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In organizing our financial lives, various kinds of financial arrangements can help us achieve our goals. At retirement in particular, we begin thinking not only about funding our own retirement needs but about our estates in general, and how we’ll pass our assets on to others in the most efficient way. Trusts are one tool that can help us do that. However, there are many varieties of trust documents that serve various purposes. It’s important to understand how these documents work in general before determining whether they can work for us.
A trust, basically, is an arrangement whereby one person agrees to hold property for the benefit of another. If you’re going out for the evening and you want your babysitter to order Chinese takeout for your children during your absence, handing her $20 to cover costs, you are creating a trust. Generally, such an arrangement would not require a legal document; you trust your babysitter to use the cash to purchase the takeout. But this simple arrangement has the four basic elements that every trust document requires:
(1) a “grantor” or creator of the trust, namely you
(2) a “trustee” or entity holding the assets, in this case the babysitter
(3) a “beneficiary,” or person who benefits — your children, who will get a meal out of the arrangement
(4) the “principal” of the trust — the money or assets held in the trust, usually provided by the grantor — in this case, $20 in cash.
If the trustee is a bank or other institution, they may charge a fee to hold the trust. If your $20 is intended to cover a serving of fried rice for your babysitter, then that might be considered the fee that you pay her.
Kinds of Trusts
The difference between the various kinds of trusts, then, is in their manner of creation and their purpose. There are a few basic characteristics that can distinguish one kind of trust from another. For instance, a trust is either a “living trust” or a “testamentary trust.” The former becomes effective during the grantor’s lifetime. With many living trusts, the grantor names himself or herself trustee; i.e., the same person creates the trust, supplies the trust with principal, and holds the assets, thereby administering the trust. This is simply a “declaration of trust.” If the grantor names a second party to be trustee, both the grantor and trustee must then agree to the terms of the trust, and the document is called a “trust agreement.”
A testamentary trust, on the other hand, only goes into effect when the grantor dies. Usually, the terms for such a trust are written into the grantor’s Last Will and Testament; if so, the will must be admitted to probate before the trust can take effect. Both living trusts and testamentary trusts can be used to pass assets to beneficiaries; however, a living trust is usually a much better way to do this; a living trust is not dependent on a will to become effective, and the assets in the trust therefore can avoid probate entirely.
Living Trust-Revocable Trust
Living trusts can also be either revocable or irrevocable. If the grantor reserves the right to amend the trust or revoke it once it becomes effective, then the document is “revocable”; if the grantor waives this right, the trust is “irrevocable” and cannot be revoked or changed. (It should be noted that testamentary trusts are by nature revocable as long as the grantor is living — the trust has not yet come into effect and can be revoked or amended simply by the grantor amending his or her will; likewise, testamentary trusts by nature become irrevocable once the grantor dies, because at that point the only individual capable of revoking the trust has died.)
Living Trust-Irrevocable Trust
It may at first not be apparent why, given the choice, one would waive the right to amend or revoke a living trust — what if we change our mind? However, there are many situations in which an irrevocable trust may make sense, or may be required. In a divorce and custody case, a court may mandate that certain sums be placed in irrevocable trust, for the benefit of the children. Elderly people might place the bulk of their assets in an irrevocable trust to qualify for Medicaid, and thereby pass on the cost of nursing home care to the government. Wealthy people use irrevocable trusts to protect their assets from creditors and lawsuits, and to avoid estate taxes. Assets in an irrevocable trust are not subject to estate tax, although the transfer of assets to such a trust may be subject to federal gift taxes. There are countless strategies for protecting wealth using such trusts, but you need a good estate lawyer to help you chart your course.
Revocable Living Trust
One of the most common trust agreements is referred to as a “revocable living trust,” created for the purpose of having one’s estate avoid probate, and all the costs and time associated with probate procedures. Typically, the grantor creates the trust, naming himself trustee, and then transfers all his assets into the trust. The grantor also designates himself the beneficiary. All the trust’s assets, therefore, are available for the grantor’s benefit for the remainder of his life. The trust also specifies secondary beneficiaries, who will receive control of the trust’s assets once the grantor dies. At this time, the assets are transferred to the secondary beneficiaries and the trust document is nullified. All assets in the trust avoid probate.
Credit Shelter Trusts and Bypass Trusts
Credit shelter trusts and bypass trusts are designed to manage a wealthy couple’s assets such that assets that would ordinarily be subject to estate tax on the death of one spouse pass automatically to the trust, where they are sheltered from tax and can pass on to heirs on the death of the surviving spouse. Credit shelter trusts can be designed such that the surviving spouse can still benefit from the assets in the trust — being able to use income from the trust, for instance — although the principal is generally “locked up” until the surviving spouse dies and the assets pass on to the beneficiaries.
Charitable Trusts and Other Trusts
Various charitable trusts are designed to allow a grantor to leave assets to a charity and enjoy the corresponding tax deductions. Charitable trusts are generally designed to allow for periodic payments to the beneficiary charity during the course of the trust, until the assets in the trust are fully spent. Life insurance trusts are meant to protect death benefits from estate taxes; a particular kind of life insurance trust, called a “Crummey Trusts,” includes provisions that allow gifts to be made to the trust (used to pay premiums on the insurance policy) that qualify for the annual gift tax exclusion. Dynasty trusts are written to last forever, paying out distributions to succeeding generations of offspring. Such trusts bypass the Rule Against Perpetuities, which limits bestowals to the lifetime of any named beneficiary living at the time a trust was written, plus twenty one years.
There are scores more, each trust having its own specific purposes. Trusts must be drafted carefully and professionally; do not attempt to draft one on your own with the expectation that it will have legal validity. An estate lawyer will be your best reference, and the few thousand dollars you may have to pay to have your trust drafted and filed properly are well worth the eventual savings your heirs will enjoy, whether tax savings or savings from probate court.