There are a number of different types of trusts, and understanding how they differ may help you choose the appropriate type to meet your financial needs. It's important to know, for example, the differences between a living trust vs. testamentary trust and a revocable trust vs. irrevocable trust. Whichever trusts you choose may help you bypass probate, gain tax advantages, help protect assets from creditors and control assets. Here's what to consider.
What Is a Trust?
A trust is a legal arrangement that allows a third party, known as a trustee, to hold assets on behalf of a beneficiary or beneficiaries. The individual who creates the trust is called a trustor, a settlor or a grantor. In the case of an irrevocable trust, the trustor may be called a benefactor. Trusts are commonly used as an estate planning tool for transferring assets to beneficiaries.
There are many different types of trusts and various arrangements that can be made within them. The type of trust used depends upon the wishes and financial priorities of the trustor or benefactor. Consider talking to an attorney about any questions you have.
Benefits of Trusts
There are a number of reasons to consider a trust when estate planning. Here are some of the common benefits:
- Bypass Probate: Assets that are willed to beneficiaries generally pass through probate, which is a legal process that can be time-consuming and expensive. Avoiding probate can help save time and money for your beneficiaries, and it can help protect your family's privacy.
- Privacy: Trusts can help protect your privacy because they do not necessarily become public record.
- Tax Advantages: Certain types of trusts allow for the transfer of assets out of the estate, which can effectively reduce estate taxes and gift taxes.
- Protecting Assets From Creditors: Similar to the tax advantage benefit, due to the change in ownership, transferring assets out of the estate can limit creditors' access to them and shelter them from judgments against you.
- Control of Assets: By specifying the terms of your trust, you can decide who receives your assets and when they will receive them after you die.
- Children as Beneficiaries: A trust can be used to name your children as beneficiaries of your life insurance policy.
Living Trust vs. Testamentary Trust
For help in understanding the different types of trusts, it's useful to begin by comparing the four main types: living trust vs. testamentary trust and revocable trust vs. irrevocable trust.
All trusts are set up by you, the trustor, and will be either a living trust or a testamentary trust. Each of the two basic types are created as their names suggest:
- Living Trust: Also called an inter vivos trust, a living trust is created while you are still alive. A common purpose of a living trust is for the efficient transfer of assets to beneficiaries. A living trust accomplishes this because it avoids probate, which is the court proceedings for distributing assets after death. Avoiding probate can save time and court fees, and potentially reduce estate taxes for beneficiaries.
- Testamentary Trust: This type of trust is set up after death according to your last will and testament. Since the terms of a testamentary trust are established in your will, and the terms can be changed at any time up until your death, this trust can be simpler and more flexible than a living trust.
Revocable Trust vs. Irrevocable Trust
A trust can be revocable or irrevocable. Here are the basics and the main differences between revocable trusts and irrevocable trusts:
- Revocable Trust: A revocable trust is a living trust because it is created while the grantor is living. Its name refers to the fact that the terms of the trust can be altered during the grantor's lifetime. The main purpose of the revocable trust is to bypass probate for the transfer of assets after death.
- Irrevocable Trust: Unlike the revocable trust, the terms of an irrevocable trust can't be altered after the trust is created. The main reason to create an irrevocable trust is for the trustmaker, called the benefactor, to transfer assets out of their taxable estate. Income from the assets is no longer taxable to the benefactor during their lifetime and the assets are not taxable to the estate upon the death of the benefactor.
Different Types of Trusts
The four main types are living, testamentary, revocable and irrevocable trusts. However, there are further subcategories with a range of terms and potential benefits.
Here are some of the different types of trusts that are commonly used in estate planning. Keep in mind that there are many more types of trusts and specialized arrangements that are not mentioned here and may suit your needs.
A charitable trust is an irrevocable trust that is set up to simultaneously benefit you, your beneficiaries and a qualified charity under IRS rules. There are two primary types of charitable trusts: charitable lead trusts (CLTs) and charitable remainder trusts (CRTs).
Charitable Lead Trust
Also called a charitable lead annuity trust (CLAT), this trust is set up to provide financial support, through an annuity, to the chosen charity or charities for a specified period of time. The remaining assets eventually go to the beneficiaries.
Charitable Remainder Trust
Also called a charitable remainder annuity trust (CRAT), this trust works like the opposite of a CLT. A CRAT can create an income stream for you and for beneficiaries with an annuity for a specified period of time, with the remainder of assets going to charity.
Qualified Terminable Interest Property Trust
A qualified terminable interest property (QTIP) trust is set up to provide income for a surviving spouse and for the grantor to control assets after the death of a spouse. QTIPs may be useful when beneficiaries exist from a previous marriage and the grantor dies before the subsequent spouse.
Grantor Retained Annuity Trust
A grantor retained annuity trust (GRAT) is an irrevocable trust that is set up for a certain period of time to minimize taxes on large financial gifts to family members or other beneficiaries. The trustor pays the taxes on the assets when the trust is established and receives an annual annuity payment for the term of the GRAT. When the established term ends, the beneficiaries receive the remaining assets.
Irrevocable Life Insurance Trust
Life insurance proceeds will usually avoid probate, but for certain wealthy individuals, a life insurance benefit may be included in the estate for tax purposes. An irrevocable life insurance trust (ILIT) can be used to exclude life insurance proceeds from the taxable estate and to transfer the death benefit immediately to beneficiaries.
Irrevocable Funeral Trust
An irrevocable funeral trust is used to set aside money to cover burial and funeral costs. The funeral home sometimes serves as the trustee. Funeral trusts are typically funded with cash, bonds or life insurance. State laws very, so consider consulting an attorney about your options.
A spendthrift trust protects inherited assets from the potential of financial irresponsibility of the beneficiary. Since the assets in the trust belong to the trust, the beneficiary and the beneficiary's creditors do not have direct access or control of the trust assets. The trustee has the discretion to decide how the trust assets will be distributed. For example, the trustee may choose a certain dollar amount per year, or they may direct what the money can be spent on.
Special Needs Trust
Similar to a spendthrift trust, a special needs trust allows the trustee to decide and direct how the assets of the trust can be used for a beneficiary. These trusts are commonly used for dependents with special needs, such as a child, sibling or parent who is disabled or otherwise unable to provide for their own financial needs.
As the name suggests, a generation-skipping trust will skip over the children of the grantor to the generation following them. For example, if you want to provide for the financial well-being of your grandchildren, this trust passes directly to them and is never owned by the generation it is skipping.
Also known as a payable on death account, a Totten trust is a simple form of trust that enables a beneficiary to directly receive the assets of the trust upon the death of the grantor. The grantor can add and withdraw funds from the trust while they are living. The grantor may also change the beneficiary if needed or desired.
A trust can be a valuable estate planning tool with potential benefits. However, trusts can be complex and they may not be appropriate for everyone. It's important to speak with an attorney to review the various benefits of trusts, and to determine if a trust is right for you and your estate planning needs.