If you’re like many Americans, trusts are probably the single most powerful tax, estate, and financial planning tool you’re not taking full advantage of. That’s because you might not know what a trust is, why you would want to set one up, or how to do so. But these are the fundamentals you’ll want to understand in order to benefit from the opportunities trusts provide.
Trusts: Just the Basics
Let’s start with some simple trust terminology.
A trust is a legal relationship in which property (sometimes called the principal or corpus of the trust) is held by one party for the benefit of another party.
A trust is created by a settlor (sometimes also called a donor, a grantor or a trustor), who transfers property to the trust.
A trust is created for a beneficiary, the person or people benefiting from the trust. A trust beneficiary can be a single individual, more than one person, or even a person who has not yet been born.
A trust is managed by a trustee, who may be a person, a group of people, or a corporation.
The trustee or trustees are responsible for managing the property in the trust in the best interests of the beneficiary or beneficiaries, according to the rules set out in the trust agreement. Eligible trustees include the trust settlor, the spouse or adult child of the trust beneficiary, or even a third party. The beneficiary, however, cannot also be the trustee.
The basic concept of a trust has existed for several thousand years, and trusts are used all over the world.
Two Types and Two Categories of Trusts
There are two main types of trusts: living trusts and testamentary trusts. A living trust (also called an inter vivos trust, from the Latin “among the living”) is established during the settlor’s lifetime. A testamentary trust, in contrast, is specified in the settlor’s will and established only after their death, as part of the implementation of the provisions of their will.
Living trusts can take one of two forms: revocable or irrevocable. Revocable trusts allow the settlor to retain control of all the assets in the trust, and the terms of the trust can be changed or revoked at any time. With irrevocable trusts, in contrast, the assets in the trust are no longer under the control of the settlor, and most often the terms of the trust cannot be changed (unless the settlor has the agreement of the beneficiary).
The Unique Advantages Trusts Can Provide for Your Financial Plans
Why are trusts such a widespread legal structure, enduring across generations and countries? Put simply, it’s because of what they can accomplish for settlors and beneficiaries alike. The main advantage of a trust is this: When a trust is established, and the settlor of the trust places property into the trust, the settlor is able to separate the legal ownership and control of that property from its beneficial (or equitable) ownership.
Although this may sound complicated, it’s actually quite straightforward—and the benefits can be significant. When a trust is established and property is placed into it, the settlor no longer holds legal ownership of the property, but is able to specify how property will be held, used and passed on to beneficiaries via the terms of the trust. Legal ownership passes to the trustee, who has a fiduciary obligation to act for the good of the beneficiary or beneficiaries, before any of their own interests. The beneficiaries, for their part, become the beneficial owners of that property—they are entitled to possess, use and benefit from the property in the trust, without being its legal owner.
This separation of legal and beneficial ownership of property can be very useful for American families today. Five examples where trusts can help are:
- If you want to ensure that your property is managed in accordance with your wishes, even if you are unable to carry out those wishes directly (because you are in another jurisdiction or otherwise unavailable; because you are incapacitated, for example by old age or illness; or after your death)
- If you want to exclude some of your assets from your estate (to reduce gift or probate taxes or for privacy reasons, if you live in a state where an inventory of assets must be filed by an estate representative)
- If you want specific people to benefit from your assets after your death
- If you’re concerned about how members of your family might use some of the assets you leave to them after your death, and you want to specify how income (e.g., interest on securities held in the trust, or rent from property held in the trust) and profit (or capital gains, resulting from an increase in the value of property in the trust) from your property are distributed to them—or how the property itself is allocated to the trust beneficiaries
- If you want to make sure your property is protected from lawsuits and claims by creditors
Common Forms of Trust in Use Today
Perhaps the most common form of trust in use today is the revocable living trust. By transferring assets into a revocable living trust, you can manage your financial affairs during your lifetime, and if you become incapacitated, you can ensure that your assets are managed in accordance with your desires. In addition, you can use a revocable living trust to distribute trust assets to heirs, as well as keep trust assets out of probate and safeguard your personal information.
Probate is the legal process by which assets are distributed after death. Note that the term “probate” can refer to this legal process, the court in which the process takes place, and the distribution of assets. When an estate is “probated,” all of its assets are valued, any debts are paid, and whatever is left over is then distributed to heirs. There are a couple of important reasons why you might want to avoid probate as the process can be:
- Slow. One to three years is typical.
- Expensive. Although it varies by state, probate costs can be as much as 10 percent of the total value of the estate.
- Public. Because probate is handled by the courts, all of the information regarding what’s in the estate, its value, and who receives distributions from the estate becomes public.
Other frequently-used trusts include spendthrift trusts, special needs trusts, and charitable remainder trusts.
Spendthrift trust: This type of trust is best if you want to have a trustee distribute income or gains from a property to an heir, rather than leave that property to the heir directly. Spendthrift trusts can be used to distribute money to an heir once that heir has reached a specified age, as an allowance, or to meet specific needs (e.g., college tuition or medical expenses).
Special needs trust: This type of trust is useful if you have a disabled family member who might not be able to earn enough income to support themselves. With a special-needs trust, you can control how income from the trust assets is distributed to the beneficiary, and ensure that the financial support available from social services is not affected by the assets in the trust.
Charitable remainder trust: A charitable remainder trust allows you to make a donation to your preferred charity now, instead of having the assets distributed as part of your estate after your passing. This makes it possible to receive a tax deduction for your gift while you are alive. In addition, you can structure the trust in such a way that you receive any income from the property donated to the trust as long as you’re living, and the charity gets whatever is left (the remainder) after your death.
Five Specialized Trusts That May Suit Your Situation
In addition to the most typical forms of trust in use today, there are also more focused types of trusts that work best in specific circumstances. Some examples include:
Qualified personal residence trusts (QPRTs): This trust subtracts the value of your home or vacation home from your estate. It can be particularly useful if you expect the value of your home or vacation home to rise over time. With a QPRT, you can continue to live in the house throughout the term of the trust, often 10 to 15 years. Once the trust term is up, your house is transferred to the beneficiaries of the trust—generally your children—but you can make arrangements to continue to live there, if so desired. The value of your house is not included when any estate taxes are calculated, thus leaving more of your estate tax exemption available to cover other assets.
Generation-skipping trusts: A generation-skipping trust (also called a dynasty trust) allows the settlor to transfer money to beneficiaries who are two or more generations younger than them. The beneficiary can be anybody, other than a spouse or ex-spouse, who is at least 37.5 years younger than the settlor. As you might imagine, this type of trust is usually employed to pass assets from a grandparent or grandparents to grandchildren. Because the children of the settlor never receive title to the assets, this process of “skipping a generation” allows the settlor to avoid estate taxes that would otherwise apply if the assets were transferred to first-generation heirs (i.e., the settlor’s children).
Irrevocable life insurance trusts: If you have a life insurance policy, an irrevocable life insurance trust can be used to remove it from your taxable estate. To do this, you must surrender your ownership rights over the policy, which means you cannot use the policy value as collateral for a loan, and you can’t change the beneficiary designation. Once the policy has been transferred to the trust, the proceeds from the policy can pay your estate costs after you die and provide your beneficiaries with tax-free income.
Credit shelter trusts: A credit shelter trust (also called a bypass or family trust) is a type of trust that can be valuable for married couples with considerable assets, who might otherwise be subject to a high estate tax. This kind of trust allows them to take full advantage of state and federal estate tax exemptions. The purpose of this type of trust is to give a surviving spouse access to income from a property transferred into the trust without adding that property to their estate (thus potentially exceeding estate tax exemption limits).
Qualified terminable interest property (QTIP) trusts: Many Americans are part of “blended” families as a result of divorces and remarriages, and those families often include stepchildren. A qualified terminable interest property or QTIP trust can be used to pass your assets to specific beneficiaries, such as children from a first marriage. You can set it up so that your surviving spouse will receive income from the trust. After your spouse dies, the trust beneficiaries will get the principal or remainder in the trust.
Your Trust Planning Checklist
As you’ve probably realized, trusts are usually implemented as part of the will and estate planning process. This means that trusts are not usually set up separately. Instead, they are created at the same time you draft your will and put your overall estate plan in place.
Typically, an estate plan might include:
- Your formal will, which specifies how your property is to be administered and distributed in the event of your death
- A “living will,” which will guide decisions regarding your financial affairs if you are unable to express or make your decisions while you are alive
- A health-care proxy, which will guide decisions regarding your health care should you become unable to express or carry out your wishes while you are alive
- The trusts that make the most sense for you and your situation, whether they are living or testamentary trusts. This may include specialized or narrowly-focused trusts.
As noted above, the most commonly–recommended form of trust is usually a revocable living trust. With this type of trust, you can help make sure that your preferences regarding your financial affairs and property are respected and followed while you are alive, without binding you to the terms of the trust.
Of course, unless you are a trusts and estates specialist, you’re unlikely to know about the various other types of specialized trusts that could help you meet your financial and other goals. That’s why it’s likely that you will need to meet with a trusts and estates attorney who can help guide you through the different options to create the plan that will work best for you.
You can expect this process to take several months, as you work with the specialist to ensure that your assets are considered along with your directions on how, when, and to whom they are to be distributed. Once your initial trusts and estates plan is in place, you should expect to review it periodically to confirm that it remains practical and relevant for you over time.
Disclaimer: This article is meant for informational purposes only and does not constitute legal or tax advice.