What are trusts, and should you have one?
Trusts are incredibly useful tools. Yet, there are so many different types of trusts such as an irrevocable trust or revocable trust. The official sounding language surrounding trusts can make them seem confusing to some people and even treated with scorn by others (as in the pejorative term “trust fund baby”).
So, what exactly are trusts?
Trusts are used for a variety of purposes. The most common type of trust, a revocable living trust, is designed to protect assets and ensure they are securely held and passed to beneficiaries according to specific wishes. There are three parties generally involved in a trust agreement:
- Grantor (or Trustor) – this is the person who establishes the trust
- Trustee – this person is set up to administer the trust should the grantor become incapacitated or once the grantor passes away
- Beneficiaries – these are the people and/or institutions who gain the benefits of the trust
“Creating a living trust isn’t a complicated process,” said Catherine Hammond, attorney at the Hammond Law Group, which practices only estate planning and elder law. “It definitely involves an investment from the person creating it because a good plan will holistically address your family, your assets, your goals, and your concerns. It should be tailored specifically to your unique situation. It’s vital to work with an estate planning attorney who can walk you through the typical challenges of disability and death and help you identify what’s important to you. The goals you identify may not be things that you would necessarily think of in your day-to-day life without the benefit of guidance from someone who deals with these issues regularly.”
Since living trusts don’t have to pass through the probate process, beneficiaries generally gain access to these assets much faster than assets that are transferred using a will. Also, the probate process can feel like a hassle and, in many states, is a public proceeding. A living trust allows assets to pass outside of the court and remain private, which is important to many. One of the most common reasons to set up a living trust is to avoid the cost of probate at death, which is largely because of the fees charged by lawyers.
The main benefit of many trusts is that they protect your wealth from certain creditors or concerns while allowing you to control it. You can set up a trust so that assets remain available to you during your lifetime while designating where the remaining assets will pass after your death. Trusts can be especially useful in complex family situations, such as when there is the potential for family fighting or there are children from more than one marriage. In addition, they can protect your assets for the benefit of your loved ones after you’re gone. If they get divorced, if they have creditors, or even if they just haven’t fully matured financially, a client’s trust can protect them from their own naiveté.
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The origins of trusts can be traced back almost 1000 years. In 1066, the aptly named William the Conqueror captured England and declared that all lands belonged to the King. However, that was a lot of land for one person to manage, so he allowed others to administer lands for him. That management was known as tenure (this is where we get the term “tenant”). A resident could pass on this tenure to the eldest son, who had to pay the King an estate tax (the foundation of today’s estate tax system).
When the Magna Carta was approved in 1215, it contained a provision that, if a tenure died and his heir was underage, a guardian was appointed until “he became of age”, which is the basis for today’s trust.
Types of Trusts
Before we break down the different types, we need to review a major distinction of all trusts: whether they are revocable or irrevocable.
Revocable trusts: When a trust is revocable, a grantor retains control of everything in the trust during his or her lifetime. These trusts are flexible and are able to be dissolved at any time, should circumstances or intentions change.
In a revocable trust, the grantor can also be the trustee (or a co-trustee) to retain ownership and control over the trust, its terms, and assets. A revocable trust typically becomes irrevocable upon the death of the grantor.
Revocable living trusts help avoid probate, but they may be subject to estate taxes and are still considered to be part of the grantor’s assets.
“Establishing a revocable living trust is the easiest way to avoid probate,” said Jessica Showers, a former attorney at the Hammond Law Group. “It allows you to have title of all your assets held in the name of the trust, while you remain in control of the trust and can designate what happens to those assets. Because they are in the name of the trust, it is not necessary to go through the probate process to get them out of someone’s name once they pass away.”
Irrevocable trusts: Once an irrevocable trust has been executed it cannot be altered by the grantor. This means that the grantor has no control of or access to the assets in the trust. It also means that all terms and conditions are final and cannot be changed.
People generally create irrevocable trusts to lower the number of assets that are subject to estate taxes, because these assets are essentially removed from the estate. In addition, the grantor is relieved of the tax liability on the income generated by the trust assets, although beneficiaries will likely have some income tax consequences.
Assets in an irrevocable trust may also be protected from legal judgments against the grantor.
Other types of trusts include:
- Irrevocable life insurance trust (ILIT) – This only holds a life insurance policy on the grantor. Because the policy is owned by the trust, the proceeds are not typically taxed as part of the grantor’s estate.
- Generation-skipping trust –This trust transfers assets to grandchildren or later generations tax free.
- Charitable lead trust – Specific benefits are sent to a charity while the remainder goes to beneficiaries.
- Charitable remainder trust – The grantor receives income from the trust for a defined period of time, and any remainder is given to a charity.
- Spendthrift trust – The trustee has discretion as to how and when distributions are made to a beneficiary. This type of trust can also protect an inheritance in the event the beneficiary divorces or from creditors.
- Special needs trust – Intended for a dependent who receives government benefits, such as Social Security disability or Medicaid. This trust ensures the beneficiary receives some income without compromising the entitlement payments.