What is a Trust?

A trust is a legal arrangement that specifies what happens to your assets when you pass away or when specific conditions are met. It appoints a third party to manage those assets.

What is a trust and do you need one? In its simplest form, a trust allows a third party to hold assets for a beneficiary. You have many options for how to structure a trust and who to leave it to. The greatest benefit of using a trust to pass on assets is that it enables the beneficiary to receive the money more quickly, and perhaps pay fewer taxes on the funds depending on how the trust is structured. Learn the ins and outs of trusts to see how they work and whether one might be right for you.

What Is a Trust?

A trust gives power to a third party to manage your assets on behalf of a beneficiary until the time comes to pass those assets to the beneficiary. In simple terms, this is an agreement that allows another entity to manage your transfer of assets. These can be items of wealth or sentimental items that you or your loved ones care about.

The purpose of a trust is to facilitate the immediate transfer of assets upon your passing. Instead of waiting for the estate to go through probate like it would with a will, the assets can move seamlessly to beneficiaries.

With a will, you outline what you want to happen to your assets when you die. But a trust is a contract, which allows beneficiaries to access their inheritance immediately. You might have both a will and a trust because some items cannot be held in the trust, such as certain types of property.

How Do Trusts Work?

Trusts can work in a variety of ways. They can distribute assets to beneficiaries during their existence or only transfer the assets upon the trust's dissolution. 

If a married couple creates a trust and one spouse passes before the other, the assets transfer to the existing spouse solely until the second spouse passes, and then the assets are distributed accordingly upon the trust being dissolved. 

The trust might not be dissolved immediately upon the creators’ passing though. Some choose to wait until their heirs reach a certain age to dissolve the trust or to only access the funds for certain use cases before dissolving the trust. However, most states adhere to the rule against perpetuities, typically allowing trusts to continue for 21 years after the death of the last identifiable beneficiary.

Physical assets in a trust, such as a car or house, will be titled in the trustee’s name instead of the trust owner’s. These assets can then transfer to the heirs seamlessly without the courts being involved.

Assets within a trust can grow with time. For example, if the trust is holding investments earning interest, the total value held in the trust can increase. Often, this interest is not accessible until the assets are transferred to the beneficiary. 

Revocable vs. Irrevocable Trusts 

While there are many types of trusts, they all fall under two main categories: revocable and irrevocable. 

A revocable trust, also known as a living trust, allows assets to be transferred without going through probate court while still allowing the trust creator to retain control over the assets as long as they are alive.

A revocable trust is flexible, allowing you to dissolve it at any point in case you change your mind about its structure or beneficiaries. However, once you pass away, the trust becomes irrevocable. 

The asset ownership remains yours throughout your lifetime with a provision that a trustee manages the assets if you can no longer do so or pass away. 

When your assets transfer to your beneficiaries, they will still be liable for estate taxes. However, the rights and control of the asset during your lifetime make this type of trust attractive.

With an irrevocable trust, you’ll have no control over the assets once you sign the contract. This can be beneficial to your heirs because they won’t pay estate taxes on the assets. However, once you execute the trust, you have no control over the assets and cannot change your beneficiaries or their allocation of your assets.

People who want to avoid estate taxes generally opt for an irrevocable trust. This is true not just once the asset transfers to the beneficiaries but is true of all interest and earnings the assets gain while held in the trust. You don’t have to pay taxes on those earnings. If you take distributions from the trust though, you will pay taxes on those distributions.

Different Types of Trusts

Revocable and irrevocable are the overarching categories for trusts. But there are many types underneath that category. Here’s a look at those various types that help you achieve your goals.

Business Trust

Place your business interests in a trust to protect your stake in the business. You might benefit from tax advantages and ease of estate planning when using this trust. If you don’t see eye-to-eye with a business partner or are worried about what might happen when you undergo a business change, this can help protect your business interests.

Charitable Trust

Create a trust fund with charitable beneficiaries. That way you can pass your assets to a charity while enjoying potential tax benefits. Not all assets in a charitable trust must go to charity; you can designate some funds for other beneficiaries. 

Education Trust

These trusts ensure that your beneficiaries only use them for educational purposes. Just know that a 529 plan might provide better tax benefits than an education trust.

Grantor Retained Annuity Trust

Gift your family members large sums of money without paying gift tax using a Grantor Retained Annuity Trust (GRAT). You can use this trust to transfer appreciating assets to your heirs through annuity payments over a set period.

Life Insurance Trust

Place your life insurance proceeds in a trust to minimize estate taxes for your beneficiaries. This can help payout funds to your beneficiaries fast if your other assets are tied up, such as in the case of business owners whose assets are mostly within their business.

Marital Trust

Assets pass seamlessly from one spouse to another when they are held in a marital trust. That way, if one spouse passes before the other, they can pass their assets to their surviving spouse without the surviving spouse paying estate taxes.

Special Needs Trust

When you have a loved one with a disability, you can help support them financially through a special needs trust. Providing them funds in this manner will help protect their government benefits because they’ll supplement that income instead of replacing it. That way, your loved ones can enjoy the quality of life they are used to.

Spendthrift Trust

When you have concerns that your beneficiary might use the inheritance irresponsibly, a spendthrift trust can be a great option. This allows you to outline specifically how the beneficiary can use your funds. You might be able to state that the funds can go directly for education, medical bills, a home purchase or a landlord for rent so you know the funds are going to good use.

Pros and Cons of Trusts

While trusts present many outstanding benefits, they also come with some disadvantages you should be aware of. Weigh the pros and cons before placing funds in a trust.

Pros

• Avoid probate: this speeds up the transfer of the assets and simplifies the process
• Flexible: decide not only who receives your assets but how. You can spread it out over time or use specific asset types.
• Less conflict: because the trust is not contested in court, it often involves less conflict than a will.
• Private: because the transfer of assets never goes to court, your assets are not public.
• Safeguard from creditors: money held in the trust is not accessible to creditors or during lawsuits.
• Reduce or avoid taxes: trusts help reduce your overall estate and can help minimize your taxes.

Cons

• Some trust structures don’t protect from creditors: revocable trusts are not protected from creditors or lawsuits.
• Permanent: irrevocable trusts cannot be changed once signed.
• Additional tax return: some trusts require that you file a tax return for the trust.

How to Set Up a Trust in 5 Steps

Once you’re ready to set up a trust account, follow these steps but know that the process can vary based on the assets you include in the trust.

1. Select the Assets in Your Trust

Not all assets must become trust assets. Instead, you can select what to place in the account. Consider whether you want to place cash, stocks, investments, bonds, business interests and real estate in the trust. 

2. Choose Your Beneficiaries

Anyone can receive your assets from your trust, including your children, spouse or charitable organization. 

3. Set Your Trust Roles

Decide how you want your assets to transfer and when. For example, you might stipulate that the assets only transfer to your children or grandchildren once they graduate high school. Choose whether you want charitable contributions to go in installments instead of a lump sum. You’re in control of how your assets move with the trust, which is one reason to choose a trust over a will.

4. Choose a Trustee

A third party must administer your trust. You can choose a friend or family member or ensure that the decisions made once you pass are completely unbiased by going with a neutral party. You might use a bank as your trustee. A neutral party can ensure that family dynamics don’t impact the way the trust pays out. Plus, these trustees know what they are doing, whereas a family member likely has no experience with trusts or knows how taxes play in.

5. Work With an Attorney to Build Your Trust Contract

Meet with an attorney to draft your trust document, outlining all the stipulations for how your assets shift to your beneficiaries. You might also include information about what happens to your trust if you become incapacitated. 

How Are Trusts Taxed?

Placing assets in a trust does not automatically mean you don’t pay taxes on them or that your heirs won’t pay estate tax. While there are many benefits to a trust estate, you could still owe taxes.

With revocable trusts, the creator retains ownership of all assets within the trust. That means that you are responsible for all taxes until you die and the assets transfer to your beneficiaries. Likewise, your beneficiaries will have to pay estate tax on these assets once the ownership transfers.

Irrevocable trusts are still subject to taxes but because you no longer own the assets, you won’t claim them on your tax return. Those assets might be subject to different tax rates based on your state’s rules for trusts. 

Trust taxation is complex and varies based on your state’s laws and the type of trust you select. Talk to a financial advisor before opening a trust so you know the nuances.

Recommended Financial Advisors

Deciding on how to handle your estate is complex and requires many considerations. Working with a trusted financial advisor can help ensure you select the best option for your needs and know the pros and cons of what you’ve selected. Here’s a look at some high-quality financial advisors.

Transfer Assets to Beneficiaries Without Probate

You’ve worked hard to earn everything you have and want to know that it will go to your beneficiaries according to your wishes. A trust enables you to transfer assets discreetly, keeping the details private and expediting the process. Talk to a financial advisor about whether a trust might be a smart way to hold or transfer your assets.