Understanding Trusts: An Important Estate Planning Tool For Everyday Americans

Fortune Recommends August 22, 2023


Understanding Trusts: An Important Estate Planning Tool For Everyday Americans

When you think of a trust, you may have visions of contentious family gatherings in an attorney’s office after the death of a patriarch or matriarch. And sure, why not add sibling rivalries on par with the Roy family of Succession fame to keep things interesting? 

But here’s the truth: Trusts aren’t just for the uber-wealthy, and using one in your estate plan can make sense no matter how much money you have.

And let’s be honest: No one wants to think about dying. But that’s where the magic of estate planning comes in, as it’s a process about living. In fact, a survey by Wealth.com found that 76% of respondents created an estate plan to take care of their families. A trust could help you achieve that goal with its unique blend of privacy, asset protection, and the ability to avoid the potentially drawn-out process of probate.

What is trust? 

At its core, a trust is a legal document that creates a triangle-like relationship between three different parties: the trust, its trustee, and its beneficiaries. 

  • The trust is the legal entity that holds title to the assets inside.
  • The trustee is the trust’s decision-maker.
  • The beneficiaries are those who receive assets from the trust.

A trust—created by an individual called the grantor—spells out how assets can be used during a grantor’s lifetime and how those assets should pass to the grantor’s beneficiaries when they die. And many types of trusts offer an added estate planning perk: They avoid probate, which is a legal process in which a will is “proven” valid in a court of law. Because of this, probate can be a long and expensive process for your loved ones.

And while the word “trust” might be intimidating for some and reek of those oak-paneled attorney’s office walls seen in the movies, they’re simple arrangements that most people already use in their day-to-day finances, says Jay Knighton, a board-certified estate planning and probate attorney with Knighton & Stone.

“Business entities like LLCs contain that same triangle relationship between the president, the decision-maker; the LLC itself, which holds title to an asset; and the LLC members, who benefit from the LLC through distributions,” Knighton says. 

How do trusts work? 

While there are different types of trusts, they all work in a similar way. 

  1. The grantor establishes the type of trust they need.
  2. While forming the trust, the grantor specifies how the assets in the trust should be managed and passed to beneficiaries upon their death.
  3. Then, the grantor typically places assets inside the trust. This removes the assets from the grantor’s name and estate.
  4. The grantor names a trustee, which is the person charged with making the day-to-day decisions for the trust, its assets, and its beneficiaries.
  5. When the grantor dies, the trustee must direct the distributions of assets held in the trust according to the trust’s terms.

You can create a trust using one of many online estate planning tools or by contracting with an estate planning attorney. Whichever route you choose, you’ll need to have your trust documents signed and notarized to make them legally binding.


What is the point of trust?

So, why choose a trust instead of a will? Beyond trusts offering your family a road map for your wishes—a wonderful gift to give, especially during a time of heightened emotions—trusts generally offer a host of estate planning and asset protection benefits that will do not.

  • Avoiding probate. Many types of trusts avoid probate, the court-supervised process that validates a will, which can be a long and drawn-out process. If you need assistance with probate, you’ll typically need to hire an estate planning attorney, which can be costly.
  • Living benefits. Many trust types allow you to stay in control of assets in the trust throughout your lifetime. Trusts can also spell out how your trustee should handle your affairs if you become incapacitated or severely ill, which can bring ease to your loved ones.
  • Potential tax benefits. Since trusts remove assets from your estate, they can potentially help reduce estate and income taxes for your beneficiaries and preserve more of your wealth.
  • Providing for children. Trusts can spell out guardianship nominations for young children, plus create plans to help children inherit responsibly.
  • Charitable giving. Certain types of trusts can help you achieve specific philanthropic goals, whether it’s leaving $250 to a local animal shelter or $250,000 to a cancer research foundation.
  • Asset protection. Trust can help protect your assets from legal action, creditors, and life-changing events like divorce.
  • Provide privacy. Since assets held within a trust are titled in the trust’s name, the grantor’s and beneficiaries’ names aren’t on public record.

No matter your financial status, a trust can help you create a plan during your lifetime to ensure that your assets pass as quickly as possible to those you intend to provide for. And it can do so with many other benefits like privacy and protection that give your family a sense of comfort.


Trusts by category

Trusts fall into several different categories. The one you choose will likely come down to a combination of factors, including the types of assets you plan on putting into the trust, and whether you want to be able to make changes to your trust during your lifetime.


Living vs. testamentary trusts

If you want to retain control of the assets you place into your trust while you’re alive, a living trust is the way to go. A living trust is one you create while you’re still alive, and gives you—the grantor—full access to all of the assets within the trust. When you die, your named trustee takes control of the trust and the assets held inside.

If you have young children and worry about what they’ll do with an inheritance when you die, a testamentary trust could be a wise choice. A testamentary trust is created by your will upon your death and specifies when and how you want assets distributed to your children. For instance, you can dictate that a child only receives access to their inheritance when they turn 18, graduate college, or reach another life milestone.

How to remember the difference: Living trusts are created during your lifetime. Testamentary trusts are created via your will when you die.


Revocable vs. irrevocable trusts

If you want to easily make changes to your trust while you’re alive, you’re looking for a revocable trust—often called a revocable living trust. A revocable trust lets the grantor make changes to their trust during their lifetime, so long as they’re mentally competent. For instance, you can sell property held by the trust and change the beneficiaries with ease.

“A living trust is like a Swiss Army knife and has lots of flexible features,” says Eric Bond, a wealth manager at Bond Wealth Management. “It avoids probate and spells out what happens if you get sick, not to mention who gets what when you die and when.”

The “irrevocable” in an irrevocable trust says pretty much everything you need to know. Once you place assets into an irrevocable trust, they belong to the trust and they’re no longer under the grantor’s control. So unlike a revocable trust, making changes to an irrevocable trust is much more complicated and requires legal or beneficiary approval to change. However, for the wealthy, irrevocable trusts have their benefits. 

“One of the benefits of an irrevocable trust is that it keeps assets out of your estate that can create unforeseen tax consequences,” says J.R. Gondeck, managing director and partner at the Lerner Group, a wealth management firm.

How to remember the difference: Revocable trusts can be changed during your lifetime. Irrevocable trusts are generally set in stone, and changes require legal or beneficiary permission.


Funded vs. unfunded trusts

A funded trust has assets titled in the name of the trust. For instance, if you place your house, car, and grandma’s diamond ring in your trust, you have a funded trust.

An unfunded trust usually has a negligible amount of assets inside—usually $1.00—to legally meet the requirements for a valid trust while the grantor is alive. But when the grantor dies, an unfunded trust becomes a funded trust through the grantor’s will. Their will specifies the assets that should be transferred to the trust. The downside? Since the will transfers assets to the trust, the will must go through probate.

How to remember the difference: A funded trust avoids probate and places assets into your trust while you’re alive. An unfunded trust only receives assets as instructed by your will when you die and doesn’t avoid probate.

What are the different types of trusts? 

While a simple living revocable trust often meets the needs of many individuals, some require more specialized trusts to achieve their goals. 


AB trust

An AB trust—often called a credit shelter or bypass trust—is a type of trust arrangement used by married couples to get the most benefit from estate tax exemptions.

An AB trust is actually two trusts. The easiest way to remember them is that the A trust is for the person “above ground,” and the B trust belongs to the person “below ground,” says Bond. 

Assets up to the annual estate tax exemption are placed in the B trust to avoid estate taxes and generally pass to the couple’s children, “bypassing” the spouse. Then, the remaining assets are placed into the surviving spouse’s A trust. When the surviving spouse dies, assets in both trusts pass to the designated beneficiaries.

From the late 1980s and early 2000s, AB trusts had their heyday since estate tax exemptions were drastically lower than they are today. For instance, individuals could exempt only $650,000 in assets from estate taxes in 1999, compared to $12,920,000 in 2023. Since today’s estate tax exemptions are so high, these trusts aren’t used as often as they once were, says Bond.

May be best for Highly affluent married couples with large estates who want to max out their estate tax exemptions.


Charitable trust

A charitable trust can benefit three parties: you, the grantor; your beneficiaries; and a charitable cause. They come in two types: charitable remainder trusts and charitable lead trusts. However, they do share one thing in common: The benefiting charity must be a qualifying organization per Internal Revenue Service guidelines.

A charitable remainder trust is a type of irrevocable trust that provides income for you or your beneficiaries during your lifetime. You’ll generally transfer highly-appreciated assets into the trust, which the trust then sells—avoiding capital gains taxes—to create the income stream. Then, whatever assets remain in the trust after your death are distributed to one or more charitable causes.

A charitable lead trust is an irrevocable trust that’s the opposite of a charitable remainder trust. It first pays benefits to the charitable beneficiaries of your choice during your lifetime. When you pass, the remaining assets are distributed to your beneficiaries. A charitable lead trust can be funded during your lifetime or when you die through instructions in your will.

May be best for Those with highly-appreciated assets like stocks that can be used to help meet philanthropic goals during or after their lifetimes.


Grantor retained annuity trust (GRAT)

A GRAT is an irrevocable trust generally used by the wealthy to reduce tax implications for their beneficiaries. To set up a GRAT, you’ll transfer assets into the trust that are expected to appreciate over time. Then, you’ll specify the term for which you’ll receive an annuity payment based on those assets. Once the GRAT’s term expires, the assets and any appreciation of those assets in the trust will pass to your beneficiaries with little to no estate tax burden.

May be best for Wealthy individuals who want to help family members avoid paying estate taxes on their inheritance.


Irrevocable life insurance trust (ILIT)

Putting life insurance into a trust? Absolutely, and it’s a strategy the wealthy use to cover several bases. 

With an ILIT, you fund an irrevocable trust using one or several life insurance policies. When you die, the payouts from those policies typically avoid estate taxes but can be used to pay for things like state estate taxes and funeral expenses. For the affluent, the funds in an ILIT can help avoid the need to liquidate assets like a business to meet these financial needs.

May be best for Those who expect to have to pay state estate taxes and want to protect life insurance policies from creditors or divorce. 

Special needs trust

If you have a loved one with physical or mental disabilities who’s under age 65, a special needs trust can help provide for their long-term care. The main benefit of special needs trusts is that assets held in them don’t impact the beneficiary’s eligibility for Social Security and Medicaid benefits. Funds in a special needs trust can be used for several purposes, including caregiving, personal attendants, clothing, furniture, and education.

Since there are three types of special needs trusts, it may be best to set one up with an attorney specializing in special needs trusts.

May be best for Those with mentally or physically disabled family members.


Trust vs. Will

While trusts and wills are both estate planning tools that direct how your assets should be distributed when you die, they share some notable differences.

  • Probate. Many trusts avoid probate, while all wills must go through probate before assets can be distributed to beneficiaries.
  • Privacy. Trusts remain private, but a will becomes a public record the moment it’s submitted for probate.
  • When they go into effect. A trust goes into effect immediately upon signing during the grantor’s lifetime, while will only go into effect upon death.
  • Living benefits. Trusts can designate how a trustee should manage your affairs if you become incapacitated, while a will only applies after death and, therefore, has no living benefits.
  • Property each transfer. A trust can only distribute property that’s been transferred into and titled in the name of the trust. A will can only direct property that’s in your name at the time of your death.


Frequently asked questions 


Who controls trust?

The person designated as the trustee controls the trust and the assets held within it. The trustee is named when the trust is created and is responsible for managing the trust and distributing the assets to the trust’s beneficiaries.


How much does it cost to set up a trust?

The cost to set up a trust generally depends on two factors: how you set it up and the trust’s complexity. Setting up a trust using online tools can cost between $200 and $800 while using an attorney generally costs $1,000 or more.


Can someone contest a trust?

A trust can be contested just like a will, and often, for many of the same reasons. Some of the most common grounds for contesting a trust include fraud, undue influence, and lack of mental capacity.

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