What is a trust?

Creating a trust can help you pass down property and belongings to your heirs.

Elissa

Elissa Suh

Published October 16, 2019

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KEY TAKEAWAYS

  • A trust is one way to pass down property and belongings to your loved ones heirs

  • One of the most significant benefits of a trust is avoiding probate

  • A trust also lets you manage how your beneficiaries use their inheritance

  • Some types of trusts help you minimize estate taxes or qualify for government benefits

When you pass away, you want to be confident that your belongings and property will go to the right people. Creating an estate plan can help you do that, and a trust can be part of it. A trust is a legal entity in which you can place your assets to be used by you or your future heirs. Like a last will and testament, a trust has rules about which assets go to whom and how the assets can be used.

Trusts can also be used while you’re still alive. These are called living trusts or inter-vivos trusts. You may use these types of trusts to, for example, create a fund for your children to access when they reach a certain age.

With another kind of trust — an irrevocable trust — you relinquish your ability to cancel the trust or modify its terms, in return for certain benefits like minimizing taxes or protecting your assets from creditors.

We’ll talk more about how a trust works, its benefits and disadvantages, and the difference between different types of trusts, including revocable vs irrevocable. Keep in mind that a trust is just one part of an estate plan.

In this article:

How does a trust work

The trustmaker, called the grantor or trustor, establishes the trust and chooses which assets are placed into it. Your assets might include your primary residence or any real estate property, or your car.

Next, they designate who will receive the assets when the grantor passes away. These are the primary beneficiaries.

They also designate a trustee to manage the trust. The trustee can be the same person as the grantor, but it can also be a lawyer, a financial institution, or any other person you choose. (Depending on the type of trust you have, the grantor may not be able to fulfill both roles.) If you’re the grantor and trustee, you must name a successor trustee to take over when you die. The trustee has a fiduciary obligation to look out for the best interests of the trust.

The location of the trust as well as information on the grantor, trustee(s), named beneficiaries, and all of the trust’s assets are listed on the respective trust document. The grantor receives a copy of the trust document when they create the trust.

Once an asset has been disbursed to the beneficiary, the beneficiary becomes the owner of the asset. Even if the grantor is still living and wishes to modify the details of the trust, they cannot recover disbursed assets.

Irrevocable trust vs revocable trust

There are two main types of trusts: irrevocable and revocable trusts. Within those categories are many types of trust as well.

Irrevocable trust

An irrevocable trust can’t be modified or revoked except when required by law and even then only under very specific circumstances. When you move an asset into an irrevocable trust, you no longer own the asset, and will face difficulty getting it back, depending on the state.

The tradeoff for this loss of ownership is that you cannot be forced to use any assets in an irrevocable trust to pay debt or liabilities. Think of the irrevocable trust like another person; if you did the crime, why should the (irrevocable) trust pay the fine?

Common types of irrevocable trusts include a spendthrift trust, a credit shelter trust, a charitable trust, and an irrevocable life insurance trust(ILIT)

The grantor also will not have to pay any taxes related to assets placed in this type of trust. An irrevocable trust has its own tax identification number.

Read more in depth about irrevocable trusts.

Revocable trust

A revocable trust can be modified by the grantor. Revocable trusts are also called living trusts, because they are created and bequeath assets to your beneficiaries while you’re alive. When you die, your revocable trust becomes irrevocable (because you’re dead and can no longer make changes to it).

With a revocable trust, your beneficiaries can access the assets as long as the trust’s terms are met. You can continue adding or removing assets, changing the beneficiaries, and updating the rules governing the trust. For this reason, a living trust is not shielded from the grantor’s income taxes. You’ll have to claim the trust assets in your individual tax return and pay income tax on any earnings.

Read more about revocable trusts.

Benefits of a trust

A trust provides a safe way to allocate your belongings and property and protect them for future use by your loved ones. When you establish the trust, you set the terms, and they are enforced just like a contract. Because the trust is a separate entity, it can’t be modified or revoked by any of its beneficiaries.

For example, if you don’t want your children to be able to access the money in a trust before they turn 30, then nothing they can do will let them access the funds prior to that date. You can stipulate almost any reasonable condition you want; it’s common to lock down assets in a trust fund for a child’s educational expenses or mortgage payments. (You may hear people refer to a trust as a trust fund.)

You can also limit the amount of money a trust beneficiary can withdraw at any time, which you might want to do if you don’t have confidence in the spending habits of your children.

Avoid probate

Trusts are especially useful for very large estates, including those that own multiple corporations or real estate property. That’s because they can usually avoid probate, which is the legal process of proving a will or determining how assets are distributed when there isn’t one. Probate can become expensive, time-consuming, and painful, especially when someone disagrees with how the assets are being distributed and decides to contest the will.

Additionally, the results of probate are made public and anyone can see what assets you have or who you passed them to. Trust disbursements are private.

Minimize estate taxes

An irrevocable trust can also help a large estate reduce or avoid estate tax. If your estate is worth a certain amount, known as the estate tax exemption amount, you will have to pay an estate tax. By transferring your assets into an irrevocable trust, you can minimize the value of the estate and pay less taxes on it, ultimately helping your beneficiaries get a larger inheritance. As of 2019, that the estate tax applies to estates worth at least $11.4 million.

Learn more about the estate tax.

Asset protection

A trust can shield beneficiaries and in some cases the grantor from liabilities and lawsuits. If your beneficiary is sued or in debt, the assets that are designated for them cannot be used to pay for liabilities until they have received them. The assets in a trust are still owned by the trust, even though beneficiaries may be named to inherit them.

With certain types of trust (namely irrevocable trusts) the grantor is also shielded from liabilities. For example, if you’re a doctor and you are sued, you cannot be forced to sell your rental property, which you placed into an irrevocable trust, to pay for liabilities. This measure of asset protection provided by a trust can also help you qualify for government benefits like Medicaid, which will only cover nursing homes if you meet the asset limits.

Disadvantages of a trust

Trusts are not for everyone. For one, they could be expensive to set up and maintain: depending on how and where you establish the trust, complicated trusts may cost several thousand dollars to start and several thousand more to maintain.

Wills are more affordable

If you don’t have a lot of assets to give away, a simple will may be a better option for you; drawing up a will is often much less expensive than establishing a trust. In this case, you can make a will online that will satisfy your estate planning needs.

You can even create a will for free, but remember that a less-than-solid will might cause an expensive potential legal battle for your survivors.

The terms can be burdensome

Consider the nightmare scenario of setting aside money in a trust for your child to use for college only for the child to get seriously ill and rack up huge medical expenses. In that case, it may be difficult or even impossible for the child to access the trust funds.

You might consider giving an asset to a minor under the Uniform Gifts to Minors Act/Uniform Transfers to Minors Act for use when he or she comes of age, or for qualified expenses that benefit him or her. Assets given under UGMA or UTMA belong to the minor, but he or she directly spend funds from the asset until reaching the age of majority.

The rules might be complicated

If you allocate the trust funds for your beneficiary to buy a house, will your beneficiary still get the funds if he or she moves into a van down by the river? It’s important to seek proper legal advice and have an estate planning attorney draft the terms of your trust to avoid such complications.

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Takeaway

A trust is a legal entity that can protect your assets for use by you or your loved ones.

Testamentary trusts: how trusts work with wills

When a will is executed, one thing it can do is create a trust. This is called a testamentary trust. Your will can specify that some assets are given away directly to beneficiaries, while other assets are put into the trust. You can also use a will to move assets into a trust that already exists. Because the assets in a testamentary trust have not fully transferred over before the person’s death, they will unfortunately be subject to probate.

Read more about the difference between trusts and wills.

Alternatives to a trust

A trust may be either too complex or too expensive for many people. There are other ways, some of which are free, that can ensure your beneficiaries are taken care of after you’re gone.

Here are some ways you can pass down your assets without a trust.

A last will and testament

As stated above, if you leave behind a smaller estate, a will is a much simpler and generally more affordable way to pass assets on to your heirs. A will is a document containing instructions not just about your assets but also what happens to minor children if your spouse dies. (However, your will must be “proved” when it’s executed, which means your assets go through probate.)

Life insurance

If you have in-force life insurance coverage when you die, its death benefit will be paid to the primary beneficiaries named in the policy. Life insurance benefits are tax-free if you paid your premiums with after-tax earnings, and they do not have to go through probate. A licensed expert at Policygenius can help you find a life insurance policy that fits your needs and budget.

Payable-on-death accounts

Don’t forget about your retirement plan or investments. You can name a beneficiary to your bank accounts and brokerage accounts. Payable- or transferrable-on-death accounts do not go through probate.

Learn more about payable-on-death accounts.

529 plan

States run 529 plans to help parents grow their child’s college savings fund. You can contribute money to either a savings or investment account for your child’s future education expenses.

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