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Trust

A trust is a legal entity you set up to hold, safeguard, distribute, and control the assets you place into it. It is a popular legacy planning tool.

Most people view trusts as something only necessary for the ultra-wealthy. Contrary to popular belief, trusts don’t need to be just for the upper-income echelons. They can be a good, tax-savvy way to pass your estate on to your heirs, regardless of the size of your assets and family, and can help you manage your property during your life and beyond.

How Does a Trust Work?

A trust is a legal entity you set up to hold, safeguard, distribute and control those assets you place into the trust. When it comes to managing your trust, there are generally four parties involved. The four parties include a trustor (a.k.a. the “grantor” or “settlor”) who sets up the trust, the trustee who manages the trust’s properties, the beneficiary who receives the assets of the trust, and the successor trustee (and beneficiary), who takes over if the original trustee is unable to serve.

A trust carries rules and provisions that you create in order to dictate what happens to the assets held under the ownership of the trust. Because there are various types of trusts, you will want to decide what type meets your objectives the best, and ensure you follow the rules for that trust so that the legal requirements continue to be met.

Why Would You Set Up a Trust?

Trusts have become a popular legacy planning tool, especially for high-net-worth individuals. Below we’ll talk about some of the advantages of using a trust in your estate planning.

Avoiding or reducing estate taxes and gift taxes

Estates of a certain size are subject to the estate tax in the U.S. This tax generally applies to estates worth more than $12.06 million (though the exact number changes each year).

In addition to the estate tax, the U.S. may also assess a gift tax on large gifts from one person to another. When you give more than $15,000 to another person in a single year, you’ll have to file a gift tax return. And once you use up your lifetime gift tax exemption (which is combined with your estate tax exemption), you must pay gift taxes on any gifts above $15,000 per year.

Certain types of trusts allow families to avoid or reduce estate and gift taxes. When you transfer assets into an irrevocable trust, they are subject to gift taxes, but then won’t be subject to the estate tax when you pass away. On the other hand, when you move assets into a revocable trust, you aren’t subject to gift taxes but could be assessed estate taxes when you pass away.

Avoiding or reducing the complex and lengthy probate process

Many people are surprised to learn that, contrary to popular belief, having a will doesn’t necessarily help you avoid the probate process. Even if you have a will that states how your assets should be distributed after you die, your assets generally must still go through probate before being distributed to your loved ones.

There are several ways to help your estates avoid probate, including by placing them into a trust before your death. Assets in both revocable and irrevocable trusts avoid probate, making them powerful estate planning tools.

Protecting your estate’s assets from beneficiaries’ creditors or legal situations

A part of the probate process is notifying your creditors of your death and giving them the opportunity to make a claim on your estate. One way to prevent creditors from making a claim to assets in your estate is to place those assets into a trust.

It’s important to note that only irrevocable trusts are protected from creditors. Assets in a revocable trust are still subject to claims from creditors because they legally belong to you until your death.

Donating to charities in tax-efficient manners

A charitable trust is a financial tool that allows a donor to transfer assets to a charitable organization by first transferring them into the trust with the organization named as the beneficiary.

In some cases, a charitable trust distributes the income from your trust assets to a designated charity for a finite amount of time. Once that time ends, the trust assets are distributed to other beneficiaries, who are usually loved ones. Other charitable trusts work the opposite, where they provide income to loved ones for a finite period of time and then distribute the remaining assets to a charitable organization.

Charitable trusts have tax benefits since the money donated to non-profit organizations is eligible for the charitable deduction. Additionally, if you use an irrevocable trust for your charitable trust, the donor won’t be on the hook for capital gains and estate taxes.

Protecting you and your beneficiary’s privacy

We’ve already talked a bit about the probate process, which can be lengthy and expensive. But the probate process is also a public one. In some states, probates must be published in the newspaper. They are also public records, meaning anyone can read up on your assets and estate. Because trusts avoid probate, they also help protect your loved ones’ privacy, since they don’t let the world know the ins and outs of your estate.

Types of Trusts

There are several different categories of trusts, each of which offers individuals and families different benefits. Below we’ll break down the different types in more detail so you can learn which is best for your situation.

Living or Testamentary

A living trust is one that’s established during the grantor’s lifetime. The grantor can transfer assets into the trust, and depending on the type of trust, may also be able to transfer assets out. For a trust to avoid probate, it must be a living trust.

A testamentary trust, on the other hand, is one that’s created after someone dies. The trust is usually created as one of the terms of the person’s will. With this type of trust, the grantor maintains ownership and control of the assets during their lifetime, and then they’re transferred into the trust after their death. Because the assets aren’t transferred into the trust until after the grantor’s death, they aren’t protected from creditors or probate.

Revocable or Irrevocable

A revocable trust is a type of living trust that allows the grantor to maintain control of the assets during their lifetime. The grantor transfers assets into the trust, but can continue to make changes to the assets and beneficiary, and even revoke the trust altogether.

When assets are transferred into a revocable trust, they aren’t subject to gift tax laws, since they still legally belong to the grantor. However, they also aren’t protected from estate taxes or creditors when the grantor dies.

An irrevocable trust is one where the terms are set in stone. The grantor can’t make changes to the beneficiaries or terms of the trust. And once assets are transferred into the trust, they no longer legally belong to the grantor, meaning they can’t later withdraw them for personal use.

The assets transferred into an irrevocable trust are subject to gift tax laws. However, when the grantor dies, those assets are protected from estate taxes and creditors.

Funded or Unfunded

When someone creates a funded trust, they transfer assets into it during their lifetime. But when a trust is unfunded, it remains unfunded at the time of the grantor’s death. In someone’s will, they could direct assets to be transferred in the trust. This is different from a testamentary trust because, in the case of a testamentary trust, it’s not created until after their death. An unfunded trust is created during the grantor’s lifetime, but no assets have been transferred in.

There are several disadvantages to an unfunded trust. Specifically, the assets that would be transferred into the trust aren’t protected from gift taxes, estate taxes, probate, or creditors.

Who Needs a Trust?

While we don’t believe a trust is necessarily exclusive only to high-net-worth people, if you have a net worth over $10 million, you will likely want to consider a trust. Also, for those who want to leave property to a beneficiary who is incapable of handling their own finances – through disability or otherwise – trusts can be a valuable tool. Individuals who want to ascertain a certain degree of control of how the assets are utilized or distributed may also want to consider trusts to outright bequests.

In addition, a trust may be the right vehicle for you if you:

  • Are middle-aged or older – or in poor health
  • Not able to take advantage of simpler probate-avoidance methods
  • Own out-of-state real estate
  • Are not worried about big creditors’ claims
  • Have incapacity concerns.

Of course, this isn’t a final list of reasons to consider a trust, so you’ll want to contact an Estate Attorney to see if a trust is right for you.

Our Take

Trusts can be helpful for families of all sizes and incomes, but creating and administering a trust can be (but isn’t always) a complex, time-consuming and relatively expensive process. Deciding whether to set up a trust, the type of trust, and what provisions to include depend on your individual circumstances and goals.

To learn more about trusts and how they can fit into your overall legacy planning, read our free Guide to Legacy & Estate Planning.

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The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

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