Most people should consider having one or more trusts in their estate plans.
To make decisions about trusts you must be aware of trust terminology and basic concepts about the most common types of trusts.
Keep in mind that some trusts are given different names in some regions or by different estate planners, but once you know the basic concepts you should be able to identify a trust by its description.
A trust is a legal agreement involving at least three parties. The terms of the trust usually are embodied in a written document called a trust agreement.
The person who creates the trust is known as a grantor, settlor, trustor, or creator.
The trustee is the second party to the agreement. The trustee has legal title to the property and manages it according to the terms of the trust agreement and state law. In most states when title to the property is recorded, the title is in the trustee’s name but as trustee not as an individual, such as “John Smith, Trustee of the Smith Family Trust.”
The third party is the beneficiary, the person who benefits from the trust. There can be multiple beneficiaries at the same time and in succession. Primary or current beneficiaries benefit from the trust now, and they can be followed by contingent, successor, or alternate beneficiaries.
Sometimes an individual is an income beneficiary, meaning he or she receives only income earned by the trust, such as interest and dividends. Other beneficiaries might be only remainder beneficiaries, receiving what remains in the trust after previous beneficiaries pass away or their rights expire.
The trustee is a fiduciary who is obligated to manage the trust property solely in the interests of the beneficiaries and consistent with the trust agreement and the law.
The same person or persons can be in more than one of these roles, even all three, at the same time.
After a trust agreement is signed, a trust is funded by transferring property to it.
A living trust, also known as an inter vivos trust, is created during the trustor’s lifetime. A testamentary trust is created in the trustor’s last will and testament.
A trust can be revocable, meaning the grantor can revoke it or change its terms at any time. An irrevocable trust can’t be changed or revoked for the most part, though limited changes might be allowed.
Perhaps the most frequently-used trust is the revocable living trust, which many people refer to as a living trust.
In a typical revocable living trust, a married couple are co-grantors, serve as the first co-trustees, and are joint beneficiaries. Ownership of most of their assets is transferred to the trust, including real estate, vehicles, financial accounts, and more. The trustees manage the assets for their own benefit just as they did before the trust was created.
After they pass away, a successor trustee named in the trust agreement (often one of the settlors’ adult children) takes over and acts for the benefit of the successor beneficiaries (usually the children and perhaps grandchildren of the settlors). The assets are distributed to the successor beneficiaries as directed in the trust agreement.
Assets owned by the revocable living trust avoid the cost, delay, and publicity of probate. The trust operates as a substitute will, directing how the trust assets are to be distributed after the settlors pass away.
A revocable living trust also ensures someone can manage the assets if the initial trustee is unable to. The trust should have a co-trustee or successor trustee who steps up if the initial trustee is unable to perform the duties.
There are no income or estate tax benefits to the typical revocable living trust. During their lifetimes, the grantors are taxed on the trust assets and income as though they still were owners of the assets, because they also are trustees and beneficiaries. In addition, the assets in the trust are included in their estates under the federal estate tax.
An irrevocable trust can save income or estate taxes or both. It also can protect assets from creditors.
When assets are transferred to an irrevocable trust, the income and gains usually no longer are taxed to the trust grantor. Income and gains are taxed to the trust when retained by the trust or taxed to the beneficiaries when distributed to them.
Under the federal estate tax and most state estate taxes, assets that were transferred to an irrevocable trust aren’t included in the grantor’s taxable estate (unless the grantor continues to control or benefit from the assets).
Transfers to an irrevocable trust are gifts to the beneficiaries. The grantor’s gift tax annual exclusion or lifetime exemption can be used to avoid gift taxes, but gifts that exceed the exclusion and exemption are subject to gift tax.
“Grantor trust” is an income tax term describing a trust in which the grantor is taxed on the income, and the trust assets usually are included in the grantor’s estate. The revocable living trust is an example of a grantor trust.
But the income tax and estate tax have different definitions of grantor trusts. That leads estate planners to recommend to some clients an intentionally defective grantor trust (IDGT).
In an IDGT the grantor is taxed on the trust income, though it is distributed to the beneficiaries or accumulated in the trust. Yet, the assets in the trust aren’t included in the grantor’s taxable estate.
In effect, the grantor is making additional tax-free gifts to the beneficiaries by paying taxes on the trust income. An IDGT can be a good strategy for wealthy people.
A trust can be discretionary or nondiscretionary.
In a discretionary trust, the trustee has authority to make or withhold distributions to beneficiaries as the trustee deems appropriate or in their best interests. The trustee might withhold or reduce distributions if the beneficiary is wasting the money or has a problem such as substance abuse or gambling. The discretionary power also can protect the money from creditors and divorcing spouses.
Discretion allows the trustee to increase distributions when the beneficiary has an unexpected spending need or a good plan for the money. The discretion also allows the trustee to take income taxes into consideration and distribute or accumulate income to minimize overall income taxes.
In a nondiscretionary trust, the trustee makes distributions according to a formula or directions in the trust agreement.
A spendthrift trust is an irrevocable trust designed to protect trust assets from being wasted by the beneficiary or seized by the beneficiary’s creditors. It can be either living or testamentary.
The key provision prevents the beneficiary or the beneficiary’s creditors from forcing distributions. The money is safe as long as it is in the trust.
Most states allow spendthrift trusts, but some limit the amount of principal that can be protected. A few states don’t enforce spendthrift provisions.
A special needs trust provides for an individual who needs help and assistance for life, often a child or sibling of the trust settlor. The trust can be either living or testamentary.
A special needs trust is written to ensure the beneficiary isn’t disqualified from federal and state support programs for those with special needs, though the beneficiary still receives support from the trust.
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