What is a trust and how does it work?

Put simply, the definition of a trust is: a legal document with your wishes for how and when to transfer your assets, which can include sentimental items, to family members, loved ones, or charities. 

A trust document or legal trust can be seen as a will, with the only difference that trusts can be managed by yourself when you’re still living and also by others after your death. Importantly, trust assets don’t need to go through probate, which allows beneficiaries easier and quicker access to their inheritances. While it may be enough to have only a will, those with one or several trusts might consider adding a will to cover any property not included by the trust.

A trust holds assets like cash, stocks, bonds, real estate, and income such as earnings over time, including interest on savings accounts, dividends, rent, and royalties.

A legal trust has three parties and works fiduciarily. That means that the first party (the grantor) allows a second party (the trustee) to hold title to property or assets for a third party (the beneficiary).

A trust can be set up in four steps.

Step 1: Consult an advisor about which trust best suits your needs.

Step 2: An attorney, typically an estate planning attorney, composes the trust document based on your wishes. It might also be helpful to coordinate with your tax and financial advisors to see the overall picture of your financial situation and goals.

Step 3: Determine the right trustee, who is responsible for holding and administering the assets for the beneficiary. A trustee might be a relative, friend, or company. They have to be reliable, responsible, and have the required experience and expertise.

Step 4: The beneficiary has the terms and conditions of the trust passed on by the trustee.

In general, there are three important parties playing a role in a legal trust:

1. Grantor/trustor. The person or institution who establishes and funds the trust.
2. Trustee. The person or company that is responsible for managing and distributing the assets.
3. Beneficiary. The person, group of people, or institution for whom the trust is established.

There are many different types of trusts that can serve your goals. Here’s a non-exhaustive list of trust types and their definition:

Marital trusts

These trusts are set up by one spouse for the other in case the first spouse passes away. It ensures that assets are seamlessly passed on to the living spouse and may help avoid estate taxes throughout their life.

Testamentary trusts

A testamentary trust can be included in a will and is only established after the grantor’s death. In the will, the trustor specifies the distribution of their assets by the trustee.

Charitable trusts

A charitable lead trust and a charitable remainder trust are the two types of charitable trusts. They both give assets to a trust, which distributes these assets to either a noncharitable beneficiary or a charitable beneficiary. Whereas charitable lead trusts allow some of the benefits to go to a charity and the remainder to your beneficiaries, a charitable remainder trust involves receiving an income stream for a certain period of time and determining that a charity will receive any remainder.

Spendthrift trusts

If you’re concerned that your beneficiary will irresponsibly spend their inheritance, you might consider a spendthrift trust. Here, you can specify when and how the trust assets should be distributed. It is also possible to determine that the money doesn’t go directly to the beneficiary but, for example, to a landlord, educational institution, or medical provider.

Business trusts

A business trust holds business interests, which are one’s rights to a stake in a business. For business owners, transferring all or a portion of their business into a trust might bring advantages in estate planning and taxes.

Special needs trusts

Special needs trusts are designed to help loved ones with a disability. You can ensure they receive financial support without losing access to government benefits. It doesn’t replace government benefits but rather adds to them and thus provides for the special needs and care of a loved one in the long run.

Education trusts

As the name of the trust implies, the assets in an education trust are intended for educational expenses.

Life insurance trusts

With a life insurance trust that holds life insurance proceeds, you can minimize estate taxes. Also, it can provide liquidity to the beneficiaries after the trustor’s death.

Grantor retained annuity trusts

With a grantor retained annuity trust, family members can receive significant financial gifts with minimized taxes. The grantor is able to transfer appreciating assets (i.e. those with increasing value over time) to the next generation with little or no gift tax and also to get annuity payments from the trust for a certain period of time.

The main difference can be seen in the level of flexibility. Revocable trusts are also called living trusts, as you have full control during your lifetime. You can change the terms and update beneficiaries, or even cancel the trust altogether. Once you pass away, however, it automatically becomes irrevocable, meaning the terms are locked in and can’t be changed.

In contrast, an irrevocable trust is set in stone from the start. Once it’s created, you can’t make changes or take back assets without the approval of beneficiaries.

The main purpose of establishing a trust is knowing that your assets will be protected and distributed as you wish. Although creating a trust can be more expensive and time-consuming than creating a will, a trust can offer benefits, such as:

• Control of assets and greater flexibility. By precisely specifying the terms of a trust, a trustor can control when and to whom distributions may be made. Creating a revocable trust gives the grantor flexibility since the trust assets remain accessible during the trustor’s lifetime.

• Protection of assets. A trust might help protect your estate from creditors, lawsuits, and beneficiaries who may not be adept at money management.

• Maintenance of privacy. As probate is a matter of public record, with a trust the grantor is able to distribute the trust assets outside of probate and remain private.

• Probate savings. Due to passing assets outside of probate, it’s possible to reduce the amount lost to court fees and estate, gift, or income taxes.

• Minimized conflict. Trust specifications can’t be contested in court like wills can, which makes conflicts between beneficiaries less likely.

It’s important to consult a qualified financial advisor before deciding whether a trust is right for you. You can also get a better idea of the tax implications by reading tax guides.

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.