Before we look at the different types of trust funds and trusts, let’s explore the subtle difference between the two things. A trust is a tool used in estate planning in which someone gives a second party, called a trustee, the right to handle assets in a fiduciary manner to benefit a third party, the beneficiary. A trust fund is the legal place, or entity, where those assets are held. The trustee manages the trust fund.
People tend to use these terms interchangeably, because they fit together so tightly. In this article we will generally refer to trusts. Just as trust funds can hold many types of assets, such as money, property, a company, stocks, or any combination, trusts can perform a wide range of functions.
What is the most common type of trust?
Revocable vs. irrevocable
A revocable trust, the most common type of trust, is one that can be changed or canceled by the party who creates it. With this capability, people tend to use revocable trusts in conjunction with or instead of wills. Any income earned by the trust’s assets goes to the person who sets up the trust, the grantor. When the grantor dies, the assets go to the beneficiaries of the trust. These trusts can help survivors avoid the lengthy probate process that is often associated with a will.
With an irrevocable trust, the terms cannot be revised or canceled after it has been signed without the beneficiary’s permission. The grantor gives up control of assets placed in the trust and the assets are removed from that person’s estate. The grantor is also no longer responsible for paying taxes related to the trust fund’s assets. This can give the individual better protection from creditors and can reduce estate taxes.
Testamentary vs. living
A testamentary trust goes into effect upon the death of the testator with the terms specified in his or her will. A will may contain multiple testamentary trusts and can address any and all portions of an estate.
A living trust is a legal document created during an individual’s lifetime (the trustor) where a designated person (the trustee) is given responsibility for managing that individual’s assets for the eventual beneficiary. Living trusts allow for the convenient transfer of the trustor’s assets while bypassing the often-expensive legal process of probate.
The benefits of a trust
Trusts are a wise investment if someone has wealth or assets that need careful distribution or protection in their absence.
- Minimize probate: Assets willed to beneficiaries pass through probate court. This legal process of settling a person’s debts and the distribution of assets can be time-consuming and expensive. The use of trusts, however, clarifies many issues and saves time and money for beneficiaries while also protecting privacy.
- Privacy: With a trust, your financial assets are protected from becoming public, as they are with a will.
- Tax advantages: Some trusts allow for the transfer of assets out of the estate. This can help reduce estate taxes and gift taxes.
- Protecting assets from creditors: Transferring assets out of the estate can limit creditors’ access to them.
- Control of assets: By defining the terms of the trust, the trustor can control who gets their assets and when and how they will receive them.
Which option is right for me?
With all the different types of trusts, the options can be overwhelming. Here are some of the options to consider when making decisions about your future:
Types of trust funds that provide for heirs and survivors
Qualified Domestic Trust: This specialized trust allows a surviving spouse to take the marital deduction on estate taxes, even if that survivor is not an American citizen.
Special Needs Trust: This specialized trust allows a disabled beneficiary to use property in the trust for their benefit while simultaneously receiving needs-based government benefits.
Qualified Terminable Interest Property Trust: People who have children from a previous marriage use the QTIP Trust, an irrevocable trust, to take care of their current spouse but ensure that the assets go to those children when that spouse dies. Thus, the grantor can provide for a current spouse but control where the assets go when that spouse dies.
Irrevocable Funeral Trust: Grantors can use this to put aside money to cover burial and funeral costs. Funeral trusts are usually funded with cash, life insurance, or bonds. An irrevocable funeral trust can help families qualify for Medicaid because Medicaid does not count it as an asset for eligibility purposes.
Spendthrift Trust: This is a trust crafted so that a trustee controls how the assets can be spent by the beneficiary. Through a “spendthrift clause,” the beneficiary is restricted from transferring the assets of the trust to anyone else. The beneficiary controls only what has been doled out according to the dictates of the trust and trustee. Creditors cannot touch the assets held in the trust fund.
Totten Trust: This is a revocable trust with a bank account that pays out upon the death of the testator to the account beneficiary.
Blind Trust: The owner (or trustor) establishes a blind trust giving another party (the trustee) full control of the trust, usually to avoid conflicts of interest between the beneficiary and the investments.
Types of trust funds that minimize taxes
With these types of trusts, you can avoid or minimize the hefty estate taxes that often come with a large inheritance. As with all the trusts being described here, these should be considered as part of a comprehensive wealth management strategy.
Generation-Skipping Trust: As part of an estate plan, this trust allows a grantor to preserve assets for their grandchildren, skipping their children to avoid estate taxes.
Marital Trust: This type of trust allows someone to pass assets on to a surviving spouse tax free. It also can protect the assets of the surviving spouse’s estate before those assets are transferred to the children.
Credit Shelter Trust, or Bypass Trust: This is used by married couples to bypass or shelter the estate from federal estate taxes. The estate is separated into two parts, each one below the federal estate tax exemption threshold. One trust, often referred to as Trust A, is for the surviving spouse. The other, Trust B, contains assets meant for the family’s heirs.
Lifetime Asset Protection Trust (LAPT) A Lifetime Asset Protection Trust (LAPT) protects you, your family, and their inheritance from mismanagement and financial catastrophes such as divorce, severe debt, illness, and accidents. The assets remain in the trust fund, and heirs receive payments from it.
GRAT and GRUT: A Grantor Retained Annuity Trust (GRAT) is another form of irrevocable trust that can help to minimize estate taxes. They are particularly useful for assets expected to see quick and significant appreciation. The individual puts assets into a fixed-term trust that will pay them an annuity for that period. Then, the assets go to the individual’s beneficiaries with little to no gift tax cost. If the assets do not perform well enough, they return to the grantor.
A Grantor Retained Unitrust (GRUT) is like a GRAT. However, instead of receiving a fixed annuity payment, the person who sets up the trust receives an annual payment (a fixed percentage of the assets’ fair market value).
IDIGT and IDGT: An intentionally defective (irrevocable) grantor trust (IDIGT, or IDGT) allows individuals to move assets out of their estates (to avoid estate taxes) but still possess them in terms of income taxes, which they pay.
ILIT (Irrevocable Life Insurance Trust): Life insurance can help families concerned about heirs having trouble with the estate taxes that might come with receiving real estate, a business, or any non-liquid asset. This type of life insurance trust can exclude life insurance proceeds from the taxable estate and transfers immediately to beneficiaries.
Philanthropic types of trust funds
CLTs and CRTs: There are two basic types of irrevocable charitable trusts – Charitable Lead Trusts (CLTs) and Charitable Remainder Trusts (CRTs). These are valuable tools for minimizing estate taxes.
CRT: A charitable remainder trust is a gift of cash or other property to an irrevocable trust. With a CRT, the donor gets income from the trust for a set number of years or for life, and the charity gets what’s left of the assets when the trust period ends. The donor receives an income tax charitable deduction when the CRT is funded, based on the current value of the trust assets that will eventually go to the named charity.
CLT: With the less common CLT (where the “L” stands for lead), an irrevocable trust is set up to send income to a charity for a certain period. The high-net-worth individual gets tax benefits for the donation. When the period is over, the assets go to the beneficiaries.
CRAT, CRUT, CLAT, and CLUT: These are forms of CRTs and CLTs.
- CRAT: Charitable Remainder Annuity Trust: In a CRAT (charitable remainder annuity trust), the high-net-worth individual places assets in a trust that pays a fixed, annual amount to a beneficiary through an annuity. The annuity is based on the initial value of the trust’s assets, and the payout must be at least 5%. When the donor dies, the rest of the assets go to a charity.
- CRUT (Charitable Remainder Unitrust) This provides income to a named beneficiary during the grantor’s life and then the rest of the trust to a charitable cause. The donor or the donor’s family members are usually the initial beneficiaries.
- CLAT (Charitable Lead Annuity Trust): This can be seen as the opposite of the CRAT. In this case, the annuity income goes to the charity. When the donor dies, the rest goes to the donor’s heirs.
- CLUT (Charitable Lead Unitrust): A CLUT could be called the opposite of the CRUT because it pays the charity an annual, variable income – a fixed percentage of the asset’s value – for a fixed time period and then gives rest to the heirs.
DAF: A donor-advised fund (DAF) is a private fund created to manage charitable donations for an individual, family, or organization. Though it confers similar tax benefits, it is not a trust. However, a trust can be written to make a DAF a beneficiary.
Making the Call
Well-drafted trusts are an essential part of estate planning. Trust funds ensure that your children, grandchildren, or selected beneficiaries receive their inheritance without undue delays or tax burdens.
Which one of these would be best for you? It depends on your assets, tax situation, and goals. Each one of these trusts, and many similar variations, are designed for specific purposes. Cope Corrales can help you and your family explore your options for trusts and develop a comprehensive plan, so your assets are well-protected.