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Types of Trusts: A Short Primer

Types of Trusts: A Short Primer
Estate planning

Trusts are used for both estate planning and tax reduction purposes. They can also be a helpful way to address asset protection concerns in some circumstances as well. A trust is a fiduciary arrangement that permits a third party, a trustee, to hold assets on your behalf for the benefit of other people that you designate, beneficiaries. How you want these assets distributed to your beneficiaries will vary depending on the ultimate goals you have for the trust.

Many people make the assumption that you can only create one of the “named” trusts. However, you can actually create a trust to do virtually whatever you would like it to do. The trusts that have traditional names can be used for their designated purpose, or they can be used as inspiration to create a trust that meets your needs exactly. Nonetheless, knowing the types of trusts available can give you an idea of how your trust can be used.

Revocable and Irrevocable Trusts

All trusts fall into two distinct categories. They are either revocable or irrevocable. The distinction is exactly as it sounds—one can be canceled or revoked while the other cannot. Revocable trusts can also be altered or modified while irrevocable trusts cannot. Some irrevocable trusts are created after the creator of the trust, the grantor, passes away, but that is not always the case.

A revocable trust is also often referred to as a “living trust” or an “inter vivos” trust. You retain complete control of your assets during your lifetime, but then a successor trustee takes over after you pass to distribute your assets to your loved ones. It is a good way to avoid the probate process, often making distributions to loved ones much faster and easier.

An irrevocable trust has the benefits of avoiding probate and some taxes, including both income taxes on the assets in the trust and estate taxes down the road. It also may provide some asset protection as well. However, you lose the ability to cancel or modify the trust once it is created, which can be daunting for a grantor.

Asset Protection Trust

An asset protection trust is designed to keep your assets away from creditors by placing them into an irrevocable trust. A third-party trustee should have the discretion to administer the trust, and the trust itself should have a “spendthrift clause,” which restricts the transferability of the beneficiary’s trust property (voluntarily or involuntarily). However, only a few states permit asset protection trusts, including:

  • Alaska
  • Colorado
  • Delaware
  • Hawaii
  • Mississippi
  • Nevada
  • New Hampshire
  • Ohio
  • Oklahoma
  • Rhode Island
  • South Dakota
  • Tennessee
  • Utah
  • Virginia
  • West Virginia
  • Wyoming

The requirements to have a full-fledged domestic asset protection trust often vary slightly by state. As such, they are usually a poor asset protection tool compared to other options, including forming a corporate entity.

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Charitable Trust

charitable trust is any trust whose beneficiaries are one or more charitable organizations. The major benefit for this type of trust is income tax savings. The grantor can place income-producing assets into this trust and the income is then donated to charity. This arrangement creates tax savings because that income is a charitable deduction. Putting assets into the trust that have a low basis but have significantly appreciated can be a good way to transfer the asset without incurring capital gains tax as well.

Charitable trusts can also be an effective way to reduce estate taxes as they can be set up to minimize the size of the grantor’s taxable estate.

Constructive Trust

A constructive trust is a legally created trust, as opposed to a formally established trust. That is, it is an equitable means to create trust when it appears that there is a trust relationship, but the trust formalities have not been followed. It is used as a tool to correct an “unjust enrichment” or unethical retention or acquisition of property.

Consider an example. Imagine that you transfer property to your cousin for safekeeping for a short time while you are out of the country. You ask your cousin to look after the property and, if anything should happen to you, give the assets to your children. If for some reason, your cousin tries to say that the property is his outright, the court may tell your cousin that the instructions you gave him created a “constructive trust,” and that the property is not his to do with as he pleases. Instead, he is really the “trustee,” and he should follow your instructions about the maintenance and distribution of the property. In this way, your cousin cannot receive the property outright, essentially completely free—which would be an “unjust enrichment.”

Special Needs Trust

When you have a family member or other loved one that has special needs, it is important to plan carefully for their well-being after you are gone. Using a special needs trust is a good way to ensure that your loved one has the resources he or she needs to live comfortably even when you can no longer care for him or her.

Careful planning will also allow your loved one to still be eligible for Supplemental Security Income (SSI) and Medicaid benefits as well. By putting assets into a special needs trust, those assets do not count “against” your loved one for purposes of calculating assets and income to determine eligibility for these helpful federal programs. Having someone else administer the trust also allows a level of care for your loved one that might not otherwise be possible.

Spendthrift Trust

Spendthrift Trust

Some people would like to leave significant amounts of money or assets to loved ones, but have concerns that these loved ones will squander the money or otherwise act irresponsibly with the property. You may also have fears that leaving your child funds will only result in their creditors taking that money instead. In those situations, developing a spendthrift trust may be appropriate.

In a spendthrift trust, the trustee has control of the property for the benefit of the beneficiary. The beneficiary only has limited access to the funds in the trust and cannot promise the trust assets to anyone else. The trustee issues either regular or discretionary payments to the beneficiaries according to the instructions in the trust document.

Tax By-Pass Trust

A by-pass trust allows you to avoid estate taxes by passing property through the trust instead of through a will. Usually, it is used to pass assets from parents to children when the second parent dies.

It is structured so that the first parent gives property to the second parent upon the first spouse’s death, and the second parent can withdraw assets from the trust when certain conditions are met. Then, once the second parent passes, the remaining trust assets pass on to their children. The second parent does not have any control over how the assets are distributed after his or her death; those instructions are already provided when the trust is created.

Learning More About Trust Options

Trusts can be an extremely valuable estate planning tool when used and established properly. You can learn more about trusts and other estate planning and asset protection tools in Protect Wealth Academy’s extensive video library.  Sign up for a free membership

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