What Is a Trust and How Does It Work?

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A trust can shield assets from estate taxes and probate fees, allowing you to leave the most to your loved ones. Learn about the various types of trusts and whether you should create a trust agreement as part of your estate planning process.

 

What Exactly Is a Trust?

A trust is a fiduciary legal arrangement that allows a person (known as the trustor, settlor, or grantor) to grant permission to a third party, or trustee, to hold trust property or assets (in the form of a trust fund or trust account) for the benefit of the trust's beneficiaries.

 

Purpose of a Trust

For one of several reasons, you may want to establish a trust instead of or in addition to a last will and testament:

Estate planning: Trusts allow you to specify how you want your assets distributed to your loved ones in advance, avoiding costly probate processes and taxation. You can also set up a trust for your children in which the trust company will hold your assets until they reach the age of majority.

Long-term care: The trust's terms may provide long-term healthcare for surviving spouses, family members, or loved ones with mental health issues, physical disabilities, or other incapacities for a period of time.

Privacy: In some cases, you may want to create a trust document to keep your affairs private, because traditional wills executed through probate court frequently contain public information.

Probate court evasion: When someone dies and leaves a will, establishing a trust allows your loved ones to avoid the costly and time-consuming probate process required by state law. Beneficiaries who avoid probate have quicker access to assets such as bank accounts and life insurance proceeds than those who go through the probate process.

Tax benefits: Including a trust in your tax planning allows your loved ones to benefit from lower IRS tax rates on trust assets (such as real estate) when compared to traditional wills. Trusts create a federal estate tax exemption, allowing your beneficiaries to pay less income tax on their tax returns.

 

12 Types of Trusts

You can choose from several trust funds, each with a different structure, depending on your needs and how you want to distribute your assets. The following are some of the most common types of trusts:

1. Charitable lead trust: This type of trust makes financial donations to the charity or charities of your choice for a set period of time before transferring any remaining assets to other beneficiaries.

2. Charitable remainder trust: A charitable remainder trust provides you with income for a set period of time, with any remaining funds going to the charity or charities of your choice. This type of trust aids in the reduction or avoidance of gift taxes.

3. Credit shelter trust: Also known as a family trust or a bypass trust, this type of trust allows you to leave an amount up to the estate tax exemption to your surviving spouse while the remainder of your estate passes tax-free to your spouse.

4. Generation-skipping trust: Often used in second marriages, this trust directs your assets after the death of your surviving spouse to the beneficiaries you name rather than your surviving spouse's family members.

5. Irrevocable life insurance trust: With this trust, any proceeds from your life insurance policy are exempt from estate taxes. Life insurance trusts are frequently unchangeable once established.

6. Living trust: Also known as an inter-vivos trust, a living trust allows you to use your assets during your lifetime while having them transferred to your beneficiaries after your death via a trustee.

7. Marital or "A" trust: Your surviving spouse will benefit from this trust, which will be included in their taxable estate.

8. Qualified terminable interest property trust (QTIP): QTIP trusts are used by married couples to maximize exclusion amounts when claiming the marital tax deduction. Property interest transfers after death under the marital deduction result in lower or no estate or gift taxes.

9. Special needs trust: This type of trust allows a disabled loved one to receive income from the trust while continuing to receive government benefits.

10. Spendthrift trust: This trust protects your loved ones' assets from creditors and prevents beneficiaries from selling their interest in the trust.

11. Testamentary trust: Also known as a will trust, a testamentary trust requires your loved ones to go through probate court to receive any financial assets.

12. Totten trust: This type of trust is only used for financial assets such as bank accounts; you create it during your life and act as the trustee, and the remaining assets pass to your beneficiaries upon your death. Totten trusts are free to create and can be established by adding legal titles to your financial accounts such as "As Trustee For," "In Trust For," or "Payable on Death to."

 

How Does a Trust Work?

Trusts are established with an estate planning attorney at a law firm or a trust company by signing a legal document outlining how and when your assets will be distributed to the trust's beneficiaries. The assets of the named beneficiaries are held by the trust company or trustee until they are distributed.

Some trusts permit the grantor to serve as both a successor trustee and a beneficiary at the same time. Others distribute the assets gradually over time or all at once after the grantor's death. Many trusts assist beneficiaries in reducing or eliminating estate taxes, protecting assets from creditors, and avoiding the probate process.

 

What Is the Difference Between Revocable and Irrevocable Trusts?

All trusts are classified as either revocable or irrevocable.

Irrevocable Trust: Your beneficiaries can avoid estate taxes and probate with the help of an irrevocable trust. You cannot change or terminate the trust once it has been established. Choosing an irrevocable trust removes trust assets from your estate, which means they are no longer taxable. When your beneficiaries receive the assets, they may be required to pay income tax.

Revocable trust: A revocable living trust allows you to control your assets during your lifetime and pass them on to your beneficiaries without going through the probate process. The revocable nature of the trust allows you to make changes or terminate it at any time, but it becomes irrevocable upon your death. In the event of incapacity or death, you may appoint a successor trustee.

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