What Is the Difference Between Fixed and Discretionary Trusts?

There are two different types of trusts: fixed and discretionary. If you wish to distribute your estate using this type of agreement, you need to choose the best option for your needs.

There are two types of trusts: a fixed trust and a discretionary trust. If you wish to distribute your estate using trust assets, choose the best option for your needs.

What Is a Trust?

trust holds assets for beneficiaries. The organization of a trust is straightforward. A trust provides assets for the benefit of the beneficiaries. A family trust is simply any trust vehicle you set up to benefit family members.

The person who creates it is the grantor (also called the trustor or settlor). The grantor establishes the trust and places assets into the trust. These assets become trust property.

A trustee controls the trust assets. A trustee ensures they get turned over to the recipients (beneficiaries or heirs) with entitlement to the trust assets.

Like a will, a trust is a way to distribute an inheritance. In some ways, a trust is more straightforward than a will. For example, the grantor legally transfers property to the trust rather than directly to the beneficiaries. This makes legal challenges and conflicts between family members over inheritance less likely.

With a trust, keeping each person's inheritance details private is also possible. The beneficiaries do not know what the other heirs received. When the trust owns assets, probate is unnecessary when you transfer all your assets to the trust.

Tax Implications for Distributions from a Trust

Trust funds can also offer tax advantages. For tax purposes, beneficiaries typically pay for the earnings they get out of the trust, not the entire value of the trust. By distributing wealth over time, you can lower the tax burden for your beneficiaries.

A beneficiary's distribution from a trust can come from the trust's interest income. A trust beneficiary is generally required to pay income taxes on it. But if the trust has already paid the income tax, there's no extra tax due. A trustee makes distributions from the trust's principal. When this happens, the IRS assumes that the settlor paid the taxes before placing the principal into the trust. When this is the case, more taxes are not required for the distribution.

What Is a Fixed Trust?

A fixed trust identifies the beneficiary or beneficiaries. A fixed trust details how to distribute assets. The trustee still oversees the distribution, but they cannot change the terms of the trust that you laid out.

As grantor, you provide directions about:

  • The schedule of distribution of the trust income
  • The division of all the assets (who gets what from your estate)
  • Any other parameters or conditions

Because the grantor provides the necessary details, fixed trusts do not necessarily need an individual trustee. In some cases, a financial institution can handle the distribution of assets in the trust.

There are two forms of fixed trusts: life interest and conditional.

Life Interest Trust

A life interest trust gives you a way of determining who will inherit certain assets. When setting up a life interest trust, you will choose the heir receiving the life interest (a life tenant). You will also determine the other beneficiaries who will get the assets upon the life tenant's death (or the occurrence of a specific event).

One of the simplest examples of a life interest trust is when you want your spouse to inherit your estate. Following your spouse's death, all the family assets go to your children. A life interest trust can ensure that your children remain beneficiaries. This would protect assets from passing to future stepchildren. If, for instance, your spouse remarries and has stepchildren, the life interest ensures assets go to your children.

Conditional Trust

A conditional trust is also known as an incentive trust. It is an agreement that puts specific rules on the distribution of the inheritance. The trustee manages the assets in the trust until the beneficiaries meet particular conditions.

As the grantor, you can make many decisions. For example, you can decide to have assets distributed when:

  • A beneficiary gets married
  • Has a child
  • Graduates from college

Conditional trusts typically inspire or reward specific decisions, types of behavior, or life choices.

If you are the grantor, you can make the rules for obtaining inheritance as simple or detailed as you want. For example, you could stipulate that beneficiaries live in the same state as their surviving parent to get a part of the estate.

What Is a Discretionary Trust?

A grantor sets up a trust but does not specify the beneficiaries in a discretionary trust. A discretionary trust does not provide any guidance about the division of the estate. The trustee makes decisions about the distribution of the assets.

With discretionary trusts, the trustee decides the distribution of the assets. The grantor passes these decisions to the trustee, who can divide the estate as they see fit. The beneficiaries have few rights in this arrangement. They cannot claim or demand any assets or funds from the trust. The trustee decides how to distribute the inheritance.

Discretionary trusts are an option when the grantor is concerned about their beneficiary's ability to manage the inheritance. These trusts may also be an answer if heirs are too young or the beneficiary struggles with conditions that would make managing an estate difficult.

Who Benefits From Each Type of Trust?

The type of trust you choose depends on the benefits you want to provide and who you would like to receive them. Here's a look at who gains from each type of trust.

Fixed Trust

Because the terms of a fixed trust are unchangeable, they benefit the grantor. A beneficiary has a fixed interest in the trust assets and a fixed entitlement to income. The trustee is legally required to follow the grantor's directions.

A fixed trust can give you the most peace of mind and control over the estate planning process. For this to happen, you need to clearly explain your wishes for the trust so there is no room for misinterpretation.

Meanwhile, the trustee has no discretionary powers over the distribution of the trust assets. They must follow the grantor's wishes. Beneficiaries can also enjoy the advantages of fixed trusts because their inheritance is less likely to be contested.

Discretionary Trust

Discretionary trusts can benefit both the grantor and beneficiaries:

  • Ensures the estate gets used for the beneficiary's benefit while engaging in asset protection, protecting against misuse or misappropriation.
  • In specific instances, such as if both parents die simultaneously, children can receive the necessary benefits to continue their education while the trustee manages the estate. The child can then take over the management of the estate when they come of age.
  • A discretionary trust can be adapted for education and health purposes to ensure orphaned beneficiaries have adequate funds for their education and medical needs as they grow.
  • Depending on the estate laws in their state, the trustee can alter the discretionary trust to increase the value of assets or create tax advantages that could benefit the beneficiaries.

Though the trustee handles the discretionary trust decisions, the grantor must select the trustee. You will maximize the benefits of a discretionary trust if you choose a reliable trustee.

Spendthrift Trust

spendthrift trust is distinct from a discretionary trust. With a discretionary trust, the trustee decides how and when to disburse the trust. With a spendthrift trust, the trustee might be required to make disbursements in compliance with specific instructions in a trust document.

A spendthrift trust seeks to distribute assets more gradually and more controlled. The grantor may be concerned that the beneficiary won't use the money responsibly or could be easily defrauded.

With either trust, once assets are distributed to a beneficiary, creditors can seize the assets. To prevent the seizure of trust assets, the trustee of a discretionary trust can pay expenses. For example, the trustee can pay tuition or the mortgage on real estate. Because a beneficiary never takes possession of such funds, creditors cannot claim the assets.

Setting up a Trust

Getting legal advice is critical to set up a fixed or discretionary trust. It would be best to consider factors like the value of your assets, your marital status and family size, and the needs of your beneficiaries. Once you understand these factors, you can start researching trusts and decide which option suits your needs.

Your attorney can help you explore several trusts, including a revocable living trust or whether to establish a testamentary trust. You must select a trustee to handle the administration of the trust and set out the conditions for managing and distributing your inheritance. Consider contacting an experienced estate planning lawyer to ensure you use the correct trust for your needs and that you set up your trust correctly.

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