Basic Information About Trusts

Many people set up trusts in order to manage their assets while they're living, and to transfer those assets at the time of their death. Trusts allow you to transfer ownership of property or money to a person who is designated to manage and distribute the assets according to your instructions, for the benefit of another.

Some trusts may provide significant tax advantages, while others are for the benefit of persons unable to handle their affairs. Other trusts provide income for a spouse or beneficiary who is not included among your heirs.

The person who establishes the trust is called the “grantor.” The person who manages the trust is known as the “trustee,” and the people who eventually receive money or other assets from a trust are called “beneficiaries.”

Trusts also are necessary if you have minor children. You can specify in your will that any money left to children who are under a certain age, be placed in a trust for their benefit until they reach the age stated. You appoint a trustee, who will see that the money is properly invested and available for the child if necessary. When the child reaches the age stated in the document, the trust is dissolved and the child receives the remaining assets. In most cases, income tax on the money earned by the trust is taken out of the trust until the child reaches the age stated in the document. At that time, the child usually has to pay income tax.

There are many varieties of trusts, but all fall under two basic flavors: revocable and irrevocable. Revocable means changeable, irrevocable means it's beyond your control—it's not changeable. Within each category are various types of trusts. Let's have a look at some common kinds of trusts.

Testamentary Trust

This type of trust is laid out in a person's will and established after his death. Until a person dies, the document can be changed, since the will can be changed at any time. However, once you die, the trust becomes irrevocable. The testator keeps control of the assets included in the trust during his lifetime, and can stipulate when beneficiaries should receive their money or property from the trust.

Testamentary trusts can help to reduce estate taxes at a second party's death (usually a spouse). Testamentary trusts can be funded directly with assets that come from a beneficiary designation, such as proceeds of a life insurance policy that names the trust as its beneficiary. Or it can be funded through assets that are subject to probate.

Revocable Living Trust

This type of trust is set up while the grantor is still living, and allows the grantor to keep full control of the assets. The grantor also has the ability to revoke or amend the terms of the trust, or change the appointed trustee, while living. A revocable living trust becomes irrevocable when the grantor dies or becomes incapacitated. Many people consider a revocable living trust to be a substitute for a will, because the trust also can instruct how assets should be distributed. It's extremely difficult, however, for a trust to include everything covered in a will—it can be done but it takes a great deal of planning.

If you have a revocable living trust, you should still have a will. A revocable living trust can reduce the cost of settling an estate, and also the amount of time it takes. Funds held in a trust can be distributed much sooner than assets in an estate. A trust can also protect privacy because assets included in the trust don't have to pass through probate, which is a court proceeding in which a person's estate is settled. All creditors are paid off during probate, and heirs receive their shares of the estate after everything is settled. Waiting isn't usually necessary with a trust—distribution can occur when the trustee feels comfortable making distribution. And, while wills can be contested, trusts very rarely are contested.

A revocable trust can be funded or unfunded at death. If unfunded, the document is held (like your will) in a safe place, and then used when assets are paid to it. If the trust is funded prior to your death, you re-register assets from your name into the name of the trust. Shares of stock for example, are re-registered from belonging to Daniel Smith, to belonging to the Daniel Smith Trust, with Daniel Smith and Susan Jones as trustees. If you fund a trust prior to death, all assets held in the trust bypass probate.

Irrevocable Trust

Usually established and used by people with a great deal of assets, irrevocable trusts, as the name implies, can't be amended or destroyed. Once the trust is set up, it remains in place, giving the grantor no opportunity to change his mind.

Irrevocable trusts are used primarily to reduce estate taxes, though they are also used to protect property for minor heirs. Irrevocable trusts also can be set up to provide income for a beneficiary, and then to divert the income to another place when the beneficiary dies.

Property that is turned over to an irrevocable trust, if set up properly, is no longer considered part of the estate of the person who turned it over. It still may be subject to other taxes, such as gift or capital gains, but those traditionally have been far lower than estate taxes. As with a revocable living trust, assets included in an irrevocable trust do not have to pass through probate.

There are various types of irrevocable trusts, the most common of which is the irrevocable life insurance trust. In that case, the trust “owns” a large life insurance policy, from which proceeds are paid directly into the trust at the time of the death of the grantor. Other irrevocable trusts include residuary trusts and marital trusts.

There are many types of trusts, all with different rules and benefits. Consult a financial planner or lawyer who specializes in estate planning for more information.

Excerpted from The Complete Idiot's Guide to Personal Finance in Your 40s and 50s © 2002 by Sarah Young Fisher and Susan Shelly. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

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