Different Types of Trusts and Why You Should Create One
Read on to find out what a trust is and what they are used for.
If you think trusts are a legal tool used only by the wealthy, you're only partially right. They are commonly used by the wealthy, but they're also valuable for anyone with any significant amount of assets — even if that's just the house you live in, savings, investments, retirement accounts, and insurance policies. What's more, there are different types of trusts that can be used under various circumstances.
What Is a Trust?
In the most general sense, we can think of a trust as a will on steroids. Both are legal documents outlining the disposition of your assets upon your death, as well as the continued care of certain parties. But a trust goes much further. It gives greater legal protections and can provide benefits for you or others while you're still alive.
There are two main parties in a trust: the trustor and the trustee.
- The trustor establishes the trust and funds it.
- The trustee manages the assets in the trust. This can be a person, agency, or institution. Sometimes the same person acts as both the trustor and trustee.
The third group of parties to a trust is the beneficiaries. These are usually close family members. But they can also be charities or even nonrelatives, such as close friends or business partners. The beneficiaries receive benefits from the trust, either while the trustor is still alive or upon their death.
Funds held in a trust can include your entire estate, a portion of it, or even very specific assets.
Examples of assets held in a trust include:
- Real estate
- Bank accounts
- Businesses or business properties
- Personal property, such as vehicles, jewelry or antiques
- Life insurance policies
What Are the Benefits of a Trust?
The trust provides several benefits, though the trustor may have a single primary purpose for setting up a trust.
- Protection of assets. An irrevocable trust (see expanded discussion below) can protect your assets from both lawsuits and creditor claims. This is a common reason for the creation of a trust by wealthy individuals, who may be targeted for lawsuits based largely on their wealth.
- More secure distribution of your estate upon your death. Many people have a will for this purpose, but your estate may have to go through probate and can be subject to legal challenges. A trust distributes your estate to your intended beneficiaries without the need to go through probate and without being subject to legal challenges.
- Provide support or care for a loved one. That can include your spouse, children, grandchildren or even one or more persons who is incapacitated and in need of special care. A trust can be set up to allocate assets toward the care of an individual or a group of individuals, either for a certain amount of time or even for life.
- Provide for yourself while you're still alive. You may decide to set up a trust to protect your assets from legal challenges and also include a provision to provide for your support for the rest of your life. For example, you may set up a trust to provide an income for your retirement or for you and your family if you're unable to work.
Setting Up a Trust for Estate Planning
Using a trust for estate planning includes virtually all the benefits listed above. But a more specific benefit has to do with tax minimization.
Federal estate tax may apply to estates worth $11.58 million for 2020. If your estate exceeds that threshold, it will be subject to a federal tax ranging between 18% and 40% of the excess.
Federal estate tax may not be a problem for most individuals due to the high level of the exemption amount. But it may be an issue at the state level, depending on where you live. In fact, 13 of the 50 states impose taxes on estate values that are much lower than the federal threshold. For example, Massachusetts and Oregon impose estate tax beginning at just $1 million, while Rhode Island does so at just above $1.5 million.
A trust can be used as an estate planning tool to help you minimize estate taxes. This can be done by taking a life insurance policy large enough to cover the anticipated estate tax at the federal and/or state level.
Considering there are 18.6 million millionaires in the United States, using a trust for estate planning to minimize taxes is becoming increasingly common.
Primary Types of Trusts: Revocable vs. Irrevocable Trusts
There are two primary types of trusts: revocable and irrevocable. Though there are other types of trusts — which will be discussed below — each must be either revocable or irrevocable.
With a revocable trust, the trustor retains control of the assets in the trust. He or she can even revoke the trust, which is why it's referred to as revocable. This type of trust does not transfer the trustor's assets into a separate legal entity. While the trustor is alive, he or she will maintain control over the trust and even be a beneficiary of it. However, when the trustor dies, the trust normally reverts to the named beneficiaries in the trust documents.
You set up this type of trust if you want to retain control over the assets in the trust. But in exchange for that control, the trust has less legal protection from creditors and lawsuits. Meanwhile, there are no tax advantages, since any income earned in the trust passes to the trustor, who must pay tax on a personal level.
Once this type of trust is created, it cannot be canceled by the trustor, which is why it's referred to as irrevocable. This makes it better protected of the two primary types of trusts. But not only can the trustor not revoke the trust, he or she also cannot modify the terms. In effect, this trust sets up a completely separate legal entity in which the trustor gives up control. The trust is protected from creditors and lawsuits directed at the trustor.
Within an irrevocable trust, assets are moved from the grantor into the trust and therefore removed from his or her personal taxable estate. So, income earned within the trust is taxed to and paid by the trust itself.
Special Types of Trusts
Apart from revocable and irrevocable trusts, there are several other special types of trusts.
1. Living Trust
Commonly referred to as an inter-vivos trust, this type of trust is made while the trustor is still alive. The purpose is to provide for the trustor and his or her beneficiaries during the trustor's lifetime. It provides protection of assets. And any remaining funds in the trust pass to the trustor's beneficiaries upon his or her death.
2. Testamentary Trust
This is the exact opposite of a living trust in that it's created upon the death of the trustor. It must be a revocable trust, generally carried out by the executor of the estate, who will also act as trustee for the trust assets.
3. Generation-skipping Trust
A trustor sets up this type of trust in order to have his or her estate pass to grandchildren rather than children. It also avoids your children having to pay estate taxes. But the trustor still has the option of leaving part of the income from the trust to their children.
4. Charitable Trust
This trust names one or more charities as the designated beneficiary. It can be a standalone trust that the trustor funds during his or her lifetime. Or it can be part of a general trust in which some of the funds will go to the beneficiaries and the remainder to the designated charities.
5. Blind Trust
Typically used when the trustor is trying to avoid conflicts of interest or even conflicts between the beneficiaries of the trust. The trustee handles this trust without the trust beneficiaries even being aware it exists. These are sometimes used by politicians to avoid accusations of conflicts of interest between public and private affairs.
6. Credit Shelter Trust
Sometimes referred to as a family trust, it's used to reduce the trustor's estate for tax purposes. Funds are transferred into the trust, allowing the trustor's heirs to receive non-trust assets free from estate taxes.
7. Spendthrift Trust
A trustor sets up this type of trust if they're concerned their heirs or beneficiaries have poor money management skills. This trust keeps them from draining their benefits or inheritance early. It allows you to specify how and when trust assets can be accessed, such as by setting up a 20- or 30-year payout plan.
8. Special Needs Trust
You can make special needs provisions for a beneficiary in a regular trust. But you can also set up a dedicated trust for that purpose. It can be set up to provide for living expenses for the special-needs beneficiary for the rest of their life, or even allocated to specific purposes, such as medical expenses.
Tips for Estate Planning
A trust is one of the most valuable tools for estate planning purposes. But there are also other strategies you can take when planning your estates. Work with appropriate professionals, such as an estate attorney, CPA or appraiser. You should also have a will and perhaps a living will, which provides advice about your care to medical providers.
Consider giving the power of attorney to someone you trust for medical and/or financial decisions. You should also make sure that several of your family members know where to access your estate documents, including your will, trust documents, retirement plan information, savings and investments held outside of the trust, the deed to your home, important account numbers and a copy of any life insurance policies.
Remember that these are heavy decisions that have a long-term impact on your family. So talk to a professional before making a final decision. Review your estate plan on a regular basis and especially after major life events, such as a divorce or birth of a child.
Final Thoughts on the Uses of a Trust
A trust is an excellent tool to have even if you aren't “rich.” If nothing else, it guarantees that your assets get to the intended beneficiaries upon your death. It also avoids probate, which often comes with a simple will.
It's not even necessary to have a lot of financial assets to set up a trust. If you own a home and have significant life insurance, you can have those assets transferred into the trust upon your death so they'll be available for your beneficiaries.
And if you're at all concerned about lawsuits, perhaps because of the occupation you're in, speak to an attorney about how a trust can best protect you from potential threats.
Most people have more assets than they realize. And life has gotten only more complicated in recent years. A trust is one of the best protection you can have. And it can form the foundation of your overall estate plan.