- A trust fund shelters assets from probate and allows people to choose how and when their assets are distributed to heirs.
- A trust must be set up as either revocable or irrevocable and have a grantor, at least one beneficiary, and a trustee.
- Depending on the type of trust fund, one or more of these parties may be responsible for paying income and estate taxes.
Setting up a trust fund gives you control over how your money is used after your death, and sometimes even during your lifetime. Trust funds serve various purposes, such as sheltering assets from some estate taxes, paying your heirs an annual income, or giving to charity, all while potentially avoiding some of the problems that can come from transferring assets, like wills getting held up in probate court.
You can be as specific and conditional as you like when it comes to when, how, and to whom your assets are distributed, and some trust funds are more flexible than others. There isn't one single operational structure, but rather multiple types of legal agreements and countless ways to specify how you want your assets distributed.
Here are the trust fund basics you should know before setting one up.
What is a trust fund?
First, it's important to clarify that a trust and trust fund, while often used as interchangeable terms, are slightly different. A trust is a legal agreement that specifies how assets should be transferred from one party to another. A trust fund refers to the financial aspects of a trust; it's not one specific fund but rather an overarching structure that can virtually hold almost any asset, including real estate, bank accounts, investment accounts, business interests, and life insurance policies. They are often set up as part of your estate plan.
"A trust is in place to establish control about who's in charge of the money," says Jaime Eckels, CFP and wealth management partner with Plante Moran Financial Advisors. "It provides the wishes of the grantor as far as who gets the money, when they get it, how they get it, and who's in control of it."
Trusts typically shelter assets from going through probate, or the legal process after a person dies, in which the courts handle the payment of debts and taxes and distribute the remaining property according to the will or state law.
The type of trust and trust documents stipulate exactly how and to whom your assets will be distributed, whether in the form of annual income paid to yourself or your beneficiaries, money or property to be transferred to your heirs, or gifts to charity at your death.
Three parties are involved in the operation of every trust fund:
- The grantor: who opens and funds the trust
- The beneficiary: who is the person, people, or charity receiving the assets
- The trustee: the person, group of advisers, or organization that has a fiduciary responsibility to manage the trust, including now and after the grantor's death, depending on the trust structure.
In some cases, there will also be a remainderman. This person or organization (such as a charity) could differ from the beneficiary and inherit the remainder of the trust assets at the grantor's death.
A trust fund can end when all the assets are paid to the beneficiary. However, assets such as stocks will often continue to generate income, perhaps faster than income is being paid out. So, some trust funds last indefinitely. However, rules vary by state. Some impose a complex statute, the "rule against perpetuities," which means that a trust must expire no more than 21 years after the death of a potential beneficiary. Other states, however, allow for so-called dynasty trusts, which can last for many years and are a tool for avoiding or minimizing estate and generational wealth transfer taxes.
Revocable vs. irrevocable trusts
There are two main types of trust (either revocable or irrevocable), which refer to the grantor's ability to change the trust after it is set up and funded. They also have different tax implications.
Revocable trust
Also known as a living trust, revocable trusts can be altered throughout the grantor's life and even canceled (although technically a living trust doesn't have to be revocable). With a revocable trust, sometimes a single person can act as the grantor, beneficiary, and trustee during their lifetime.
If a trust pays out a portion of its assets as income or holds assets that appreciate or generate interest income, such as real estate or stocks, then that could trigger income taxes. In a revocable trust, the grantor is typically responsible for paying income taxes during their lifetime.
Although the revocable trust assumes legal ownership of the assets in a trust fund, the grantor still controls these assets, thus their value is still considered part of their estate. So, revocable trusts don't carry inherent estate tax benefits. However, these trusts can still be used to plan income distribution during and after the grantor's lifetime, so it's possible to set them up in tax-advantaged ways.
Irrevocable trust
Once the grantor dies, a revocable trust typically becomes irrevocable, meaning it cannot be altered. However, irrevocable trusts are also commonly set up during the grantor's lifetime, but the grantor can not change them afterward. Due to their irrevocable nature, there's generally more separation between the grantor and the assets placed into the trust. This often enables irrevocable trusts to be used for tax planning purposes, such as to reduce the size of a taxable estate or protect assets from creditors.
That said, the taxation and legality of any trust is complex. While an irrevocable trust often provides tax advantages, it's important to carefully construct the trust and follow associated state and federal rules to maximize benefits. That's why grantors often use professionals like estate planning attorneys to set up irrevocable trusts that maximize benefits.
Types of trusts
Under the categories of revocable and irrevocable trusts, there are also subcategories of specific trust types, including:
- Testamentary trust: Otherwise known as a will trust, a testamentary trust is created through a last will and testimony. This is an irrevocable trust that kicks in once the grantor passes away, after which the trust's beneficiaries can receive the trust assets based on the terms established by the trust.
- Totten trust: Sometimes called a payable-on-death account, this trust lets the grantor fund a bank account or other security to be set aside for a beneficiary once they die. This is a revocable trust.
- Marital trust: One spouse creates a trust for the other spouse's benefit. If one spouse passes away, any assets and income in the trust are passed to the surviving spouse while avoiding estate taxes during the surviving spouse's lifetime. If any assets remain in the trust once the surviving spouse dies, the trust might specify another beneficiary or the surviving spouse might be able to pass on the assets to heirs; at that point, however, the assets might be subject to estate or other taxes.
- Bypass or credit shelter trust: This type of irrevocable trust is often used in conjunction with a marital trust, where some assets are placed into the bypass trust to take advantage of estate tax exemptions for heirs, while the rest is placed into a marital trust or transferred directly to the surviving spouse.
- Generation-skipping trust: A trust, often irrevocable, for a grantor who wants the assets or income to be passed on to younger generations such as their grandchildren. These trusts may still be subject to the generation-skipping transfer tax, but they might be structured to maximize the exemption for this tax.
- Charitable lead trust: In general, charitable trusts allow people to create a legacy of giving within their estate plans. With a charitable lead trust, an irrevocable trust, grantors can designate a portion of assets to go toward select charities for a set period of time, like the rest of one's life, after which the assets go toward non-charitable beneficiaries. In other words, this type of trust "leads" with charitable giving but later switches, such as to pass money on to family.
- Charitable remainder trust: This irrevocable trust is essentially the opposite of a charitable lead trust. Folks who set up a charitable remainder trust can designate income from the trust's assets to go to beneficiaries like family members over a set period. After that, the remaining assets go to a designated charity.
- Life insurance trust: This can be either an irrevocable or revocable trust that holds a life insurance policy. So when the policyholder (usually the grantor) dies, the policy proceeds are transferred to the trust and can be accessed by the beneficiary according to the trust's terms. Establishing an irrevocable life insurance trust (ILIT) is often done to minimize estate taxes, while a revocable life insurance trust (RLIT) is more about control, rather than being part of a tax planning strategy.
- Grantor retained annuity trust: A grantor retained annuity trust (GRAT) is an irrevocable trust that can minimize gift and estate taxes if used properly. Grantors can contribute assets to the trust as a gift but then receive most or all of that money back via annuity payments, which reduces the taxable value of the initial gift, meaning grantors can preserve more of their lifetime gift exemption. Meanwhile, the proceeds of the GRAT's assets can grow and potentially be transferred to beneficiaries with minimal, if any, tax obligations. GRATs can also be set up to end after a minimum of two years, so it's possible to transfer the proceeds to beneficiaries during the grantor's lifetime or set it up so that the proceeds move into another trust fund.
- Special needs trust: A trust that sets aside assets for those with special needs, like disabilities, without affecting the beneficiary's eligibility to receive government benefits, like Medicaid and Supplemental Security Income (SSI). A special needs trust (SNT) is typically irrevocable to more easily preserve government benefits, but some third-party SNTs (meaning funded with assets belonging to someone other than the beneficiary) are revocable, often for financial planning purposes before switching to an irrevocable structure.
- Spendthrift trust: This can be a revocable or irrevocable trust. Rather than transferring ownership of all trust assets to the beneficiary outright, the trust remains the official owner and doles out funds to the beneficiary according to the grantor's terms. The purpose of this trust is often to prevent misuse by the beneficiary by establishing restrictions on how the assets and income in the trust can be accessed.
Common purposes of trust funds
Parents and grandparents commonly use trust funds as part of estate planning and a secure method of passing on inheritance. Not only are grantors able to dictate when and how beneficiaries receive assets, but some trusts also offer protection against creditors.
Grantors can set up payout schedules, establish specific milestones, and determine what age assets can be distributed. Moreover, the contents of the trust are managed by financial professionals familiar with dealing with large sums of money.
Wealthy families may be able to use trusts, particularly irrevocable trusts, to diminish the value of their estates and thus decrease taxes on their children's inheritance. Trusts can also minimize taxes such as if interest or dividends earned from trust fund assets are then transferred to the beneficiary who is in a lower tax bracket than the grantor or the trust itself.
Trust funds are also commonly used to distribute wealth to one or multiple charities. You can even designate specific assets to be donated to specific charities at set points.
How to set up a trust fund
You typically need to consult an estate planning attorney to set up a trust fund, particularly for drafting legal documents. However, you might first want to meet with an advisor such as a CFP to discuss more of the financial aspects of trust planning.
Choosing the right trustee
One of the most crucial elements of setting up a trust fund is choosing the right trustee (aka the person, group, or organization responsible for managing the assets). Like a Registered Investment Advisor, a trustee has a fiduciary duty to manage the trust's assets for the good of the beneficiaries and put their interest first.
A trustee can be an individual family member or trusted friend. Or, you can have your trust fund managed by a corporate trustee or trust company. Regardless of who it is, your trustee should be honest, with good judgement and some kind of knowledge or experience in managing financial assets.
"There are a lot of benefits to having a professional trustee, but oftentimes, people don't think a bank will know their family or the grantor's true wishes," states Eckels. "It feels less personal, so people naturally go to individuals they already trust and know. But often, we like the balance of both corporate and personal trustees."
You can designate multiple trustees, or even backup trustees, in the event that the trustee is unable to perform their duties.
Trustees can have a wide range of responsibilities, like making investment decisions, filing tax returns, managing the assets in the trust, and communicating effectively with the beneficiaries. Although a trusted friend or family member may feel like the most comfortable option, professional trust fund management, such as from corporate trustees and trust companies, will often provide the most expertise and lack of biases. Professional trustees are also usually better for complex assets. But you may have to pay fees.
Funding your trust fund
The grantor can fund a trust fund all at once or gradually over time with assets such as:
- Cash
- Stocks
- Bonds
- Real estate
- Artwork and other collectibles
Benefits of trust funds
Trust funds are often used as estate planning tools for people to protect and manage their wealth. One of the main benefits of setting up a trust fund is that grantors generally get complete control over establishing who the beneficiaries are, when they can access the assets, and how, although with irrevocable trusts, the grantor gives up control after initially establishing these terms. So, if you're worried about misuse, you can structure your trust according to what you want.
If the beneficiaries lack experience managing complex assets, you can establish a financial expert or institution as the trustee to manage the funds and ensure they are being used responsibly. Another possible advantage is reduced estate taxes if using an irrevocable trust. Grantors can reduce taxes for themselves and their beneficiaries by lowering the taxable value of their estate. Moreover, you can avoid high probate costs with either revocable or irrevocable trusts.
"A trust can help you avoid the unnecessary cost and time-consuming process of probate," says Eckels. "It's important to not just have the trust documents in place, but make sure that all the assets are listed on your balance sheets and that beneficiaries are titled appropriately."
Drawbacks of trust funds
Trust funds can be costly as you may have to pay trustee administration fees, tax filing fees, accounting fees, investment management fees, legal fees, and more. The initial cost of drafting a trust document can also be expensive. Therefore, trust funds are not generally ideal for fee-conscious individuals.
However, the additional cost may be worth it, especially for people with larger estates.
"I tell people that are hesitant because it seems like a hassle or too much money that the consequences of not organizing things in your lifetime, and not paying those upfront costs, could lead to additional costs for your family later on," comments Eckels.
Remember that trusts are complex legal documents, so you'll either need to be knowledgeable of how trusts are established to meet your goals or work with a professional like an estate planning attorney who can help you determine the best trust fund for your situation and help you draft the legal documents. There's also always a chance of mismanagement, especially if the trustee is a friend or family member with poor decision-making, so be aware that trust fund management is something to take seriously.
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FAQs
Can anyone set up a trust fund?
Yes. Anyone can establish a trust fund, as no specific wealth requirements exist. Trust funds are often viewed as an estate-planning tool for the wealthy, but they can be used by anyone who wants to set up a trust for their loved ones. However, the costs and complexity often make trusts better suited for those with particular estate planning goals, like managing taxes or providing for children with special needs.
How much does it cost to set up a trust fund?
A trust fund can be expensive due to high legal fees, management fees, trustee fees, and more. It can cost from a few hundred dollars to several thousand to establish, depending on the type of trust and the assets held in the account. Ongoing professional trustee fees could also be roughly 1-1.5% of assets annually.
Are trust funds only for the wealthy?
No, trust funds are not only for the wealthy. Although considered an estate planning tool for the wealthy, trust funds are great financial tools for all kinds of investors and families of varying wealth levels. However, remember that trust funds involve high fees, so you'll have to weigh these costs against the benefits for your situation.
How long does a trust fund last?
How long a trust fund lasts depends on the terms of the trust. Some trust funds have regulations by the grantor that require the beneficiary to be a certain age or meet other qualifications to access the assets. Others are designed to last indefinitely, with only the earnings from the assets paid out.
Can a trust fund be changed or revoked?
Some trust funds can be changed or revoked, while others are more limiting. Revocable trusts can be altered or dissolved by the grantor during their lifetime. Irrevocable trusts, on the other hand, can't usually be altered once established.
How do trust funds pay out?
Trust funds pay out based on the terms set by the grantor and type of trust, which can vary substantially. For example, some trusts give full control to beneficiaries at a certain age, while others pay out a certain percentage of assets on a set schedule.
