Trusts are no longer an agreement kept written down on a piece of parchment inside a safety deposit box or a delicate wooden ornate container. Actually, they might still be, but trusts are no longer a thing of the past. Trusts, in fact, have become part and parcel of estate planning. But what are they?
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What is a Trust?
A trust is a legal instrument by which you transfer property to someone (called a “beneficiary”), but just not right away or all at once. If you give property to someone right away and all at once, that would be a completed gift and doesn't require a trust. In simple terms, a trust is something that allows you to set the terms on how and when a beneficiary will receive the property that you transfer.
In estate planning, a trust offers several important benefits that you might not get otherwise. Curious about setting up a trust? Learn why a trust can be one of the most effective and commonly used methods of transferring property at death.
When you die, all of the property that you own at the time of your death makes up your “estate.” Your estate must be distributed to others who can make use of your property. As such, your estate will be divided into two parts: your “probate estate” and your “non-probate estate.”
Your probate estate
As the name suggests, your “probate estate” is the property in your estate that is “probated.” “Probate” refers to the legal process through which the court distributes your property to those who are legally entitled to it.
There are two reasons why your estate would have to be probated through the court:
You died with a “last will and testament” (a will)
When you die having executed a will, your will must be probated. This means that your will must be presented to the probate court, so that the court can officially transfer the title of your property to the person you named in your will to receive it. It is a way of making your will legally binding.
You died without a will (and without a “will substitute” or a “non-probate transfer”)
When you die without a will telling the court what to do with your property, and you do not have another method for legally transferring your property, then you die with property that the court has no idea what to do with. In this case, you are said to have died “intestate.”
When you die intestate (without a will), the court will order that your property be distributed according to the state’s intestate laws. These are laws that distribute your property to your living relatives (called “heirs”). Therefore, if you die without a will, your estate must go through probate so the court can determine which of your heirs are legally entitled to your property.
When you die, your probate estate—the property you own that has to go through the probate process—consists of everything that is included in your will. Everything that is not included is then considered your non-probate estate.
Your non-probate estate
Your non-probate estate is all of the property in your estate that is not part of your will, nor part of intestacy, but instead gets transferred by some other legally binding method of transfer. These could include any or all of the following:
- Completed gifts during life
- Payable-on-Death Accounts, like life insurance, jointly held property, or retirement and investment accounts
- Certain kinds of trusts
So when you die, the property you own that does not go through the probate process-- previously mentioned as your non-probate estate—will consist of everything that is not included in your will. That property has its own method of transfer mandated by the specific instrument or account that the property is in. These instruments or accounts are legally binding and do not require the probate court to take any action to transfer the property.
The probate process may require you to incur several expenses, including:
- Attorney fees
- Fees for an executor or representative (if you have a will)
- Court costs and filing fees
There are other aspects of the probate process and having a will that can be disadvantageous. Some of these examples include:
- The probate process can take a long time--perhaps as long as a year or more
- The probate process can delay the distribution of your property
- A will is a public document; anyone can see your will and know what property you included and who you wanted your property to go to
- Your estate will have to pay estate taxes on the value of whatever property is included in your probate estate.
Although a will is an effective method of transferring property at death and is highly recommended before intestacy, there are several good reasons to try to avoid the probate process by using non-probate instruments to transfer your property.
Out of all the non-probate transfer instruments available, a trust is one of the more useful methods that allows you to accomplish most estate planning goals that you might have.
How Trusts Work
Like most other non-probate transfers for which you name a beneficiary to receive your property upon your death, trusts help to distribute the property according to the terms set forth in the instrument. For example:
- With life insurance, you name a beneficiary on your life insurance policy to receive your benefits when you die, and the life insurance company pays the benefits according to the terms of the policy.
- For joint bank accounts, you name the other joint-account holder when you open the bank account, and when you die, the money in your account automatically transfers to the other person named on the account according to the terms of the bank account.
- When you and your spouse own your home with a right of survivorship and one spouse dies, the surviving spouse retains ownership of the home according to the terms set under the particular title that applies to your home.
In all these cases, the probate court does not become involved with the transfer of any of these assets.
With certain kinds of trusts, when you die, your property held “in trust” gets distributed to any beneficiaries you name, according to the terms set in the trust. However, instead of making one completed transaction that is payable immediately upon your death, a trust allows you to set whatever terms you want for the distribution of the property to your chosen beneficiaries.
For example, assume you have $100 and you want your grandchild to benefit from that $100. Consider the different ways you could transfer that property to your grandchild:
- If you simply want your grandchild to receive the entire $100 right now, you could just gift them $100. You would not need a trust.
- Likewise, if you want your grandchild to receive the entire $100, but only when you die, then you could leave $100 to your grandchild in your will. When your will is probated, your grandchild will receive the $100.
However, when you place that $100 in trust, you do not transfer that $100 directly to your grandchild. Instead, with a trust, you give your property to someone else (called a “trustee”), who holds the property for the beneficiary. Although the trustee holds legal title to the property and therefore legally belongs to them, the trustee is not allowed to do anything with the property except what you tell them to do with it.
The trustee is only allowed to give the property to the beneficiary you name, and only according to the terms that you set. In legal terms, the trustee is said to hold “legal” title, and the beneficiary is said to hold “equitable” title.
However, the beneficiary also has a right to ask a court to enforce the trust if the trustee is not following the terms of the trust. Otherwise, the beneficiary has no right to the possession of the property until the terms of the trust provide for them to receive it.
So back to the example. If you have $100 that you want your grandchild to benefit from, but you do not want your grandchild to squander the entire $100 on something you do not approve of (let’s say, candy), then you could put the money in a trust.
With the money in trust, you could name your child (your grandchild’s parent) as the trustee and set the terms of the trust to direct your child to use the $100 on your grandchild by purchasing $25 worth of school books at the beginning of the next four school years.
By using a trust, you can ensure the following:
- Your grandchild will benefit from your $100.
- Your grandchild will not squander the $100 on candy because they do not have possession of the $100. Legally, it belongs to your child--the trustee.
- Your child cannot spend the $100 on anything other than school books for your grandchild.
- You approve of what the $100 will be used for.
- The $100 will not be part of the value of your estate, on which you must pay estate taxes when you die. It is no longer property that you own because you transferred the legal title of the property to the trustee.
- You can take comfort in the fact that if your child does not use the $100 to purchase $25 worth of school books for your grandchild at the beginning of the next four school years, your grandchild can ask the court to enforce the terms of the trust.
So if you’re looking for a little more structure to your estate planning, there are many benefits gained by using a trust to transfer property upon death.
Different Types of Trusts
There are many different types of trusts. The type of trust you use will depend on what you want to accomplish. Here are some of the most common types of trusts that you can use and what you can do with them.
Living (inter vivos) or revocable trust
Living trusts are created during life. Therefore, as the person creating the trust (a “grantor”), you are free to modify or revoke the trust before you die.
Also, you are free to remove the property from the trust. However, since you still have access to the money in the trust, your creditors may petition the court to have access to it to satisfy your debts when you die. When you die, since you can no longer revoke the trust, the trust becomes irrevocable.
An irrevocable trust is one that cannot be modified or revoked. Because you cannot revoke it and have no access to the funds in the trust, it is not part of your taxable probate estate.
In a mandatory trust, the creator of the trust mandates specific acts to be performed by the trustee. For example, the grantor might direct the trustee to pay the beneficiary’s college tuition every year. Although the tuition may fluctuate, the duties of the trustee are mandatory.
Unlike a mandatory trust, in a discretionary trust, the creator of the trust authorizes the trustee to exercise discretion in distributing the trust funds to the beneficiary. For example, the grantor might allow the trustee to pay the beneficiary’s college tuition if the trustee deems it necessary.
A-B or by-pass trust
A by-pass trust allows a spouse to leave money to the other spouse, tax-free, based upon a qualified exemption for spouses, which then limits the amount of federal estate taxes paid upon the death of the second spouse.
A spendthrift trust limits a beneficiary’s access to the funds in the trust. It also protects the property from the creditors of the beneficiary until the beneficiary receives the property.
Asset protection trust
An asset protection trust protects a person's assets from future creditors by restricting the grantor’s access to the funds in the trust while there is creditor liability. When the risk of credit liability is removed, the trust is terminated and the assets are returned.
Charitable trusts benefit a specific charity that the grantor names or may benefit the general public. Charitable gifts can reduce estate and gift taxes.
A constructive trust is created by the court to avoid unjust enrichment of a beneficiary who nevertheless obtains legal title to property in trust. The court may create a constructive trust that provides the benefit to the person the grantor intended to benefit under the trust, based on principles of equity.
Special needs trust
A special needs trust is used to enable a disabled beneficiary to qualify for federal or state benefits based upon financial eligibility. Because the beneficiary cannot access the funds, they do not count toward the beneficiary’s financial eligibility for the government benefits.
A Totten trust is created during life and functions as a revocable bank account that the grantor opens as trustee to another person or entity, but the funds are not distributed until the grantor’s death. The funds are then excluded from probate.
A pour-over trust is an inter-vivos trust that names the grantor’s last will and testament as the beneficiary of the trust, and the grantor then names the beneficiary in the will. Likewise, when a will names as beneficiary an inter-vivos trust, this is called a pour-over will.
How to Set Up a Trust
Creating a trust requires only five things:
- Grantor or Settlor. A trust requires that someone intends to create a trust by setting money or property aside, giving up legal title to a trustee, for the benefit of one or more beneficiaries.
- Trustee. A trust requires someone to take legal title to property and to be subject to the fiduciary responsibilities of holding the property for the benefit of the beneficiaries named in the trust. A grantor may serve as the trustee, provided the grantor is not also the only beneficiary.
- Beneficiaries. A trust requires that there be a beneficiary who holds an “equitable” interest in property that a grantor gives to a trustee to manage for the benefit of the beneficiary. Once the legal and equitable titles are joined through the distribution of the property to the beneficiary, and the purpose of the trust is fulfilled, the trust is finished, or necessarily terminated.
- Funds. A trust must be funded with property. The funds in a trust are called the “res,” “corpus,” or “principal.”
- Intent or Precatory Purpose. A trust must include directives that limit the trustee’s use of the property in trust to accomplish an intended purpose. Without express directives intended to be fulfilled, the trust necessarily terminates.
Provided a grantor intends for a trust to be created and to be bound by the limits of the trust, a trust does not require that the writing include the word “trust” or any express language of the sort.
A Trust Can Provide Many Benefits to Your Estate Plan
Now that you know about trusts and how they are used, you can make decisions that include specifics like asset protection, tax savings, and avoiding probate.
There are few limitations to the type of trust you can create except for the purposes you want to accomplish when transferring property upon death. Speak to your estate planner about whether a trust is right for you.