Trust Fund Basics Explained

Trust funds have gotten a bad rap. Many Americans view them as a tool for wealthy parents to ensure that their adult children can't squander their inheritance. But trust funds are also an estate planning tool. They can help those with moderate incomes control the distribution of their assets to family members after they die.

While attorneys usually draft the trust document, the legal process is reasonably straightforward. A trust agreement is a legal arrangement that allows a person to transfer assets to a trust fund that will benefit specific individuals or organizations. The person who establishes the trust is generally referred to as a settlor, trustor, or grantor. Trust funds also provide tax exemptions and benefits. The IRS does not levy gift taxes on trusts. Some trust assets also are excluded from your taxable estate. In contrast to a last will and testament, trusts avoid the hassle of waiting for a probate court to distribute a decedent's assets.

This article outlines trust fund basics, benefits, and the many different types of trust funds. It also explains the advantages and disadvantages of trust administration.

Trust Fund Basics

A trust fund is an independent legal entity that holds assets for the benefit of trust beneficiaries. Trusts are often used as an estate planning tool to control and distribute assets. These assets can include:

• Bank accounts
• Retirement accounts
• Personal property
• Real property
• Life insurance and annuity proceeds

To create a trust fund, there must be at least three parties that fall into one of the following categories:

• Grantor: The person who establishes the trust and transfers the money, stock, business, or other assets into the trust.

• Beneficiary: The person or organization intended to benefit from the trust. A beneficiary does not own the trust property. Instead, the beneficiary has the right to receive the benefit of the property as the terms of the trust allow.

• Trustee: The trustee acts as a fiduciary, manages the property owned by the trust, and follows the trust's directions. A trustee can be an individual or an organization, such as a bank or a law firm. Many trusts also name a successor trustee in case the original trustee is unable or unwilling to fulfill their fiduciary duties.

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. These 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 that the child's ex-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 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 both 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 an inter vivos trust, this is a type of trust where the grantor places assets during their lifetime. As opposed to a testamentary trust, which is created by a will after the grantor's death, a revocable living trust allows the grantor to 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 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.

• Spendthrift Trust: This trust limits the ability of a beneficiary's creditors to access the trust's assets in order to satisfy the beneficiary's debts.

• Life Insurance Trust: This is an irrevocable trust where the assets include a life insurance policy.

Funding Your Trust

Funding your trust is the process of transferring your assets into your trust's name. If the property or funds aren't properly transferred, the trust will still exist, but it will not fulfill its objectives. Any assets that are not correctly transferred to the trust will revert to the grantor. They will be distributed through probate under the intestate succession laws of your state.

There are 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. However, the assets may still go through probate and be exposed to creditor claims.

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, your surviving spouse can live in your family home until their death, and then the property will transfer to a named beneficiary.
• Trust funds can protect your assets from being squandered by your beneficiaries.

Disadvantages of a Trust Fund

While trust funds offer estate planning benefits, there are some drawbacks. 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 is subject to 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 the proper legal documents for your trust and that your beneficiaries enjoy its benefits.