Your Basic Guide to Trusts
Trusts are a great way to pass on your assets without burdening your heirs with additional taxes and costs.
A trust is one of those things that most people have heard mentioned throughout their lives but only have a very vague idea (if that) of what they are. Most people assume they're just for the extremely rich so there's no need to figure out all the details. But knowing something about trusts will help you decide whether setting one up makes sense for you.
What Is a Trust?
A trust is a fiduciary agreement that allows a third party to manage assets for a beneficiary. Trusts are typically used to allocate property after the trustmaker has deceased. They can also be used for estate protection and assisting charities.
Typically, three parties are involved in creating a trust:
- The trustmaker is the individual who wants to manage assets by creating a trust
- The trustee is a third party that holds title to the trustmaker's assets
- The beneficiary is the person receiving assets or property as described by the trust
There are two main types of trusts, testamentary and living:
- A testamentary trust is created from the trustmaker's will and is valid only after their death
- A living trust is also known as an inter-vivos trust and is created during the trustmaker's lifetime
Revocable and Irrevocable Trusts
Living trusts fall into two categories: irrevocable and revocable.
An irrevocable trust is the less complicated of the two. A trustmaker places property into the trust, relinquishing all ownership of the property. The trustee then manages these assets and distributes them to the beneficiary upon the death of the trustmaker.
Property in an irrevocable trust is no longer considered the property of the trustmaker. As a result, this property will then no longer contribute to the trustmaker's estate value when calculating death taxes.
A revocable trust allows the trustmaker to change and remove assets within the trust and terminate the trust in the future.
Property in a revocable trust is still considered the property of the trustmaker and therefore contributes to estate value when determining death taxes.
Revocable trusts have one advantage when it comes to probate estate. Property in revocable trusts is exempt from probate, bypassing probate costs and simplifying asset distribution.
Types of Trusts
There are many different types of trusts that accommodate a large variety of needs. Some are less complicated and suit many trustmakers and trustees, while others are created for specific circumstances. We'll look at a few types here but many others exist.
Asset Protection Trust
This covers a broad range of trust forms that allocate assets on a discretionary basis. Trustmakers use this type of trust to plan and protect assets by shielding the assets from tax claims.
These trusts are typically irrevocable for a number of years. After a set period, assets are then returned to the trustmaker – assuming there are no imminent threats from creditors.
Also known as the Totten Trust, this is a simple solution to transfer control of the funds after the death of the trustmaker. The trustmaker names a beneficiary, who they can change at any time, to receive access to the funds at the time of death.
This type of trust is the easiest way to avoid probate. Setting up a Totten Trust is a very common process and as easy as filling out some paperwork at the bank.
This trust allocates funds at the time of the trustmaker's death to grandchildren or beneficiaries at least 37.5 years younger. The trustmaker's children forego the chance to receive assets, thereby avoiding estate taxes.
Charitable trusts offer tax breaks and reduce estate taxes, while at the same time providing funding to non-rofit organizations (if you run one, see 7 Essential Insurance Policies for Nonprofits).
Charitable trusts can be either remainder or lead trusts.
A remainder trust allocates funds to a charitable organization for a predetermined amount of time. Once this time is over, all funds, interest, and profit become the property of the organization.
A lead trust, by contrast, shares any earned interest between the charity and the beneficiaries. After a lead trust expires, all funds return to the beneficiaries of the trustmaker.
Special Needs Trust
A special needs trust allows beneficiaries with a disability to avoid problems that can come up as a result of inheriting money. A cash inheritance, for instance, could disqualify an individual from receiving Medicaid and Supplemental Security Income(SSI).
Through a special needs trust, a trustee allocates funds to pay for goods and services for the beneficiary. Since the beneficiary is not directly in control of the inheritance, the allocated funds no longer pose a threat to the beneficiary's Medicaid and SSI eligibility (for related reading, see Why You Need Disability Insurance).
Estate Planning with Trusts
There are many different types of trusts that are commonly used to manage and allocate an individual's assets before and after death. One of the main advantages of a trust is that it allows individuals to decide how assets and property are allocated after their death. At the same time, trustmakers can make sure their heirs receive as much of the estate as possible by reducing estate and gift taxes and avoiding probate costs.