There are many reasons to create a trust, such as handling estate tax or passing money to trust beneficiaries, making this property distribution technique a popular choice for many people when creating an estate plan.
You should understand some practical information about trusts, such as:
This article will review the general trust process and the types of trusts you may want to consider.
Why Would I Want a Trust?
A trust allows the grantor to specify conditions before someone else receives any benefits (typically money.) It also spreads the payment of benefits over a period of time instead of making a single gift.
These main reasons are why people prefer to include a trust in their will. It is a great way to reinforce their preferences and goals after death.
Creation of a Trust
Typically, a trust grantor will set up a legal arrangement. This arrangement allows a person (called the “trustee") to manage and administer the trust property. The money in the trust and the management of it are all for the benefit of a beneficiary.
The basics of trust creation are fairly simple. To create a trust, the property owner (called the "trustor," "grantor," or "settlor") transfers legal ownership to a family member, professional, or institution.
This person is called the "trustee." They manage that property for the benefit of another person (called the "beneficiary"). The trustee often receives compensation for their management role.
Trusts: Relationship Between The Creator, Trustee, and Beneficiaries
Trusts create a "fiduciary" relationship running from the trustee to the beneficiary. “Fiduciary" simply means a relationship involving trust. This relationship means that the trustee must act solely in the best interests of the beneficiary when dealing with the trust property.
If a trustee does not live up to this duty, the trustee is legally accountable to the beneficiary for any damage to their interests.
A trustee is often compensated for their management of the trust. Regardless of whether they are paid, they still must act in the beneficiary's best interests.
Can I Create a Trust and Be the Trustee?
The property owner or “grantor" may act as the trustee for their living trust. This will keep ownership of your property instead of transferring the property.
In short, this pauses the trust, since it won't be effective until you allow the property to transfer. However, you must still act in a fiduciary capacity for the trust and protect the trust.
A grantor can also name themselves as one of the beneficiaries of the trust or among several beneficiaries. In any trust agreement, however, the trust doesn't become effective until the grantor transfers the property to the trustee.
Naming A Successor Trustee
As stated above, a grantor may name themselves as trustee of a living trust during their lifetime only. They should name a successor trustee to act when they are disabled or deceased. The obligations created by these different roles are important to consider when establishing a trust.
At the grantor's death, the successor trustee must distribute the assets of the trust according to directions in the trust document. In many states, certain people must be notified of the death of the grantor.
Example of a Legal Trust Situation
Let's say a grantor transfers money to a bank account. The bank is serving as the trust company, or trustee, for the grantor's children.
The bank is instructed to pay the children's college expenses as needed. Over the years, the bank carefully manages the money to ensure there are funds available for this purpose.
The bank is performing its fiduciary duty correctly. The children do not have control of the funds and cannot use the funds for any other purposes.
Years later, the children have graduated and never had to worry about expenses. The trust has been fulfilled. Any money left in the trust will go to the children, or wherever the terms of the trust wanted leftover funds distributed.
Types of Trusts You Can Create
A trust can be an important tool for anyone looking for help managing money and property during their lifetime. A trust can also be a good tool to use in planning what will happen to your money and property when you pass away. It allows your family to inherit from you without having to go through the long and expensive probate process.
There are many different kinds of trusts possible. Generally, all trusts can be separated into two groups:
- Revocable trusts: can be changed or completely revoked at any time by their creator or “grantor."
- Irrevocable trusts: cannot be changed or revoked by the creator or grantor at any time for any reason.
The key difference (that one can be revoked and the other cannot) is apparent in their names. However, the reasons for selecting one or the other have more to do with details about ownership and control.
Testamentary Trusts vs. Living Trusts
After revocable and irrevocable trusts, trusts fall into two broad categories:
- Testamentary trusts: transfers property into the trust only after the death of the grantor.
- Living trusts (sometimes called an "inter vivos" trust): start during the life of the grantor but may be designed to continue after their death.
You may hear about trusts that are a combination of these different terms, such as a revocable living trust. The details of different types of trusts are explained in more depth below.
Testamentary Trusts 101
The testamentary trust is not automatically created at death. It is commonly specified in a will. As a will provision, the trust property must go through probate prior to commencement of the trust.
Example of a Testamentary Trust
A parent named Taylor writes a will. The will specifies that upon their death, Taylor's assets should be transferred to a trustee or co-trustee.
The trustee manages the assets for the benefit of Taylor's children until they reach a certain age. This age could be set by Taylor, or whenever the trustee believes the children will be ready to control the assets on their own. The trust ends once the children control the assets.
Living Trusts 101
Living trusts are trusts that are created during the lifetime of the person who set up the trust – usually referred to as the “grantor" or “settlor."
The most common reason for a living trust is to avoid the probate process, which is required to administer a will. A living trust is a good option for a parent who:
- Wants to provide some income and security for their child.
- Doesn't believe that the child could handle the full amount of property responsibly
Aside from protecting a minor, a living trust can also help an individual reduce taxes and regulate the use of their assets. This can be important if the settlor ever becomes incapacitated.
A living trust may help avoid probate if all assets subject to probate are transferred into the trust prior to death. A living trust may be "revocable" or "irrevocable."
Revocable Living Trust 101
A revocable trust is one that can be changed or removed. They are often just called a "living trust." These are trusts where the person making the trust:
- Transfers their title of property into the Trust
- Serves as the initial Trustee
- Has the ability to remove, change, modify, alter, or entirely revoke the trust during their lifetime
The grantor of a revocable living trust can change or revoke the terms of the trust any time after the trust commences. The grantor of an irrevocable trust, on the other hand, permanently relinquishes the right to make changes after the trust is created. It can't be altered, changed, modified, or revoked once it has been created.
A revocable trust typically acts as a supplement to a will, or as a way to name a person to manage the grantor's affairs should they become incapacitated. Even a revocable living trust usually specifies that it is irrevocable at the death of the grantor.
Trusts of this sort are useful because the trust owns the property, rather than the person making the trust. This is helpful when the person dies because the property held “in trust" is not subject to probate.
Living Trusts and Debts
Revocable trusts may be vulnerable to claims by the creator's creditors. To access these assets, the creditor needs to petition the court for an order enabling them to access the assets of the trust.
However, the control the trust maker maintains in trusts of this kind is precisely what makes the assets vulnerable to creditors. Upon death a revocable trust becomes irrevocable.
Tax Benefits of Trusts
Trusts can provide various tax benefits, including lowering your overall tax liability in some circumstances. Most trusts come with various tax incentives.
There can be reduced estate taxes, for example, for more complicated living trusts.
AB Trust and Marital Bypass Trust
Another type of trust that has tax benefits is the AB or marital bypass trust. The AB trust is only available to married couples and it allows them to maximize their federal estate tax exemption.
The basic idea is that upon one spouse's death, their property goes into an irrevocable trust (trust A) and the surviving spouse's share goes into trust B.
The irrevocable trust can be used for the benefit of the surviving spouse, even though they don't actually own the property.
Once the surviving spouse dies, the couple's children are able to receive the property from both trust A and trust B without having to pay taxes.
Another common trust is a charitable remainder trust – which also provides tax benefits. In a charitable remainder trust, a settlor sets up a trust and put the money they want to give to charity in it. This must be approved by the IRS.
The charity serves as the trustee and pays a portion of the accumulated income of the trust funds back to the grantor, or other named person. The trust terminates upon the grantor's death and the property donated will go to the charity.
One major benefit to the grantor's heirs is that the money and property in a charitable trust are not included when determining the deceased person's estate tax.
Irrevocable trusts transfer assets before death and thus avoid probate. However, revocable trusts are more popular as a means of avoiding the probate process.
If a person transfers all their assets to a revocable trust, they don't own any assets at their death. Therefore, their assets don't have to be transferred through the probate process.
Even though the grantor of the trust died, the trust did not die, so the trust assets do not have to be probated. However, trusts avoid probate only if all or most of the deceased person's assets had been transferred to the trust while the person was alive.
To allow for the possibility that some assets were not transferred, most revocable living trusts are accompanied by a "pour-over" will, which specifies that at death, all assets not owned by the trustee should be transferred to the trustee of the trust.
Example of Transferring Assets With a Trust
Tan sets up a revocable trust. It states that when they die, Tan's assets should be distributed to Tan's children in equal shares. Tan transfers a house to the trust but does not transfer some owned rental real estate property.
At Tan's death, the trust can distribute the house outside of the probate process. However, the rental real estate will have to be probated.
Based on the will, the probate court will order the rental real estate to be transferred to the trustee. Then, the trustee will distribute it according to the terms of the trust.
Learn More About Trusts from an Attorney
Trusts have important tax, governmental assistance, probate, and personal ramifications. It's best to consult an experienced trust attorney who can help with any stage of the process, from preliminary discussions to the execution of trust documents.
A trust involves a lot of paperwork and can be difficult to set up properly. However, there are other estate planning documents you can DIY from home. If you have a simple estate, then a guided, state-specific estate plan may be the right step for you.