no other sufficient legal solutions are available, then a constructive trust can be an option.
Good for: People looking for a simple way to pass on simple assets without probate
A totten trust (or a payable-on-death account) allows you to pass on a bank account directly to a beneficiary without probate upon your death. The beneficiary doesn’t have access to the accounts while you are alive.
Totten trusts are revocable and relatively simple to manage compared to other trusts. However, it’s limited to certain financial assets and doesn’t offer the flexibility or protections of other trusts.
Good for: Individuals who need to avoid conflicts of interest
A blind trust, which can be either revocable or irrevocable, allows the grantor to relinquish control over assets to an independent trustee to avoid conflicts of interest, as the trustee manages the assets without the beneficiaries’ knowledge. The beneficiaries have no input into how the assets are handled.
Although blind trusts are particularly helpful when conflicts are likely among the beneficiaries, ensure the chosen trustee is highly trustworthy and competent, as they will have full discretion over the management of the trust funds and assets.
Good for: Pet owners who want to ensure their animals are well cared for after they pass away
A pet trust is a legal arrangement that ensures your pet’s well-being in the event of your death or incapacity. Unlike a will, which may leave the care of your pet uncertain, a pet trust creates a binding obligation for a designated trustee to follow your specific instructions for your pet’s care. The trust can detail anything from the type of food your pet should eat to its walking schedule.
One major advantage of a pet trust is its immediate effectiveness upon your death or incapacitation. It also allows for periodic inspections to ensure the pet’s caregiver is following your wishes. Funds in the trust can be dispersed in installments, ensuring longer-term care.
When creating a pet trust, it’s crucial to consider state laws, which may limit the trust’s duration. For instance, some states terminate pet trusts after 21 years, which could be problematic for pets with longer life expectancies. Also, it’s advisable to appoint an “enforcer” to oversee the trustee’s actions, as pets cannot legally enforce the terms of a trust.
Conclusion: What type of trust do you need?
With many different trust structures available, deciding which one is right for you can be challenging. Each kind of trust described above has unique features, but they all share expected benefits, including estate tax reduction and avoidance of probate. Whichever type of trust you choose to protect your assets, you can be assured that you’re making a necessary, responsible choice for your loved ones.
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