Trusts (or trust funds) are one of the more commonly misunderstood concepts in financial planning. While many people have heard of trusts, their impressions tend to be rooted in pop culture references, which can provide a very skewed view of what trusts are, and what they can do. In actuality, trusts are a diverse financial planning tool that can help with a wide array of objectives, from estate planning to tax planning, and providing for a child with special needs.

What is a trust?

A trust is a legal arrangement where a trustor (owner of assets) transfers those assets to a trustee who manages them on behalf of a beneficiary. 

The trust refers to the fund, account, vehicle, or legal documents surrounding those managed assets. For instance, a building might be owned by a trust, assets might be placed in trust, and so on.

Typically, the trustor selects a trustee to manage the trust. In some situations, the trustor acts as trustee or selects a trusted colleague, friend, or family member to fill that role. While you don’t need to hire a professional trustee to manage a trust, there are many situations where appointing a professional trustee will benefit you, in terms of making sure things are managed (and documented) properly.

Revocable versus irrevocable trusts

While there are dozens of types of trusts, the biggest distinguishing factor between trusts is whether they are revocable or irrevocable. Revocable trusts have a certain set of pros and cons that are distinct from irrevocable trusts, and vice versa. 

With irrevocable trusts, you generally cannot undo or alter the terms of the trust once it’s created and funded. Once you pass assets to an irrevocable trust, they are owned by the trust. This can lead to significant tax savings for you (since you no longer have to worry about any capital gains if that money appreciates, and it no longer counts towards your estate for the purpose of estate taxes). However, this transfer also comes with a loss of control, generally speaking.

Most pop culture references to trusts refer to some version of an irrevocable trust. However, there’s another, highly useful type of trust. 

Revocable trusts are changeable, or revocable, as the name implies. These documents are often used as an estate planning tool, as they can help families avoid probate and allow for more flexibility (with fewer updates) than a will. They are sometimes referred to as living trusts.

A revocable trust allows you to stipulate, for example, what happens to your assets if a beneficiary dies before you do. If your child predeceases you, do you want their share of your estate to go to their children (your grandkids) or have it reallocated among your remaining children? With a trust, you can build these terms into the document in advance, versus updating a will every time a major life event happens.

Irrevocable trusts, on the other hand, can be used to address more specialized needs, from tax management to legacy planning.

Types of irrevocable trusts

Irrevocable trusts can be structured differently to help you achieve specific goals.

Special needs trusts

Special needs trusts can help you financially support someone with special needs without disqualifying them from government benefits or other aid. When you set up and fund an irrevocable special needs trust, the trust owns the assets for the benefit of the beneficiary. This is a key distinction—if you simply left the assets to the beneficiary directly, their net worth might be impacted such that it would disqualify them from benefits and programs designed to support them.

Charitable trusts

You can set up trusts designed to benefit specific charities or causes you care about. You may be able to combine this endeavor with other financial goals. 

• A charitable lead trust establishes a trust that will make preset payments to a qualified charity (the beneficiary) for a prescribed period. Once that window ends, the remainder of the assets in the trust are distributed to heirs or other beneficiaries. 
• A charitable remainder trust does the opposite. The trust is set up to benefit someone for a set time (this could be your heirs, it can also be you, as the trustor); once that period ends, the remaining assets get distributed to a qualified charity.

Trusts to help mitigate estate taxes

Families with significant wealth who are worried about estate and/or inheritance taxes might consider several irrevocable trusts to help manage the potential tax complexity. Two of the more common are life insurance trusts and dynasty trusts. 

Life insurance trusts

Some families use a life insurance policy such that the death benefit would help cover any potential tax burden for their heirs. Unfortunately, the cash value of that type of policy can impact the value of the estate, and the very tax bill it intends to address. To remedy this problem, families might consider placing their policy into an irrevocable life insurance trust, thus removing the policy from the taxable estate. 

Dynasty trusts

Dynasty trusts are designed to help families preserve wealth across multiple generations, as the name implies. Once assets pass to these irrevocable trusts, they no longer count towards your taxable estate. Families can fund these trusts strategically to avoid triggering the annual gift tax threshold as well as the lifetime exemption. Funding these trusts early means the assets can grow separate from the estate. These assets don’t grow tax free, and distributions may still be subject to tax; dynasty trusts are primarily designed to help with estate tax concerns rather than income taxes. The terms (including how long these trusts can last) vary significantly by state.

Choosing and setting up a trust

Because of the complexities involved in irrevocable trusts, they tend to benefit from management by a professional trustee. These trust funds may need to file legal, tax, and regulatory paperwork on a regular basis. 

Many revocable trusts, on the other hand, can be implemented and administered with fewer complications. They can help supplement a will, a letter of intent, powers of attorney, and other estate planning documents. 

Because trusts are legal documents, we recommend consulting with an attorney that specializes in estate planning prior to executing a trust. You may also want to consult with a tax attorney and/or accountant. In all cases, financial advisors can be brought in to help manage assets within a trust or to help you understand how a trust might fit into a broader financial and legacy plan.

If you have questions about how a trust might fit into your overall financial plan, we’re here to help. Set up a call to discuss.