Takeaways
- A trust gives a trustee the responsibility to hold and manage beneficiaries' assets.
- Trusts are efficient for passing assets and investments from one generation to the next.
- Trusts provide clear and specific instructions for how assets are distributed.
- Trustees are fiduciaries and manage trusts in accordance with the grantor's wishes.
- Trusts fall into three buckets: living or testamentary, revocable or irrevocable, and funded or unfunded.
What Is a Trust?
A trust is a legal arrangement in which one party, the trustee, holds and manages assets for the benefit of another party, the beneficiary. Trusts are formed under state laws, and each state has nuances to consider. [1]
Trusts help ensure assets are managed and distributed according to the grantor's wishes. The grantor creates the trust and transfers assets into it. Trusts are versatile tools in estate planning, allowing individuals to control their wealth management.
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How a Trust Works
The grantor must draft a legal document to create a trust, often called a trust deed or instrument.
This document outlines the terms and conditions of the trust, including the trustee and beneficiaries, assets included, and the timing of asset distribution. The trustee then manages the trust assets according to these instructions.
Trusts can serve various purposes, including estate planning, tax planning, and protecting assets from potential creditors. They offer flexibility and control over asset distribution, ensuring that beneficiaries receive their inheritance in a structured manner. For example, a trust can specify that a beneficiary gets funds only upon reaching a certain age or other milestone, such as college graduation.
Trusts can help minimize estate taxes, provide for minor children or dependents with special needs, and protect assets from lawsuits and creditors. By placing assets in a trust, the grantor can ensure that their estate is handled according to particular wishes rather than subject to the default rules of intestacy, which apply when someone dies without a will.
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3 Categories of Trusts
Three main categories of trusts are living or testamentary, revocable or irrevocable, and funded or unfunded. Understanding these categories can help you choose the right type of trust for your specific needs and goals.
1. Living or Testamentary
- Living Trust: A living trust becomes effective during the grantor's lifetime. This type of trust allows the grantor to manage the assets and make changes to the trust while they are still alive. Living trusts can help avoid probate, the legal process of distributing a deceased person's assets, which can be time-consuming and expensive.
Living trusts are particularly beneficial for those who want to ensure their estate is smoothly managed if incapacitated. Since the trust is already in place and funded, the successor trustee can step in immediately to manage the trust assets without needing court intervention.
- Testamentary Trust: A testamentary trust is created through a will and only takes effect after the grantor's death. This type of trust does not avoid probate but can provide significant benefits, like controlling the distribution of assets to beneficiaries over time.
Testamentary trusts are often used to provide for children, ensuring their inheritance is responsibly managed until they reach adulthood.
2. Revocable or Irrevocable
- Revocable Trust: A revocable trust can be altered or terminated by the grantor at any time during their lifetime. This flexibility allows the grantor to make changes as their circumstances or wishes change.[2]
Revocable trusts often become irrevocable upon the grantor's death. Because the grantor retains control over the assets in a revocable trust, these assets are still considered part of the grantor's taxable estate.
Revocable trusts are famous for their flexibility and easy management. They allow the grantor to adjust trust details like changing beneficiaries, altering the distribution plan, adding assets, or removing investors from the trust. Because the grantor retains control over the trust assets, they do not provide the same level of asset protection as irrevocable trusts.
- Irrevocable trusts: Irrevocable trusts are often used in estate planning to reduce taxes and protect assets from creditors. By transferring assets to an irrevocable trust, the grantor removes them from their taxable estate, potentially saving significant amounts in estate taxes.
Irrevocable trusts can also protect beneficiaries, ensuring their inheritance is preserved and managed responsibly.
3. Funded or Unfunded
- Funded Trust: A funded trust has assets transferred into it by the grantor. These assets include cash, real estate, stocks, bonds, and other investments. The trustee manages these assets according to the terms of the trust.
Funded trusts are effective immediately, giving the grantor peace of mind that their estate is being managed according to their wishes.
Funding a trust involves formally transferring ownership of assets to the trust. This process can include retitling property, changing account registrations, and updating beneficiary designations. Adequately funding a trust is essential to ensure that it operates as intended and that the grantor's estate plan is fully implemented.
- Unfunded Trust: Unfunded trusts do not have any assets transferred into them during the grantor's lifetime. This type of trust can be funded in the future, either by the grantor or through other means, such as life insurance proceeds upon the grantor's death.
Unfunded trusts do not provide benefits until they are funded, so it is essential to have a clear plan for transferring assets to the trust.
Who Controls a Trust?
The control of a trust depends on the type and structure of the trust. Here are the primary parties involved in a trust:
1. Grantor
The grantor creates the trust and transfers assets. The grantor sets the terms of the trust and decides how the assets should be managed and distributed.
2. Trustee
The trustee is the individual or institution responsible for managing the trust assets and ensuring that the terms of the trust are followed. The trustee has a fiduciary duty to act in the best interests of the beneficiaries. Trustees can be individuals, such as family members or friends, or professional trustees, such as banks or trust companies.
3. Beneficiary
The person or entity benefitting from the trust. There can be multiple beneficiaries, and their interests may vary depending on the terms of the trust. Beneficiaries can include family members, friends, charities, or nonprofit organizations.
In a revocable living trust, the grantor often serves as the initial trustee, retaining control over the trust assets during their lifetime. Upon the grantor's death or incapacity, a successor trustee, named in the trust document, takes over management responsibilities. This arrangement ensures a smooth transition and continuous management of the trust assets.
In an irrevocable trust, the grantor typically cannot serve as the trustee, which would defeat the purpose of removing the assets from their control. Instead, an independent trustee or a trusted family member or friend is appointed to manage the trust. The trustee's role is crucial in ensuring that the trust operates according to the grantor's wishes and that the beneficiaries receive the intended benefits.
Advantages of Trusts
Trusts are an integral part of financial planning and can be used to ensure your hard-earned savings and investments flow to your children or grandchildren the way you want. Here are three primary advantages of establishing a trust:
- Controlling Your Funds: Much like a will, you can determine who gets cash, stocks, bonds, real estate, and other family assets with a trust. You have the flexibility to choose the timing of these funds flow, too.
- Shielding Wealth: A trust allows you to ensure money and assets are distributed to family members in a way that will enable beneficiaries to access only parts of the estate funds or receive regular payments. For example, prebuilt time-based payments can help manage this for those who don't have the knowledge or desire to manage large amounts of money. This ensures that a beneficiary doesn't spend the entire estate at once frivolously.
- Avoiding Probate and Privacy: Properly written and constructed trusts enable your family to avoid probate when you (the grantor) pass away. Probates are records, so a trust allows the asset transfers to remain private. Additionally, beneficiaries save on legal fees and taxes.
- Reducing Conflict: A well-written trust allows grantors to assign who gets assets in precisely the manner they want. Beneficiaries are beholden to the grantor's wishes, and a trust cannot be disputed in courts like a will. Otherwise, if an estate is left unattended, there can be family conflict and animosity. Family, friends, and creditors could try to take advantage of the grantor's wealth.
7 Types of Trusts
There are various types of trusts designed to meet specific needs and goals. Some common types of trusts include:
1. Revocable Living Trust
This type of trust allows the grantor to manage and change it during their lifetime, with the trust becoming irrevocable upon their death. It is commonly used to avoid probate and provide for the grantor's incapacity.
2. Irrevocable Life Insurance Trust (ILIT)
Used to remove life insurance proceeds from the grantor's taxable estate, providing tax benefits and ensuring that the proceeds are managed according to the grantor's wishes. An ILIT can help beneficiaries receive the full benefit of life insurance proceeds without being subject to estate taxes.
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3. Special Needs Trust
Established to provide for a beneficiary with special needs without disqualifying them from government benefits. Special needs trusts ensure beneficiaries can access additional resources while preserving their eligibility for essential public assistance programs.
4. Charitable Remainder Trust (CRT)
This trust allows the grantor to donate assets to a charity while retaining the right to receive income from those assets for a specified period. After the income period ends, the remaining assets go to the designated charity. CRTs provide tax benefits and support charitable giving while providing income to the grantor or other beneficiaries.
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5. Spendthrift Trust
This trust protects beneficiaries from creditors by restricting their ability to access the trust’s principal. It ensures that beneficiaries receive regular income, dividend income, or other distributions while preventing them from squandering their inheritance or having it seized by creditors.
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6. Qualified Personal Residence Trust (QPRT)
This trust allows the grantor to transfer a primary or secondary residence to the trust while retaining the right to live in the property for a specified period (Read more about how to buy your first home). QPRTs can help reduce estate taxes by removing the value of the residence from the grantor's taxable estate.
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7. Dynasty Trust
Dynasty trusts are designed to last for multiple generations, providing long-term asset protection and wealth preservation. They can minimize estate taxes and protect family wealth from creditors, divorce, and other risks.
Smart Summary
Financial planning is a critical part of building and preserving wealth. If you are taking the time to increase your net worth, manage multiple investments, and invest in your future, you should also understand how to protect it over the long term. Regardless of how much you have accumulated, creating an orderly distribution of your assets with a trust can alleviate family tension later down the road. Coordinate with a financial advisor or robo-advisor to analyze what makes sense for your money.
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(1) Internal Revenue Service. Definition of a Trust. Last Accessed January 14, 2025.
(2) American Bar Association. What is a Revocable Living Trust. Last Accessed January 14, 2025.
