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Trust funds often get a bad rep—too often, we assume the people who inherit them are spoiled, entitled and ultra wealthy.
But that’s not actually true (or doesn’t have to be). Sure, trust funds might be a good place to park your cash if you’re a millionaire. But you don’t have to be rich to make a trust fund a part of your financial toolkit.
A trust fund can be a useful component of your estate planning, (in addition to writing your last will and testament and picking your children’s guardians). That's especially true if you want to help your money get to your kids without a hitch when you pass away.
How do trust funds work? What is a trust fund, exactly?
We spoke to Alexander Joyce, CEO and president of ReJoyce Financial, a financial and estate planning firm in Indianapolis. He shared how you might go about setting up your kid (and your cash) with a trust.
Read on for the definition of a trust fund, how a trust fund works and whether you might need one.
Let's start with a trust fund definition and the roles for each person in the process.
A trust fund is a legal entity that can hold property on behalf of someone or some group.
If you are the person who’s creating a trust, you’re called the grantor, trustor, settlor or trust maker. If you set up a trust through your will, you could also be called the testator or decedent. This person chooses the rules behind the trust and decides what property the trust will own (by transferring assets into the trust’s name).
The person you ultimately want to receive your money or property is your beneficiary. Being named a beneficiary of a trust is different from owning property, though, because there are generally rules attached. For example, a trust might allow a beneficiary to live in a home owned by that trust, but not rent it out or sell it. Depending on how the trust is set up, beneficiaries often end up inheriting the trust’s assets, according to some trigger like age—for instance, inheriting money when the person turns 21.
The person or entity you want to oversee the money and fulfill the various responsibilities is the trustee. This person doesn’t actually own the property in the trust but rather oversees the distribution of the property to the beneficiaries and makes sure that the stipulations put in place are being followed. Trusts can have multiple or co-trustees, or even institutional trustees (meaning that a company oversees the administration of the trust). Many trusts name successor trustees in case the first-choice trustee becomes unavailable.
In many cases, the trustee receives some sort of compensation for the effort, like a management fee.
Trust funds can hold lots of kinds of property, from cash to investments to real estate to artwork. They can even hold whole businesses in them. Basically anything that is valuable can go in a trust fund.
OK, so, trust funds are “entities.” What does that mean, if you're trying to understand how trust funds work?
Putting money in a trust lets you pass property to someone in a structured way, where you can impose rules. For example, you might say that your beneficiary can’t use these funds to pay off debt. Or, you might impose rules on how old the beneficiary needs to be before she gains control over the money.
You consider putting money in a trust if you want it to go to a specific person in a specific manner after you’ve passed away.
After all, accounts like your 401(k) may let you assign payable on death beneficiaries, but your real estate, cash and personal stock accounts generally don’t.
Here are some common reasons people choose to create trust funds:
Designate exactly who should receive their estate. Perhaps you’ve gotten remarried and want to make sure your children (but not your new spouse’s children) get your money.
Set limits on how old a beneficiary needs to be. Legally, your children could gain access to money you leave behind at 18. If you don’t think they’ll be ready, you could set up a trust that doesn’t grant access until they’re 21, or 25, or 35, or whatever.
Specify how the assets can be used. You might stipulate that the money can only be spent on education.
Pay out at intervals. You can prevent your beneficiaries from blowing all the money at once by instructing that a trust be paid out at intervals. Maybe they get one payment when they turn 25, then at 35, and again at 45.
Insert a “spendthrift” clause. You could stipulate that the assets in the trust can’t be sued to satisfy debts. In other words, say this person spent a ton of money and got into massive debt. He couldn’t utterly bankrupt himself by sapping up all the trust fund money to pay it off.
Skip a generation. You could specify that your money should jump a generation and go directly to your future grandchildren.
Designate a pro to manage your affairs. Let’s say you have a family history of Alzheimer’s or dementia. You could use a trust to set up a framework for a professional to manage your affairs. If you were to become incapacitated, he or she would step in.
Protect a business you own. Let's say you run a business and want to protect your employees’ jobs. You also want to pass down the profits to one of your kids. You could name a trustee to put in the effort of overseeing the management of the business and pass on profits to your child. (Here's what entrepreneurs should know about life insurance.)
Reap tax advantages. This can include a “charitable annuity trust” or “charitable remainder trust,” a GRIT, a qualified personal residence trust and more. We’ll explain those more in depth, below. Trusts may also be able to optimize estate tax planning.
Protect your privacy. Unlike a will that goes through probate court, which leaves public records, trusts are private. If you want to make sure that people in your extended network—or the media, if you’re famous or of public interest—don’t have access to the details of this inheritance, you could go with a trust.
For all of these scenarios, you can set up a trust with specific instructions with the help of a qualified professional.
There are more strings attached to your heirs inheriting your property.
The cost of creating a trust can be prohibitive for some people.
It's an inconvenient extra step if you're just trying to arrange a basic set of instructions for where your property should go after you pass away.
Administering the trust fund may be more complicated than simply transferring assets to a beneficiary after you pass away. For example, a trustee may need to make regular distributions to a beneficiary and keep track of certain milestones (for example, when the beneficiary turns a certain age.)
Although trust funds may make sense in some cases because of the tax benefits, living trusts (also known as revocable trusts) don't actually confer the same major tax benefits as irrevocable trusts.
A trust in no way replaces a will. A will is the only way you can name an executor and legal guardians for your children. Without a will, the state where you live will divide up your property and assets as it sees fit.
In fact, a will is the most important part of your estate plan. (Psst: Fabric lets you make a will for free online.)
That said, having a will and a trust can help ensure that your money not only goes to whom you choose, but also in the manner you choose.
Once you have a will, you might set up a trust because wills are subject to probate. That means creditors, other relatives or even your children could challenge what it says during the probate process.
For example, say your will allocates 40 percent of your estate to your son, 40 percent to your daughter and 20 percent to charity. Your kids can legally dispute the will and try to cut the charity out. Or your daughter can sue your son if she feels she is entitled to more than 40 percent.
A trust, while more complex to set up, can bypass the probate process down the road.
When contemplating trust funds, many people become nervous that a trustee might ransack the trust for personal purposes. To be clear, this is illegal. Specific laws vary depending on where you live, but a trustee is never allowed to withdraw funds for his or her own personal use. That's because the trustree has a fiduciary responsibility, which means that he or she is bound to act in the best financial interest of the beneficiary and must follow the rules and terms of the trust agreement.
The trustee is the only person (or people) who can take money out of a trust account.
As with many areas of financial planning, you’ve got choices.
This kind of trust, as the name implies, can’t be modified or dissolved later. Once you place assets in the trust, they are no longer yours. They are under the care of a trustee. That can include a bank, attorney or other entity set up for this purpose.
The good news? Since the assets are no longer in your direct possession, you don't have to pay income tax on any interest made from the assets, or estate taxes.
Similarly, an irrevocable trust would protect your assets from creditors or lawsuits. If you create an irrevocable trust to donate your assets to charity, you can take a charitable income tax deduction for those assets, too.
Another plus of an irrevocable trust is that, because this money is “no longer yours,” it’s shielded from nursing homes. If you end up needing long-term care, this money won’t get sapped by an expensive facility. That said, if you lock up a lot of your assets in an irrevocable trust, you might not have the money you need for living expenses down the line!
While there are benefits to creating an irrevocable trust, the biggest negative is you can’t make any modifications. You can’t get that money “back” later, even if you really need it.
This is the opposite of an irrevocable trust, as you might’ve guessed from the name. You can revoke it later, plus you can make modifications. Also called “living trusts,” these trusts take effect when you’re still living.
Of course, that means you don’t get the same tax benefits as an irrevocable trust, but you maintain a lot more flexibility. This kind of trust still gives you the ability to set rules on who should inherit your assets, and how.
You can also set out guidelines for a future trustee. For example, if you fear you might become physically or mentally incapacitated, you could manage your own assets but have a trustee in the wings to step in if needed.
One reason to consider a trust fund is if you have a child with special needs. You can help ensure he receives detailed care through a trust, even if you were to pass away unexpectedly.
You can designate the special needs trust as the beneficiary of your life insurance policy, and not the dependent directly. This has a few advantages. First, if your dependent isn't capable of managing the money, it puts someone else in charge. Plus, making the trust the beneficiary might help you stay eligible for as many government resources as possible.
(If you’re caring for someone with special needs, you’ll likely want to work with an attorney who specializes in special needs estate planning.)
These types of trust funds could potentially shield money from taxes while passing down money to a charity you care about. With a charitable remainder trust, you can donate your assets to a charity, which serves as the trustee and manages those assets, even while you’re alive. When your investments produce income, the charity would pay you (or another beneficiary) those proceeds. This would keep going on for a certain period of time, often for the life of the grantor.
In other words, you could “pre-gift” a charitable contribution now to receive an immediate tax benefit, and also shield your assets from estate taxes by reducing the size of your estate upon your death (at which time the funds would belong to the charity in full).
Testamentary—like last will and testament. You can actually create a testamentary trust through your will to control what happens to your assets and how your property should be inherited. If you go this route, then the probate court would examine your will after you die. Provided that the court accepts your will and agrees to fulfill the instructions you’ve laid out, that’s when any trusts would take effect, if you dictated that they should be created through the document.
This kind of trust specifically helps ensure that the trustor’s spouse can remain in their home until he or she dies, but doesn’t allow that spouse to sell the property. This is particularly useful for blended families. So, let’s say you are married, and have an adult child from a prior marriage. Now let’s say that you want to leave the house to your child when you pass away. You might use a QTIP trust to make sure that, if you passed away, your spouse wouldn’t be “kicked out” of the house where you’d been living together. When your spouse passed away after however many years, that’s when your child would be able to inherit the house.
This is a broad term to describe trust funds that are constructed to let the trustee withhold money to the beneficiary if he or she believes that the beneficiary would waste it or have it collected by a creditor. For example, this might make sense if you wanted to pass down money to children but weren’t sure they’d be responsible enough to spend it well. Or, say, if you wanted to pass down money to someone with a substance abuse or compulsive spending problem.
This type of trust fund is most relevant for the very wealthy. The idea behind this type of trust is to try to reduce how much the government values your property for estate tax purposes. If your estate is worth over a certain amount, you might have to pay estate taxes—that’s why GRITs let the trustor earn interest income from assets in the trust yet don’t count the value of that property in the grand total for estate tax purposes.
Similar to how GRITs are constructed to help reduce your tax liability, qualified personal residence trusts serve a similar purpose. These are a kind of irrevocable trust that can be used to keep your primary or vacation home “out” of your estate for tax purposes. Because it’s an irrevocable trust, that means you can’t go back and reclaim it, but this maneuver can be useful if you want to transfer a house to family members.
Well-off people often use trusts because they can create a shield for estate taxes.
The government imposes a maximum amount that you can bequeath to someone without incurring federal gift or estate taxes. In 2018, the exemption was $11.2 million per taxpayer. So if you’re really, really rich, a trust fund can be a good way to gift money without your heirs having to pay a hefty tax.
So, yeah, there’s a reason many people associate trusts with one-percenters. That said, there are plenty of uses for the rest of us, too.
To create a trust fund, you’ll need the following information:
Name of the trust
Description of the trust, namely why the trustor is creating it
Trustee name plus any directions about replacing a trustee if he or she can no longer serve
List of property owned by the trust fund
Duties and abilities of the trustee (for example, whether the trustee can buy or sell property contained in the trust or how the process works if the trustee wants to resign or transfer responsibilities to someone else)
Details on what should happen if the trustor, trustee or beneficiaries passed away or became incapacitated
Setting up a trust is complex and does cost money. That's why many people get stalled at the "how to set up a trust fund" stage. Many attorneys will charge anywhere from $1,000 to $5,000 to create a new trust. The price will depend on where you live and the complexities of your situation.
You could also consider using online preparation services such as LegalZoom or Quicken to reduce costs. While this option can be more affordable, you should still consult with a licensed attorney if you need legal advice. A very basic trust fund can involve little more than a few pages of paperwork.
A trust fund is a vehicle that contains other assets, meaning that not every trust fund is the same. You need to put assets or property into a trust fund. So, if the assets you have inside the trust fund grow (for example, investments that grow over time or earn interest), then yes.
A trust account can be as simple as a bank account where the money is owned by a trust rather than an individual. Like other bank accounts, some trust accounts can also earn interest. Generally speaking, this interest is paid to the account beneficiary.
Trusts can last for a long time, but the exact rules tend to vary by state. For example, in many places the trust can't keep going more than 21 years after the death of a potential beneficiary who was alive when the trust was set up. That's called the "rule against perpetuities" and is intended to restrict trusts that could theoretically last forever.
That said, some states like California have made their own related but different laws. In California, for example, there's a version of the rule that just says that a trust can last about 90 years. Delaware lets trust keep going for up to 300 years, though, and some states don't have any expiration. These neverending trusts are sometimes called "dynasty trusts." They're chiefly used by the super rich because of the tax benefits; you'd only need to pay gift or estate taxes when you transfer money into the trust, but then many subsequent generations would be able to inherit property without paying estate taxes.
Trusts can terminate early if they run out of property, or if the probate court orders it to end. (That's rare.)
If you don’t want to create a trust, you probably will need to relinquish some control over how your assets are distributed. The simplest way to pass down property to a loved one without a trust is through a will. If you go this route, you may be subject to more taxes and your estate will need to go through the probate process.
That said, it’s an opportunity to share your wishes in broad strokes and to designate a legal guardian to watch your children. (Hint: Fabric lets you create a will online, for free.)
Fabric exists to help young families master their money. Our articles abide by strict editorial standards. This article has been reviewed and approved by a compliance professional who is a licensed life insurance agent.
This article is meant to provide general information and not to provide any specific legal advice or to serve as the basis for any decisions.
Fabric isn’t a law firm and we aren’t licensed to practice law or to provide any legal advice. If you do need legal advice for your specific situation, you should consult with a licensed attorney and/or tax professional.
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