The world of trusts is not one-size-fits-all. The type of trust you choose should reflect your unique wishes for how your assets are handled now and in the future.
You may want help navigating specific tax concerns or creditor protection. Or perhaps you want to ensure your wealth supports not just your family, but a charitable cause you believe in. Whatever your wishes, there’s a trust for you.
Types of trusts: Revocable vs. irrevocable
The two basic trust structures are revocable and irrevocable. The biggest difference is that revocable trusts can be changed after they are created, while irrevocable trusts typically cannot. (There are a few exceptions, though, as certain state laws have changed over the previous decades.1) Both revocable and irrevocable trusts can provide specific benefits depending on your intent.
- Revocable trusts
- Irrevocable trusts
As stated above, a revocable trust — also referred to as a living trust — is one that can be changed after it’s created. A revocable trust can accomplish many of the same things as a will. There is one key difference, however. By creating and transferring your assets to a revocable trust, you can avoid the probate process that’s required for a will. Probate can be both lengthy and public, and a revocable trust usually is not public.
Because you can make changes to your revocable trust at any time, for certain purposes you are still viewed as the owner of the assets — even though you have a trustee who manages the trust for you. For example, you’ll be responsible for making tax payments and reporting on the trust’s investment returns, and revocable trust assets are includable in your estate and are available to creditors.
You can set up your revocable trust to play out in several different ways, too. You can have your revocable trust end upon your death, and have all assets distributed to your beneficiaries at that time. You can also set it up so that when you pass away, that revocable trust automatically creates irrevocable trusts that continue for different people or institutions.
With an irrevocable trust, you typically cannot change or amend the trust after it’s created. The assets move out of your estate, and the trust pays its own income tax and files a separate return. This can give you greater protection from creditors and estate taxes.
As stated above, you can set up your will or revocable trust to automatically create irrevocable trusts at the time of your death. When you use your will to create irrevocable trusts, it’s called a testamentary trust. But you can also set up irrevocable trusts during your lifetime.
Types of irrevocable trusts
Taking a closer look at irrevocable trusts will help you understand the various types you can set up depending on your unique circumstances. There are dozens of irrevocable trust types to choose from. In general, when choosing a type of irrevocable trust, you should consider:
- The main purpose of the trust. Is it to transfer wealth to the next generation? Keep a family business in the family? Leave a lasting legacy with a charity you support?
- Specific tax considerations. Are you comfortable with paying gift tax up front if it means avoiding estate tax down the line?
- Creditor concerns. Will you need a trust that helps shield your assets from creditors?
The world of trusts is not one-size-fits-all.
The following are scenarios where these concerns can be addressed through a type of irrevocable trust.
- Irrevocable life insurance trusts
- Grantor retained annuity trusts (GRATs) and qualified personal residence trusts (QPRTs)
- Charitable remainder annuity trusts
- Special needs trusts
- Self-settled trusts (i.e. domestic asset protection trusts)
- Generation-skipping trusts
This type of trust (also called an ILIT) is often used to set aside funds for estate taxes. An ILIT might be particularly useful if you own a family business that’s set to remain in your estate when you pass away. You can create an ILIT ahead of time to ensure the business stays in your family, despite estate bills, by gifting the premium on your life insurance into the ILIT each year.
Your trustee will own the policy, and when you pass away, the trustee collects the policy proceeds. Those proceeds can be distributed to the trust’s beneficiaries, who can use them to pay estate taxes, ensuring they won’t have to sell the family business. They may also use it to fund a buy/sell agreement where they buy out the remaining owners once you pass away so they can control the company.
There are certain irrevocable trusts that are intended to last for only a specific term of years. Two examples are grantor retained annuity trusts (GRATs) and qualified personal residence trusts (QPRTs).
GRATs are a common way for people to minimize taxes on financial gifts to their beneficiaries. With this type of trust, you contribute assets to the trust and earn a rate of return specified by the IRS as the 7520 rate.2 When the terms of the trust end, leftover assets (based on any appreciation and the 7520 rate) can go to your beneficiaries tax-free. If you’re no longer alive when the terms end, the assets will be part of the estate and subject to estate tax.
QPRTs are another way to transfer assets to beneficiaries – more specifically, real estate. You might set up a QPRT that exists for 10 years and state that if you’re still alive at the time the trust terminates, then the property passes outside of your estate and on to your beneficiaries.
These are strategies to leverage both time and appreciation to get assets out of your estate with the goal of saving money on estate taxes.
Certain irrevocable trusts, such as a charitable remainder annuity trust, can also help you leave a lasting charitable legacy. In this instance, you can set up the trust so that the primary beneficiaries (your children, for example) receive income to start, and then a charity you choose receives any remaining assets. Or you could have it set up the opposite way, meaning the charity receives income from the trust and then, after a certain period of time, the trust terminates and the remaining assets go to your children. You may also be able to take an income tax deduction up front for setting up this type of trust for a charitable donation.
If you have a child or family member with a disability, you might consider setting up a special needs trust. Special needs trusts are typically created for individuals who are eligible for government benefits due to disability. You can set up this type of trust to provide for that individual in addition to them receiving government assistance. Gifting money to a child with special needs outside of a special needs trust may disqualify them from receiving Supplemental Security Income (SSI). With a special needs trust, you can provide for your child while ensuring they are not disqualified from government benefits.
A self-settled trust (also called a domestic asset protection trust) can be set up to protect assets from future creditors, though it’s not an option in every state. Some people set up this type of trust for their children so that assets stay in the family in the event of a divorce (the spouse wouldn’t have a claim on the assets).
A generation-skipping trust (GST) is also a trust people often choose for tax reasons. When you place assets in this type of trust, you designate assets to your grandchildren, skipping your children in order to bypass estate taxes that would occur if they directly inherited your assets. While there is something called generation-skipping tax to consider, each individual has a generation-skipping tax exemption, just as you have an estate tax exemption. The key would be to fund your trust with an amount equal to your generation-skipping exemption, located in a state with liberal laws as to how long a trust can last, and let it grow through the generations.
These are just some of the many types of trusts available. When you know what you want out of your trust and how you want it to affect future generations, you can work with your tax and legal advisors to narrow down which trust makes the most sense for you.