Understanding Different Types of Trust Funds and How They Work
When you hear the word “trust” in financial or business terms, you probably think of either Teddy Roosevelt or rich kids who drive Range Rovers in high school. The truth, however, is that trusts aren’t only for the wealthy and many average families can benefit by including them in their estate planning. Trusts come in many shapes and sizes and can deal with issues as varied as Social Security, insurance, and inheritance. If you have a will, it’s very likely that you could benefit from a trust. Here’s what you need to know.
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Trusts Offer a Unique Set of Benefits
Trusts are legal arrangements that allow third parties (trustees) to hold assets on behalf of the person who created the trust (a trustor, grantor, or benefactor) as a means of distributing those assets to the beneficiaries who are to receive them.
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Trusts can reduce estate taxes and gift taxes, according to Western & Southern Financial Group, but people also use them for privacy since they’re not always part of the public record. Trusts can also provide protection from creditors and shield assets from legal judgments. Perhaps most importantly, some trusts let you bypass probate, the lengthy and expensive legal process for distributing a person’s assets to his or her beneficiaries after the person dies.
Living vs. Testamentary Trusts
There are many different kinds of trusts and each can be structured differently within, but they all fall into one of two broad categories — the kind you make when you’re alive and the kind made on your behalf after you die.
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Living trusts, also known as inter vivos trusts, allow the trustor to access the assets held in the trust while the person is still alive, but then pass the assets to a beneficiary through a trustee after death. People set up living trusts mainly because they allow them to transfer their assets to their beneficiaries without going through the probate process.
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Testamentary trusts, on the other hand, are created after death according to the trustor’s will. In this case, assets can enter the trust only through the grantor’s will, and therefore must pass through probate court before the beneficiaries can receive them.
Revocable vs. Irrevocable Trusts
Revocable trusts are living trusts that the trustor can change or terminate at any time while still alive. Irrevocable trusts, on the other hand, can not be changed by the trustor once they’re created without permission from the beneficiaries.
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Since trustors surrender control of the assets in irrevocable trusts, those assets no longer count as part of the trustor’s estate. This kind of arrangement can dramatically reduce estate taxes, which is the main reason for setting up an irrevocable trust.
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Although living trusts can be revocable or irrevocable, all revocable trusts become irrevocable when the trustor dies because he or she is no longer able to terminate or alter the trust.
Other Kinds of Trusts
Now that you understand the broad, overarching categories that define most trusts, here’s a look at some more specific kinds of commonly used trusts:
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- Charitable remainder trust: This kind of irrevocable trust allows donors to generate income from assets, with the remainder distributed to a charitable organization as a gift.
- Qualified domestic trust: This arrangement allows surviving spouses who aren’t U.S. citizens to take the marital estate tax deduction.
- Credit shelter trust: This kind of trust is designed to greatly reduce or even eliminate estate taxes when a surviving spouse dies and passes assets from the marriage onto children or other beneficiaries.
- Blind trust: People use this kind of trust when the assets held within could otherwise cause a conflict of interest. The beneficiaries have no knowledge of what assets are held in the trust and they have no control over how the assets are handled. In this case, an independent, third-party trustee has total control over the assets and can buy, sell, and manage them without input from the beneficiaries.
- Insurance trust: In this kind of irrevocable trust, a life insurance policy is an asset. The trustee becomes the holder of the policy and upon the trustor’s death, pays all necessary taxes on the policy and distributes the rest to the beneficiaries.
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