Trusts are a popular estate planning vehicle for several reasons. Trusts can offer asset protection, they can be tax-efficient, and they can help specify which beneficiaries receive the assets housed in the trust.
For many people, a will, which specifies how the assets named should be distributed upon your death and how other personal affairs might be handled, will be sufficient estate planning.
But for others, a trust can provide additional benefits that serve their families well.
Let’s look at what trusts are, why they might be useful, and how to go about setting one up.
A trust is a legal arrangement in which one person, the grantor, transfers ownership of assets to another person, the trustee, who will administer the assets for the benefit of a third person or group, the beneficiaries.
Although there are many different kinds of trusts, they all fall into two categories: revocable and irrevocable trusts.
A revocable trust allows the grantor (i.e., you) to retain control over the assets in the trust during their lifetime and to make changes to the trust. Income from the trust is distributed to the grantor during their lifetime, and after their death the assets in the trust are transferred to the trust’s beneficiaries.
With an irrevocable trust, the grantor relinquishes control of the trust once the trust agreement is finalized. An irrevocable trust generally has its own tax ID, and the grantor is not responsible for any taxes on income earned by the trust.
Differences between a revocable trust and an irrevocable trust include:
| Revocable Trust | Irrevocable Trust | |
|---|---|---|
| Creditor protection | No | Yes |
| Ability to change and adjust | Can be changed and adjusted during the grantor’s lifetime | Once established, an irrevocable trust cannot be modified, with certain exceptions |
| Sheltered from estate taxes | No, because the trust is still under the grantor’s control | Yes, because the assets are no longer under the control of the grantor |
| Probate | Assets avoid the probate process | Assets avoid the probate process |
| Grantor control of assets | The grantor controls the assets in the trust | The trustee controls the assets and decides how they are used and invested |
| Duration of the trust | Revocable trusts can last as long as the grantor desires and can be revoked at any time. | Irrevocable trusts are permanent. They last through the lifetime of the grantor and beyond. |
A trust can offer a number of benefits that may be right for your estate planning needs. These can include:
Avoiding probate. Probate is the process by which a will is executed. It involves a probate court, which both validates the will and makes a final decision on how assets will be distributed. Depending on the complexity of an estate, it can take substantial time. A trust avoids probate and speeds up the distribution of your assets.
Privacy. Probate is a matter of public record. Passing assets through a trust is a private process.
Flexibility and control. A trust can not only identify who receives your assets, but also when and how those assets are distributed.
Reduce contesting by heirs. Unlike with a will, the terms of a trust are extremely difficult to contest in court.
Protection from creditors and others. An irrevocable trust may provide you with protection from creditors so long as the trust wasn’t set up with the intention to defraud creditors.
Reduced taxes. Certain types of trusts can help reduce estate, gift and/or income taxes.
The benefits of a trust will largely depend on how it’s set up, which is why working with an experienced estate attorney will be critical.
Trusts can be set up in multiple ways to serve multiple purposes. Here are some examples.
A marital trust is generally established by one spouse for the benefit of the other spouse when the first spouse dies. When the first spouse dies, their assets are transferred to a trust that benefits the surviving spouse, which allows for the deferral of estate taxes until the death of the surviving spouse.
This kind of trust is often combined with what’s called a B (bypass) trust to form an A-B trust. Upon the death of the first spouse, a portion of the assets are transferred to the A trust for the benefit of the surviving spouse. The remainder of the assets are transferred to a bypass or family trust to benefit other beneficiaries. This trust is irrevocable and allows these assets to bypass any estate tax liability.
A QTIP, or qualified terminable interest property trust, is used to provide income to the surviving spouse upon the death of the first spouse. When the surviving spouse dies, the remaining assets go to the named beneficiaries instead of the estate of the surviving spouse. This type of trust is often used in second marriage situations.
The assets passing to the surviving spouse avoid taxation since they qualify for the marital deduction. There is no taxation until after the death of the surviving spouse.
A special needs trust is structured to provide for the needs of a beneficiary with special needs, whether that’s a minor child or an adult. Special needs trusts are designed to provide financial support to the beneficiary without jeopardizing their access to governmental benefits, which are often contingent on limited assets.
An irrevocable life insurance trust, or ILIT, is a type of trust that is often used to ensure that a major asset doesn’t need to be liquidated to cover estate taxes. The grantor of the trust will gift the premiums for the life insurance policy to the trustee who will then pay the premiums on the policies. The grantor uses the annual gift tax exclusion to gift the premiums to the trust.
An ILIT can be a way to cover the estate taxes on major assets upon the death of the grantor. This allows the assets to pass to the beneficiaries of the estate without having to sell a major asset to cover the estate taxes. This may be a useful strategy for a family business, real estate or other significant assets.
With a grantor retained annuity trust (GRAT), the grantor of the trust contributes assets to the trust and then receives a regular annuity payment. This payment is usually a set percentage of the original amount in the trust.
A GRAT is an irrevocable trust that lasts for a specified number of years. When the term of the trust expires, the assets in the trust will transfer to the trust’s beneficiaries gift-tax free. If the grantor has died at the time of the trust’s expiration, then the assets in the trust will be included in their estate and potentially subject to estate taxes.
A QPRT is an irrevocable trust where the grantor transfers ownership of their home to a trust. This might be a parent transferring ownership to an adult child.
There is a set period of time where the grantor can live in the home rent free. This might be 10, 15, 20 years or some other period of time. At the end of that time period if the grantor is still alive then the residence passes to the beneficiary outside of the grantor’s estate. If the grantor dies before the trust term, the residence leaves the trust and reverts to their taxable estate. It's important to set a time period for the QPRT that is realistic based on the age and health of the grantor.
Determining whether a trust is the right tool for you is a key part of the estate planning process. This process should involve your financial advisor and also entail looking at your estate planning goals and situation.
If so, one of the trusts listed above or another of the many varieties of trust types available might be right for your situation.
If a trust is right for your situation, be sure to work with a qualified estate planning attorney, ideally in conjunction with your financial advisor and your tax advisor. Discuss your goals for a potential trust and get their take on the best option given your goals. If you move forward they can draft a trust with the proper language and provisions. Be sure they coordinate with your financial and tax advisors to ensure that all bases are covered.
It's important to find the right trustee for the trust. This might be a friend, a relative or a corporate trustee, like a bank or trust company. The trustee manages the distribution of the trust’s assets in accordance with your wishes. The trustee you chose should be someone you trust and who has the ability to understand the trust provisions and to carry them out.
Finally, be sure to fund the trust! It does no good to establish a trust if the assets involved aren’t transferred into the trust.
While a trust can be more complicated than a basic will, there are many situations ordinary people might find themselves in that would benefit from a trust, despite the time and expense involved.
Peace of mind from knowing your assets will go where you want them to, reduced taxes that will offset the cost of setting up the trust, and ensuring loved ones with special needs will be taken care of financially without losing their benefits are all worthy goals.