Common Types of Trusts and How They Work
Trusts are a common planning tool that can be used to allow one person to hold property for the benefit of another. There are different types of trusts with different benefits and drawbacks. In fact, there are so many different types of trusts that it can often be confusing for people who are considering setting up a trust as part of their estate planning. You should not be intimidated by trust-based planning. With the help of a knowledgeable advisor, trusts can be an extremely beneficial component of a thorough retirement and estate plan.
Before we discuss types of trusts, it is important to understand what a trust is. Every trust must satisfy four basic requirements. First, someone must create the trust (Trustmaker). This person is usually called the grantor, although some people might refer to the person as the donor, the settlor, or the trustor. Second, some person or entity must agree to hold the assets that will go in the trust for the benefit of someone else. This is the trustee. There may be more than one trustee, and a trustee does not have to be an individual, a trustee can be a corporation with trust powers, such as a bank. Third, some assets (money and/or property) must actually be held by the trustee. These assets are called the trust principal or corpus. The principal of the trust will likely change; it may be spent or invested and it may go up or down in value. Fourth, someone must benefit from the trust. This person is called the beneficiary. There may be more than one beneficiary. Aside from these four basic requirements, trusts can vary greatly depending on the manner in which they are created, what the assets are, and the purpose for which they are created.
There are two general categories of trusts: living trusts and testamentary trusts. A living trust, also known as an “inter vivos” trust, is set up during a person’s lifetime. A testamentary trust is set up in a will and established only after the person’s death. It is subject to review and accounting to the probate court.
Living trusts can be divided further into two main types: revocable and irrevocable. A revocable trust allows you to retain control over all of the assets in the trust and revoke or change the terms of the trust at any time. This flexibility does have a cost, however. A revocable living trust does not avoid estate taxes because you still own the property in the trust, although it can help to reduce expenses and avoid probate upon death. An irrevocable trust, by contrast, generally cannot be revoked by the Trustmaker once it has been created. You can specify the beneficiaries of the trust, how it will function, and who will serve as trustee. But, you typically cannot make changes to the trust once it is established without the consent of the beneficiaries or another third party. Because the assets in an irrevocable trust are no longer yours, the appreciated assets in the trust are not subject to estate taxes. Irrevocable trusts can also be used to protect property from the claims of your creditors and those of the beneficiaries.
The trusts mentioned above are just some of the many types of trusts available. There are also many more sophisticated uses of trusts that apply to specific situations. Below is a list of just a few additional types of trusts (keep in mind that the names identify one use of the trust and not all of its uses):
- Irrevocable Life Insurance Trusts- These trusts can be used to remove your life insurance from your taxable estate. The proceeds from the policy can then be used to pay estate costs and provide your heirs with tax-free income. However, once you have transferred your life insurance policy into this type of trust, you can no longer borrow against the policy or change the named beneficiary.
- Credit Shelter Trusts (also known as Bypass Trusts or Family Trusts) - These trusts can be used to avoid estate taxes. The grantor will leave assets up to the estate tax exemption to the trust through a provision in his or her will, then pass the rest of the estate to his or her spouse tax-free. As an added benefit, even if the money in a credit shelter trust grows, it is never subject to estate tax.
- Special Needs Trusts- Parents and family members of someone with special needs can establish this type of trust to provide for the well-being of the disabled family member while preserving the individual’s eligibility for government benefit programs.
If you have questions about trusts and how they might be incorporated into your retirement and estate plans, contact Weatherby & Associates at 888-822-8778 to schedule a consultation.