While it may be a common perception that trusts are something only the wealthy use, they actually provide practical benefits for people of all incomes. Trusts are used to ensure your assets will pass on to your heirs following your wishes. This is often done with greater protection than a will because it cannot be challenged by creditors or other interested parties.
However, trusts are also legally binding documents with lots of specific rules and language. To better help you understand them, here’s what you need to know about the different types of trust funds and how they can benefit your family.
What is a Trust?
A trust is a legal arrangement where you transfer your property to a third party. This third party will then distribute the property to the beneficiaries in accordance with the terms of the trust.
Trusts can be one of the most important documents you have when it comes to estate planning. Selecting the right type of trust will not only protect your assets from probate, but it can also make them more tax-efficient for you and your heirs too.
The Basic Elements of a Trust
● Grantor: The person who creates the trust and funds it with property. Grantors are also called settlors or trustors.
● Trustee: The person or entity who holds legal title to the trust. Trustees have a fiduciary responsibility to distribute the property within the trust to the beneficiaries.
● Beneficiary: The parties who will receive the benefits of the trust property.
● Property: Assets held inside the trust such as money, investments, real estate, insurance policies, etc.
● Revocable: A trust in which the terms can be changed after it is created.
● Irrevocable: A trust in which the terms cannot be changed once it is created.
● Taxes: Money that is owed to the government according to the IRS rules.
Common Types of Trust Funds
Revocable trusts can be changed, modified, or even revoked entirely. They are created while the grantor is alive, hence why you will often hear them referred to as “revocable living trusts”.
To fund the trust, a grantor will designate the trust as the beneficiary of their financial assets. Then, upon death, these assets will bypass probate and transfer directly into the trust where they can be divided to your heirs as instructed. This allows the grantor the ability to enjoy their property while they are alive while providing a safe way to transfer assets upon death.
An irrevocable trust cannot be changed, modified, or revoked after its creation. Once assets transfer to the trust, they become the property of the trust. No one, including creditors and even the trustor, can remove these trust assets outside the terms of the trust.
Typically, irrevocable trusts are used to provide iron-clad protection for beneficiaries. This is why revocable trusts often evolve into irrevocable trusts after the grantor passes.
A Medicaid trust is a special type of irrevocable living trust designed to preserve your assets while still qualifying for Medicaid.
Under the rules of Medicaid, you must have little to no assets to qualify for assistance. Since nursing home care can be quite expensive, this usually means that most people will drain their assets leaving almost nothing for their heirs. However, by setting up a Medicaid trust several years in advance, they can partition this property from Medicaid’s resource limit.
Asset Protection Trusts
Asset protection trusts are intended to protect your property from creditors. By design, the trust is set up to be an irrevocable living trust for a specific number of years. Then, once the term expires, if there are no outstanding claims from creditors, the grantor can once again regain control over the assets.
A charitable trust is created to benefit a charity or non-profit organization. In addition to the satisfaction of supporting a good cause, charitable trusts can also allow the grantor to bypass estate and gift taxes.
Special Needs Trust
A special needs trust is useful when a person needs to receive income but does not want to become disqualified from receiving government assistance (such as a veteran or someone who is disabled).
A generation-skipping trust is a specific arrangement where the trust assets skip the grantor’s children and instead pass down to their grandchildren. Thanks to the American Taxpayer Relief Act of 2012, this makes it possible to bypass any estate taxes that would normally be owed.
Life Insurance Trust
A life insurance trust is a type of irrevocable trust where the asset is a life insurance policy. Because the trust is both the owner and beneficiary of the policy, it allows the grantor of the policy to make this asset exempt and the proceeds can be used to pay for estate taxes.
A spendthrift trust protects a beneficiary from having their interest in the trust taken. Under the rules of a spendthrift trust, creditors cannot lay claim to the beneficiary’s assets until they have been distributed out of the trust.
A Totten trust is one where the grantor sets up a financial account and names it to a beneficiary. The grantor funds this account throughout their life, and then, after death, the proceeds are delivered to the beneficiary. Totten trusts are sometimes referred to as a payable on death (POD) account.
A testamentary trust is created by a will after the grantor dies. This can help combine your assets into one holding and then distribute them according to your final wishes.
However, unlike a revocable living trust, a testamentary trust is not established or funded until after death. This means that your will (and assets) are still subject to the probate process. Therefore, a court may decide to distribute the assets to creditors or other parties who lay claim to it.
When it comes to estate planning, trusts can be very useful tools for passing on assets and providing tax efficiency. However, they are also legally binding documents that should be approached with caution. If you or a loved one creates any type of trust, it should be added to your important documents organizer.