One of the most important tools in the estate planning process is a trust. For many people, the will serves as the heart of the estate plan, but the truth is that wills can be contested and face a long probate process. A trust provides a smoother transition of assets to loved ones.
The term trust actually includes a number of different types of products depending on your particular needs. The simplest definition of a trust is a legal contract between two parties, the trustor, who creates the arrangement, and the trustee, who manages the assets according to outlined wishes. Trusts can involve beneficiaries, which may be individuals or charitable organizations, that receive assets from the trust based on how the trustor sets up the arrangement. Many types of assets can be transferred to a trust, including bank accounts, property, investments, collectibles, and business interests.
There are many reasons to establish a trust. One is that assets transferred through a trust do not go through probate as they do with a will. Avoiding probate means greater privacy for your assets and less time before they are dispersed. You can also set up the will to take effect when you become incapacitated so that designated people can carry on your plans. A trust allows you to set rules or requirements for receiving an inheritance. Often, a trust reduces the estate and gift taxes that future generations face when they inherit assets. Because of these benefits, many people rely on trusts to ensure the smooth transition of assets between generations rather than wills or other options.
The Two General Classifications of Trusts
Trusts come in two general flavors. The first is a revocable trust, which may also be called a revocable living trust. With this type of arrangement, you maintain control of your assets while you are alive. At any time, you may choose to change or even dissolve a revocable trust, hence the name. You may, for example, revoke a trust when you get divorced or make changes as you acquire new assets. Revocable trusts come with a lot of flexibility since nothing is permanent until you become incapacitated. You can even name a successor trustee who will take over when you become incapacitated. This person can make changes or revoke just as you can. Also, you should know that creditors can only rarely claim assets in a revocable trust to satisfy outstanding debts.
The other type of trust is an irrevocable trust. This trust cannot be changed or modified in any way. Once you choose for an asset to get transferred, that action must happen. Since this type of trust has much less flexibility, you may wonder why anyone would create one. The main reason is to create a haven for assets. Any asset in an irrevocable trust cannot be claimed by creditors, other beneficiaries, or even organizations like Medicaid. Also, irrevocable trusts remove assets from your estate, which provides shelter from estate and gift taxes.
For obvious reasons, an irrevocable trust comes with some risk. Creating one can have great benefits, but it is important to consider the ramifications of this sort of arrangement, especially if you do not anticipate incapacitation in the near future.
Some of the Special Types of Trusts
As mentioned already, many different types of specialty trusts help with estate planning. Depending on your circumstances, it may make sense to create one of these special agreements. For example, married couples often create A or B trusts. An A trust is established by one spouse for the benefit of the other. This agreement would allow you to avoid paying estate taxes on inherited assets. However, this protection only lasts for one generation and any heirs would face estate taxes.
A B trust can be used to reduce the estate tax burden on heirs. This irrevocable trust transfers assets from one spouse to another at the time of death. The surviving spouse does not hold the assets directly. Instead, the trustee manages them, and they go excluded from the surviving spouse’s estate. When that person dies, any remaining assets get passed to beneficiaries without estate tax. You may also consider a generation-skipping trust, which allows you to transfer assets directly to your grandchildren; a spendthrift trust, which allows you to set limits on how assets get accessed and used by beneficiaries; or a special needs trust, which allows you to leave assets to someone with special needs without compromising any ability to qualify for or receive government benefits based on disability. Another commonly used option is the life insurance trust, which holds life insurance proceeds after your death. The trustee then manages these proceeds on your behalf. This is an irrevocable trust and allows you to avoid estate taxes on any life insurance payouts.