When it comes to estate planning, one of the most important factors to keep in mind is that trusts are formed in accordance to state, not federal, law.
That’s why it is so important for people who want to establish a trust to consult with a tax law expert who specializes in the laws within their state of residence.
But what is a trust? And how can it improve the outcome of your estate planning process? Let’s find out.
What is a trust?
A trust is a legal document that outlines therelationship between individuals and their obligations regarding assets in an estate. For instance, the grantorof a trust holdsthe title to a property and the trustee is obligated to either keep or use the property for the benefit of another, whether that’s a spouse, child, nonprofit entity or other benefactor.
You set up a trust while you are living to ensure that your assets will be used in the way you want after you pass away. Once a trust is formed, a third party — known as the trustee — will manage affairs pertaining to the trust, including how the assets are invested postmortem and to whom the assets are distributed after the owner of the trust dies.
One of the main reasons people choose to set up a trust instead of opting for the more popular will is to avoid the probate process, which can be rather lengthy. A trust can be an especially appealing option for those who own property in more than one U.S. state. Additionally, most probate court decisions are public records, which can be a concern for certain grantors.
Two main categories of trusts
There are two main types of trusts: revocable trusts and irrevocable trusts.
Revocable trusts
Also known as living trusts, revocable trusts incorporate clauses that permit the grantor to either adjust or eliminate the terms of the trust at any time during his or her lifetime. Easier to set up than irrevocable trusts, revokable trusts offer more flexibility. That said, a revocable trust becomes an irrevocable trust as soon as the grantor passes away.
Irrevocable trusts
Irrevocable trusts are typically impossible to change once they are established. Once you create an irrevocable trust, you — as the grantor — must relinquish all rights and control over your trust, including the property within it. While this may sound frightening, the main draw of irrevocable trusts is the tax-related benefits that do not come with revocable trusts.
Different trusts for different purposes
Now that you know the two main categories of trusts, let's explore the different types within each category. Every type of trust serves its own unique purpose. Let’s take a look at some of the most common types of trusts.
Asset protection trusts
Also known as offshore asset protection trusts, asset protection trusts are quite complex. As one of the most complicated trust designs, asset protection trusts are intended to keep the grantor’s assets safe from creditors, lawsuits and judgments. While these trusts are not available in every U.S. state, some foreign jurisdictions — namely non-treaty countries — recognize these trusts as valid.
Bypass trusts
Bypass trusts make it possible for the grantor to leave assets behind for their spouse's estate in a tax-free manner. Under these trusts, if the surviving spouse passes away after receiving the assets, then the assets will be passed along to the couple’s beneficiaries tax-free as well. Note, this pertains specifically to estate taxes.
Charitable remainder trusts
Charitable remainder trusts are a type of irrevocable trust that can be used as a source of income until the grantor passes away. At that point in time, the assets that remain in the trust will be distributed to one or multiple organizations of the grantor’s choice, which would have been determined prior to the grantor dying.
Charitable lead trusts
Charitable lead trusts are another type of irrevocable trust. With a charitable lead trust, you — as the grantor — can set aside specific assets of yours with the intention of having them passed along to one or more organizations when you pass away.
Family trusts
A family trust is specifically intended to benefit the family members of the grantor, whether they be children, grandchildren, siblings, spouses or other family members. An added bonus is that family trusts can be either revocable or irrevocable.
Special needs trusts
By establishing a special needs trust, you can provide disabled beneficiaries with income after you pass away. Plus, you can do so without disqualifying said beneficiaries from receiving government benefits, such as Social Security Disability Income.
Spendthrift trusts
Spendthrift trusts distribute the assets of a trust over time instead of passing them along to beneficiaries as a lump sum. Also, the assets are not considered the beneficiary’s personal assets until they are fully distributed.
Testamentary trusts
A testamentary trust is created via a will, so testamentary trusts must go through the probate process. This means your estate will become a matter of public record, so keep this in mind.
Totten trusts
A Totten trust is a type of revocable trust that must be set up at a bank. When the grantor dies, the assets in the bank account will be passed along to the beneficiary.
Each type of trust carries its own advantages and disadvantages. To ensure that you don’t get confused or miss out on any vital information pertaining to trusts, make sure you consult with a tax professional who is familiar with both federal and state laws. That way, you can rest assured that your estate plan contains a legal, beneficial and fully intact trust according to your situation.
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