What Is A Trust?

Within the realm of estate planning, two common terms that you've likely seen batted around are "trusts'' and "wills."

So, what is a trust? In a nutshell, a trust is a legal entity that lets a third party, also known as a trustee, take responsibility and manage and maintain assets for beneficiaries.

If you're considering creating a trust for your loved ones, it's important to understand its intricacies, the different types, and the steps involved in creating one. Otherwise, you'll find yourself scratching your head and getting stuck on legal terms and complex processes. We'll walk you through everything you need to know to have a basic understanding of a trust.

How Does A Trust Work?

What exactly does a trust do? Digging into the weeds, a trust establishes a fiduciary relationship where the trustee can manage and hold onto assets on behalf of the beneficiaries. A fiduciary, by the way, is essentially someone who handles the property, money in retirement accounts and bank accounts, investments or other assets on their behalf. And by law, fiduciaries need to make decisions that's always in beneficiaries’ best interests and benefit.

Trusts can be either revocable, which means they can be changed at any time; or irrevocable, which means changes can't be made. There are a lot of benefits to having a living trust. For instance, you get to call the shots on when and to whom your wealth gets distributed.

Trusts also protect your legacy against your beneficiaries' debt collectors. Plus, it means your wealth gets passed outside of probate. Probate, which is a court-supervised legal process to transfer your assets to your heirs, is a costly, time-consuming ordeal. Probate records become public records, so having a trust in place keeps your assets private.

Trusts, along with wills, advance directives, and power of attorney, can make up an important part of an estate plan. The ultimate goal of an estate plan is to make sure your assets are managed based on your wishes and properly protected. Further, estate planning makes sure the wealth you leave behind go to your designated beneficiaries without a hitch, free from costly legal proceedings, squabbles between loved ones, headaches and hurdles.

Parties Involved In A Trust

To make a trust work, specific parties are involved. Trusts typically include — but aren't limited to — the following parties:

• The grantor: Also known as the creator, settlor or trustor, the grantor the creator of the trust relationship. Typically, the grantor is the person who owns the initial assets and property that funds the trust.
• The trustee: The trustee is the person, firm or third-party that is responsible for managing the trust, tax filings, and making sure the assets are properly handled and distributed to the beneficiaries, according to the trust. Trustees are commonly family members, attorneys or financial advisors. Trustees might be picked according to their relationship to the grantor, their understanding of the dynamics between beneficiaries, and their ability to execute the trust.
• Successor trustee: In case a trustee passes or becomes incapacitated, the successor trustee takes their place and responsibilities.
• The beneficiary: Beneficiaries are the folks, charities, or entities that are to receive the assets — such as property or money — from your estate. There can be one beneficiary or multiple beneficiaries.

How Do I Create A Trust?

While there are nuances and intricacies to your personal situation and how you want to set up a trust, there are some basic steps involved. Here's what's involved in creating a trust:

1. Work with an attorney: You'll want to work with an estate attorney who is well versed in creating wills, trusts and all other elements of an estate plan. If you need to set up a special type of trust, such as one for an heir who receives disability benefits, look for an estate attorney who has experience in this area.
2. Choose the type of trust you need: Next, work with your estate attorney on pinning down the type of trust you need. There are a handful of different types of trusts — living trusts, testamentary trusts, revocable trusts, irrevocable trusts, a trust fund and unfunded trusts — to name a few.
3. Choose your trustee: Your trustee can be a fiduciary, attorney, trusted friend or family member. While a trustee can also be one of your beneficiaries, it might not always be a wise decision, due to potential conflict of interest.

Besides choosing someone who will always have your best interests at heart, your trustee should be carefully selected based on their character, understanding of dynamics in your family, and also have the fortitude to carry through.

4. Discuss the terms and conditions of the trust: The terms and conditions of the trust will be specific to you, your needs and situation. Your estate attorney will walk you through the ins and outs of the different parts of the trust, and needs to be addressed. For example, who will manage the trust, where the trust assets will be held, who has access to the funds and when and how, and distribution of the assets.
5. Fund the trust: Just like how there are many ways to skin a cat, there are many ways you can fund a trust–transferring real estate, personal property, and bank accounts. You can also transfer copyrights, patents and trademarks, as well as an annuity and other types of life insurance policies.
6. Review your trust and make changes accordingly. A trust is a living, ever-changing document. You'll want to review it regularly and work with your estate attorney to make changes as needed.

Types Of Trusts

Under the umbrella of trusts, there are different types of trusts. Let's take a look at its main categories:

Living Trust

As the name implies, a living trust is a type of trust that you can create during your lifetime. There are two types of living trusts — revocable trusts and irrevocable trusts. We'll get into the specifics of these types of trusts in just a bit.

Testamentary Trust

While a living trust is made during the grantor's lifetime, a testamentary trust is made after the grantor dies. How? It's created by what's outlined in the grantor's will. While a living trust goes into effect right after it's made (during the grantor's lifetime), a testamentary trust goes into effect after the grantor passes.

Revocable Trust

A revocable trust is a type of living trust where the grantor can make changes at any time. In turn, it can be a time and money saver should you need to make any amendments. However, a downside of a revocable trust is that if you owe any debts when you pass, creditors can go after the assets in your trust.

Irrevocable Trust

An irrevocable trust is a type of living trust that is pretty much set in stone once it's created. It would be very hard to make changes or dissolve after the fact. As the grantor, you essentially give up control of the trust and hand it over to your trustee. If you did want to make any changes or revoke it, you would have to get permission from your beneficiaries or a court order.

Trust Fund

The trust fund is part of a trust and is where the assets are held. You can think of it as a place for safekeeping for the assets to be kept until they are given directly to beneficiaries. A variety of assets can go into a trust fund – money, property, investments, copyrights and trademarks, collectibles, art, and jewelry.

Unfunded Trust

An unfunded trust is a trust that has a trust agreement but no funding. You can think of it as a fishing boat, but no bait or provisions stored on the boat. If a trust is unfunded at the time of its creation, it can be funded once the trustor passes. Otherwise, it remains without funding.

What Is The Benefit Of A Trust?

There are many advantages to trust. Let's walk through some of the most common pluses: 

• Better tax planning: Your attorney or accountant might use a trust to safeguard you from certain estate and income tax liabilities.

Plus, a trust can be a great way to bump down taxes that the trust's beneficiaries might need to pay. For one, when a beneficiary receives distributions from the principal balance of a trust, they're not on the hook for paying taxes on the distribution. Plus, while the beneficiary pays income taxes on income generated by assets held in the trust, the trust pays capital gains taxes.

• Preparation for disability or age-related illness: Let's say one of your dependents gets Social Security disability benefits. If that's the case, you, the trustor, might want to create what's called a Special Needs Trust (SNT) that has beneficiary income without putting the benefits eligibility in jeopardy.

How it works is that it helps keep the beneficiary's income below a certain limit. In turn, they can still qualify for these Social Security benefits.

• Avoid probate court: When you don't have an estate plan in place, your assets will go to probate court. Probate court can be costly and time-consuming, and cause delays in your assets getting properly distributed.
• Protect your privacy: By creating a living trust, you can avoid the probate process. Because probate records become public records, details of the estate — your assets, debts, and who will receive your property and money once you pass. Creating a trust keeps the details of your assets private.
• Preserve assets like Medicaid: A special trust known as a Medicaid Asset Protection Trust (MAPT) moves assets that go above Medicaid financial limits to receive Medicaid's benefits of nursing home care. In turn, you can safeguard your trust assets from Medicaid's penalties or fines. You'll want to speak with an attorney who specializes in Medicaid planning.
• Protect your legacy: If created in the right way, a trust can shield your assets from getting taken from your beneficiaries' debt collectors.

Trusts FAQs

Let's walk through some frequently asked questions about trusts:

What does a trust do?

A trust fund is an option for estate planning that is created to hold assets. These assets might include property, money, investments, copyrights, trademarks, collectibles, and artwork. A trust is managed by a trustee, which helps administrator the terms as outlined in the trust. The trustee also is responsible for distributing the assets to the named beneficiaries.

What’s the difference between a will and a trust?

Both a will and a trust are parts of an estate plan. A will is a legal document that offers details and instructions on how to dole out assets to beneficiaries after someone passes. A trust is a legal arrangement where you transfer your assets into an account. This account is managed by a third party, otherwise known as a trustee.

Do you make money in a trust?

If the trust holds assets that generate income, then the trust can make income. Examples of assets that can earn interest income include savings accounts, bonds, commercial real estate and stocks.

Do trusts pay taxes?

Grantors must pay taxes on any income that's generated by the trust. Beneficiaries, on the other hand, must pay taxes on the distributions they receive from the trust's income.

The Bottom Line: Trusts Can Help You Secure Your Future

Establishing a trust helps ensure your assets will be protected, managed and distributed according to your wishes. It also helps avoid probate, which is costly and time-consuming. Consider planning for your future by talking to a financial advisor. To monitor your expenses and assets, which contribute to your net worth, download the Rocket Money^SM app today.