Pick the Perfect Trust

A well-crafted estate plan ensures that a person's assets will be smoothly passed on to his or her chosen beneficiaries after one passes away. The absence of an estate plan can lead to family conflict, higher tax burdens, and exorbitant probate costs. While a simple will is an essential component of the estate planning process, sophisticated plans should also include the use of one or more trusts.

This article outlines the most common types of trusts, coupled with their defining characteristics and benefits.

Key Takeaways

  • A well-crafted estate plan involves pairing a simple will with the creation of a thoughtfully designed trust, to ensure a benefactor's assets are transferred to their loved ones.
  • Trusts may be broadly defined as "revocable", which means they may be amended during a grantors living years, and "irrevocable", which means they cannot be altered or revoked.
  • Trust entities generally pay separate taxes and therefore must obtain a federal identification number and file an annual return. 
  • Trust funds can hold a variety of assets, such as money, real property, stocks and bonds, a business, or a combination of many different types of properties or assets.
  • The dynamic of every family is different, so it's important the trust(s) you select to care for your loved ones after your death is well-suited to your loved ones' needs.

Basic Characteristics of Trusts

A trust is an account managed by a person or organization, for the benefit of another. A trust contains the following elements:

  • Grantor: Sometimes called a "settlor "or "trustor", a grantor refers to the individual who creates the trust and has the legal authority to transfer property into it.
  • Trustee: This is an individual or organization who administers property or assets for the benefit of a third party, by temporarily holding onto the property, but without taking direct ownership of it. Trustees have the fiduciary responsibility to operate in the best interests of the grantor and the beneficiaries, and must faithfully execute the mandates outlined in the trust document. Therefore, it is critically important to appoint only reliable people to this position.
  • Beneficiary: This is the party that benefits from the trust. There may be several beneficiaries to the same trust—each of whom may be entitled to different amounts of the assets.
  • Property: This refers to the asset held in the trust, and may include cash, securities, real estate, jewelry, automobiles, and artwork. Sometimes called the "principal" or the "corpus", such property can be transferred into the trust while the grantor is still alive, via a living trust. Alternatively, assets may be transferred into a testamentary trust after the grantor dies, as per the mandate of a will.
  • Revocable trust: This type of trust may be altered as many times as desired, during a grantor's living years.
  • Irrevocable trust: This type of trust can never be altered, amended, or revoked.
  • Taxes: Generally speaking, each trust pays separate taxes, and therefore must obtain a federal identification number and file an annual return. Some living trusts use the grantor's tax identification number.

Common Types of Trusts

Here are the most common types of trusts:

Living Trusts

A living trust is usually created by the grantor, during the grantor's lifetime, through a transfer of property to a trustee. The grantor generally retains the power to change or revoke the trust. But after the grantor dies, this trust becomes irrevocable and may no longer be changed. With these vehicles, trustees must follow the rules delineated in the creation documents, relating to the distribution of property and the payment of taxes.

Living trusts offer the following advantages:

  • Healthcare/end-of-life provisions desired by the grantor
  • Protection against incapacity of grantors and beneficiaries
  • Elimination or reduction of probate delays and expenses
  • An easy succession of trustees
  • Immediate access to income and principal by beneficiaries
  • Privacy during situations where the state requires the filing of an inventory of assets

Living trusts have the following limitations:

  • Titling of Property: In some cases, a piece of real estate property should be excluded from a trust. For example, in states like Florida, primary residences are shielded from creditors by way of a "homestead exemption", but if the primary residence is placed in a trust, the homeowner may surrender that creditor's protection. In such instances, a pour-over will can be used to coordinate the transfer of assets into a trust, after the grantor dies.
  • Creditor Claims: A living trust generally does not provide protection from claims made by creditors, because the grantor of the trust is considered to be the owner of the trust's assets, due to the fact that the grantor may revoke the trust at any time.
  • Taxes: All income earned by the trust is taxable to the grantor's personal tax return, as though the property had never been transferred to the trust.

A living trust is often referred to as "inter-vivos".

Testamentary Trusts

A testamentary trust, sometimes called a "trust under will", is created by a will after the grantor dies. This type of trust can accomplish the following estate planning goals:

  • Preserving assets for children from a previous marriage
  • Protecting a spouse's financial future by providing lifetime income
  • Ensuring that beneficiaries with special needs will be taken care of
  • Gifting to charities

Irrevocable Life Insurance Trust

An irrevocable life insurance trust (ILIT) is an integral part of a wealthy family's estate plan. The federal government currently affords individuals an $11.7 million estate tax exemption for the 2021 tax year. But any portion of the estate above that amount may be taxed as high as 45%. So, for estates containing more than the $11.7 million applicable exclusion, life insurance can be an invaluable tool in the estate planning kit. ILITs provide the grantor a flexible planning approach and a tax savings technique by enabling the exclusion of life insurance proceeds from both the estate of the first spouse to die and from the estate of the surviving spouse.

The ILIT is funded with a life insurance policy, where the trust becomes both the owner and the beneficiary of the policy, but the grantor's heirs can remain beneficiaries of the trust itself. For this plan to be valid, the grantor must live three years from the time of the policy transfer, or else the policy proceeds will not be excluded from the grantor's estate.

Although trusts were established to allow IRA beneficiaries to receive the required minimum distribution (RMD) each year from the inherited IRA or 401(k), the Secure Act of 2019 states that non-spousal IRA beneficiaries must withdraw all of the funds in the IRA or 401(k) by the end of ten years following the death of the original account owner.

Charitable Remainder Trust

A charitable remainder trust (CRT) is an effective estate planning tool available to anyone holding appreciated assets on a low basis, such as stocks or real estate. Funding this trust with appreciated assets lets donors sell the assets without incurring capital gains tax. Furthermore, charitable remainder trusts are irrevocable, meaning they cannot be modified or terminated without the beneficiary's permission. The grantor effectively removes all of her rights of ownership to the assets and the trust upon the creation of its irrevocable status.

Qualified Domestic Trust

This special trust lets non-citizen spouses benefit from the marital deduction normally afforded to other married couples. Normally, a surviving spouse is eligible for a 100% marital deduction of any estate taxes owed on assets. This means the surviving spouse pays no taxes on assets with no limit. However, if the surviving spouse is not a U.S. citizen, the marital deduction is not allowable. The qualified domestic trust makes up for this rule.

Special Needs Trust

A special needs trust is a legal arrangement that lets a physically or mentally ill person, or someone chronically disabled, have access to funding without potentially losing the benefits provided by public assistance programs. Since public assistance programs set up for people with special needs are predicated on certain income and asset restrictions, money put into a special needs trust doesn't affect their eligibility for public assistance.

Types of Trusts FAQS

What Types of Trusts Can Be Set Up for Minor Beneficiaries?

There are many different types of trusts that a grantor can use for their minor beneficiaries. A pot trust for example designates certain assets to a couple's children after the death of the last surviving spouse. Education trusts set aside money for the specific purpose of higher education. There are also generation-skipping trusts.

What Type of Investments Are Allowed in Trusts?

Trust funds can hold a variety of assets, such as money, real property, stocks and bonds, a business, or a combination of many different types of properties or assets.

What Types of Trusts Are Available for People on SSI?

There are three types of trusts designed for people receiving Social Security income: third-party special needs trusts, self-settled special needs trusts, and pooled trusts.

What Type of Trusts Are Allowed for Shareholders of an S Corporation?

The three types of trusts most commonly used by shareholders of an S corporation are grantor trusts, qualified subchapter S trusts (QSSTs), and electing small business trusts (ESBTs).

The Bottom Line

Estate planning is a complex process demanding professional oversight. The structure and dynamic differ in every family, so it's important the trust(s) you select to care for your loved ones after your death is well-suited to your loved ones' needs.

Whether this means caring for a disabled family member or friend, protecting the security of your spouse, or simply helping to secure the financial futures of your children and/or grandchildren, a properly formatted trust can go a long way in effectively carrying out your wishes.

Article Sources
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  1. IRS. "Estate Tax."

  2. U.S. Congress. "H.R. 1994 - Setting Every Community Up for Retirement Enhancement Act of 2019."

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