Trust Fund Basics Explained
Trust funds have gotten a bad rap. That's primarily because many Americans view them as a tool for wealthy parents to ensure that their adult children can't squander their inheritance. The reality is that trust funds are a widely used estate planning tool that can help even those with moderate incomes control the distribution of their assets after they die.
While attorneys usually set up trust funds, they operate in a reasonably straightforward manner. Essentially, they are a legal arrangement that lets a person place assets in a trust fund to benefit specific individuals or organizations. Trust funds also provide tax benefits and avoid the hassles of waiting for a probate court to distribute your assets.
The following sections will outline trust fund basics, their benefits, and the different types of trust funds. They will also explain the advantages and disadvantages of using a trust fund for estate planning.
Trust Fund Basics
A trust fund is an independent legal entity that holds assets and property for the benefit of people or organizations. They are often used in estate planning to hold money, investments, businesses, property, and other types of assets.
To create a trust fund, you must have at least three parties that fall into one of the following categories:
- Grantor: The person who established the trust and put the money, stock, business, or other assets into the trust.
- Beneficiary: This is the person, group, or organization intended to benefit from the trust. They do not own the trust property but have the right to receive the benefit of the property as the trust allows. For example, a grandchild can receive distributions to pay for college.
- Trustee: The trustee is responsible for managing the property owned by the trust. A trustee can be an individual or an organization, such as a bank or a law firm.
What Are the Benefits of a Trust Fund?
Establishing a trust fund for your designated beneficiaries can provide substantial benefits if you plan on passing assets along to your loved ones after you die. Those benefits include:
- Protecting your beneficiaries: If your children are minors or lack the skills necessary to manage their own assets, a trust fund can ensure that someone else is looking after the assets on their behalf. If you are setting up a trust fund for minor children, you can set up the trust so that the assets are released to them when they reach a specified age.
- Asset protection: Putting your assets in a trust fund can ensure that other parties cannot take the assets from your beneficiaries. For example, if you set up a trust fund for one of your children and they get divorced after you die, the trust fund can be structured to ensure the spouse has no claim on the assets.
- Reducing the estate tax: The federal estate tax is applied to an individual's assets when they die. By placing your assets into a trust fund before you pass away, you minimize the size of your estate and can substantially reduce or eliminate the estate tax due.
- Avoiding probate: Probate is the process through which your assets are distributed to your beneficiaries by a probate court. While the process ensures that your beneficiaries receive what they deserve, probate can be time-consuming and expensive. Assets placed into a trust will usually pass to the beneficiaries outside of the probate process.
Types of Trust Funds
The type of trust established by the grantor will depend on their goals in establishing the trust and the benefits they seek for their beneficiaries. Your state's laws will also govern the types of trusts that are permitted, how trusts are created, as well as how trusts operate.
Commonly used trusts include:
- Irrevocable Trust: As the name suggests, they generally can't be changed once these trusts are created. This form of trust is used by individuals concerned about estate taxes or protecting assets from future creditors.
- Revocable Living Trust: Also known as a living trust, this is a type of trust where the grantor places assets during their lifetime. However, unlike an irrevocable trust, the grantor can still change the trust or revoke it while they are alive. Once the grantor dies, the trust becomes irrevocable and can no longer be changed.
- Special Needs Trust: These trusts are set up to provide for a beneficiary who is disabled and relies on government assistance. Special needs trusts are set up to allow the beneficiary to remain eligible for Medicaid and Supplemental Security Income (SSI).
- Charitable Remainder Trust: This is designed to distribute assets to a specified charity at the end of the trust. Benefits include immediate tax credits to the grantor and a fixed-percentage amount of income to the beneficiary during the life of the trust.
Funding Your Trust
Funding your trust is the process of transferring your assets into your trust's name. It would be best if you funded your trust; otherwise, the trust serves no purpose. If the property or funds aren't properly transferred, the trust will still exist, but it will not fulfill its objectives. The assets that were not correctly transferred to the trust will revert to the grantor and will be distributed through probate under the intestate succession laws of your state.
You have two opportunities to fund your trust: when you are alive or after you have died. Funding your trust while you are alive ensures the process is handled according to your wishes. All titled property, such as real estate or stocks, need to have the title changed to reflect the trust's ownership.
A "pour-over will" can be used to fund your trust after you die. The will "catches" any forgotten asset and sends it to your trust. The assets may still go through probate first and be exposed to creditor claims, but then they can be distributed according to the instructions in your trust.
Advantages of a Trust Fund
There are several advantages to creating a trust fund, including:
- Trusts remain private, so only the trustees and the beneficiaries know your wishes. A will becomes public record after you die.
- A trust can provide for distribution over a period of time. For example, a monthly living allowance can be provided until a child reaches a predetermined age.
- Trusts can cover property that a will cannot, such as life insurance policies and retirement plans.
- In some states, a trust can live on indefinitely.
- You can ensure your property is distributed under the conditions you set. For example, the remaining spouse can live in a family home until their death, and then the property will transfer to a named beneficiary.
- Trust funds can protect assets from your beneficiaries.
Disadvantages of a Trust Fund
While trust funds offer estate planning benefits, there are some drawbacks. Most of them are in the form of increased costs. For example, trust funds are usually set up by estate planning attorneys working with a financial planner who can charge hundreds of dollars an hour.
Additionally, trust funds usually incur annual management fees that pay for the work involved in overseeing the assets. The rate charged depends on the manager. Some charge a percentage of the value of the assets under management, while others charge per transaction.
One final disadvantage of a trust fund is that it will need to pay federal income taxes on any income it receives from its investments and does not distribute to its beneficiaries.
Additional Questions? Contact an Attorney
Deciding whether a trust fund is appropriate for you depends on your unique circumstances, what you want to accomplish, and the laws of your state. There are numerous types of trusts used to address specific situations. Consulting with a local estate planning attorney and a financial planner will ensure that you establish a trust that meets your needs and that your beneficiaries enjoy its benefits.
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