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.
“A trust can help you navigate specific tax concerns or creditor protection, ensure your wealth supports your family, or leave a legacy for a charitable cause you believe in,” says Sally Mullen, senior vice president and chief fiduciary officer for U.S. Bank Wealth Management. “Whatever your wishes, there’s a trust for you.”
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 state laws can vary considerably.1)
“Both revocable and irrevocable trusts can provide specific benefits depending on your intent,” Mullen continues.
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. However, there’s one key difference,” says Mullens. “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.
The world of trusts is not one-size-fits-all.
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.
You typically cannot change or amend an irrevocable 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.
There are a variety of irrevocable trust types to choose from, depending on your unique circumstances. “Your reason for setting up an irrevocable trust is critical in helping you select one that fits your needs,” says Mullen. Are you setting up a trust to:
- Transfer wealth to the next generation?
- Keep a family business in the family?
- Leave a legacy with a charity you support?
- Minimize estate taxes for you or your beneficiaries?
- Shield your assets from creditors?
The following are scenarios where these concerns can be addressed through a type of irrevocable trust.
Irrevocable life insurance 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.
Grantor retained annuity trusts (GRATs) and qualified personal residence trusts (QPRTs)
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,” says Mullen. With this type of trust, you contribute assets to the trust and receive an annuity payment on a regular basis, usually a set percentage of the original amount of assets. The assets in the trust will inevitably rise and fall in value.
When the terms of the trust end, any remaining funds, including appreciation on the funds, transfer to your beneficiaries gift-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. “Let’s say you want to give your home to your child but have no plans to move out,” Mullen says. “You could set up a QPRT for 10 years. If you’re alive at the time the trust terminates, the property passes outside of your estate and on to your child.”
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.
Charitable remainder annuity trusts
Certain irrevocable trusts, such as a charitable remainder annuity trust, can 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.
Special needs trusts
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’re still qualified for government benefits. Read more about financial planning for families with a disabled child.
Domestic asset protection trust
A domestic asset protection trust (DAPT), also called a self-settled 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).
Generation skipping trusts
A generation skipping trust (GST) is a trust people often choose for tax reasons. “With 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,” says Mullen.
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,” Mullen adds.
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.
Naming your trustee is a critical step in setting up a trust. See our checklist for how to choose a trustee.