What Is a Trust?
Trusts allow you to protect your assets both during and past your lifetime. This article details how they work and the different types.
Taking proactive steps to secure your wealth both during your lifetime and beyond is always a good idea. Often recommended by financial advisors and professionals, trusts are an effective tool that can do just that. They can help you plan your estate and safely hold your assets for a variety of reasons.
This article will define trusts and explain how they work. We’ll also break down the different types, outline benefits, and answer some frequently asked questions.
How Trusts Work
A trust is an agreement where a trustee holds assets for the eventual benefit of one or more beneficiaries. In the arrangement, a grantor grants a trustee rights to assets or property, such as cash, real estate, or investments. Then, the latter manages them with the understanding that they’ll eventually be transferred to a beneficiary.
Below are the three parties involved in a trust:
- Grantor (also known as a trustor or settlor). The person or organization that grants the rights of their assets to a trustee. In some cases, it may also be a beneficiary.
- Trustee. An individual or larger firm that manages and protects a grantor’s assets or property. They have a fiduciary duty to carry out the best interest of the beneficiaries and handle several duties, such as accounting, managing taxes, and maintaining assets.
- Beneficiary. A person or entity who’s been designated to receive benefits or transfer of assets from the trust.
Trust agreements control the relationship between the three parties. These set forth how the trustee is to take care of the assets granted by the grantor. They also identify how the assets will be distributed to the beneficiaries, as well as how it would work to amend or revoke the trust.
Revocable vs. Irrevocable Trusts
There are two main forms trusts can take, revocable and irrevocable. Here are the primary differences between the two:
Revocable, or living, trusts can be amended or revoked after their creation and are established during a grantor’s lifetime. Their main advantage is that they can allow your assets to avoid probate and, therefore, make it easier for your family or heirs to receive your assets upon death or becoming incapable of managing your portfolio.
As a grantor, you can either identify a trustee or be one yourself while you’re alive. Per the American Bar Association (ABA), living trusts won’t help you minimize estate taxes. This is because you still have access to your assets and have the freedom to terminate it at any time.
Irrevocable trusts typically can’t be changed or canceled once they’re in effect. With these, you grant the rights to your assets to a trustee with the intention of them eventually transferring to one or more beneficiaries upon your death or incapacitation. These could be your children, grandchildren, or even friends.
Because you pass over full control of your assets to a trustee, irrevocable trusts are better for avoiding estate taxes. Your money also stays safe and sound from litigation or creditors. This is because it’s fully separated from you and is in someone else’s control.
Other Types of Trusts
While trusts are usually divided between revocable and irrevocable, there are several other types. Each one comes with a different function and may or may not be best for your situation. Here’s a list of ten main ones, along with some brief information about them:
These involve two people, often married couples, who’d like to protect or transfer their assets. If one of the two dies, the surviving person will often become the sole trustee.
Marital and Bypass (A-B)
A-B trusts are common in estate planning for married couples. They comprise two parts, a marital (A) and a bypass (B). If one spouse passes away, the former helps provide non-taxed benefits or income to the surviving spouse. At the time of the surviving spouse’s death, however, it will face estate taxes.
The B trust, often referred to as a credit shelter trust, exists as a further way to protect wealth by maximizing tax exemptions. In short, a piece of the assets, typically equal to the estate tax exemption amount, belonging to the deceased spouse goes into an irrevocable B. By doing this, the assets in the B stay safe from taxation.
These offer no information to beneficiaries as to what types of assets or benefits they may receive from them. A grantor will often use them if they wish to minimize conflicts of interest surrounding the types of assets or if they simply don’t want the beneficiaries to have full knowledge of them. The trustee has total freedom over how to manage and, eventually, distribute assets or property.
Special Needs (SNT)
These are a good way to provide for a disabled dependent, such as a child or relative, without them losing their government benefits. If your disabled family member receives too much income, they could lose their Medicaid or Supplemental Security Income (SSI). Naming them as a beneficiary in a special needs trust lets you provide for both their financial needs and quality of life while also keeping their benefit eligibility intact.
Irrevocable Life Insurance (ILIT)
ILITs provide the ability to eliminate life insurance proceeds from your taxable estate after you pass. This makes it easier for beneficiaries to receive the benefit from your life insurance policy as soon and with as little taxation as possible.
GSTs allow you to name your grandchildren (or further) as beneficiaries to receive your assets. This gets around any estate taxes that you may incur if you were to name your children as recipients.
Qualified Terminable Interest Property (QTIP)
Despite the long name, QTIPs are quite straightforward. They direct income to a surviving spouse and allow grantors to manage the distribution of the trust’s property to the beneficiaries upon the passing of a spouse.
Grantor Retained Annuity Trust (GRAT)
GRATs are irrevocable trusts that let you set aside assets while also earning an annuity from them for a certain period. Once the set time passes, the contents will distribute to the beneficiaries.
Pros and Cons
Trusts are helpful tools in the estate planning process. Setting one up helps you ensure that the beneficiaries you name can receive your property as cleanly as possible when you want them. Here are some other advantages:
- Asset protection. Placing your assets under the care of a trustee protects them from creditors, lawsuits, and more.
- Avoiding probate. Because the trust is in control of the assets upon a grantor’s death, it can bypass court proceedings when it comes time to distribute assets to beneficiaries. This minimizes various types of legal fees.
- Privacy. Staying out of probate also means your assets in the trust will stay private from public record.
- Tax optimization. Often, trusts minimize estate, charitable giving, or other types of taxes you or your beneficiaries might face.
While trusts come with plenty of upsides, they’re not for everyone. Here are three disadvantages:
- Complex. Trusts are complex legal agreements that only get more difficult if you have more assets to put in. You’ll need to keep records and figure out a plan that works for you. There are also several different types to choose from, and it can be difficult to know the right one for you.
- Expensive. Setting up a trust often involves costly attorney and trustee fees and could have tax implications.
- Inaccessible. Trusts separate you from your assets and property under the idea they’ll eventually go to someone else. So, once you set one up, your assets are, for the most part, inaccessible. This is especially the case with irrevocable agreements.
Frequently Asked Questions
Should I put my money in a trust?
Deciding whether to set up a trust depends on various personal factors. They’re good if you want to make sure your money gets to who you want it to upon your passing. And, depending on the type you go with, they also have specific tax benefits. We recommend consulting with a financial advisor or estate planner to see if this arrangement is right for you.
Does money from trusts count as income?
Money earned from the trust counts as income and, in some cases, could incur taxes. This, however, might depend on the type you set up. Assets or cash you receive as a beneficiary may also incur taxes.
What is the best type of trust to have?
The best type to choose will rely on your circumstances. Revocable trusts may be better if you prefer to have more control and want to avoid probate. Irrevocable ones are often good for mitigating taxes. Beyond these two, though, there are several types. If you want to establish one, it’s not a bad idea to talk to an estate professional.
What types of assets go in a trust?
You can place several types of assets into a trust. Here are some common examples:
- Real estate
- Certificates of deposit (CDs)
- Personal property
- Life insurance policies
- Bank accounts
- Stocks, bonds, index funds, and mutual funds
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