What is a trust — and what are the different types of trusts?
Trusts come up a lot in estate planning, and for good reason. They can be incredibly effective in helping fund education, provide for heirs, donate to charities and more. For high net worth individuals, trusts are also an important strategy to reduce taxable estates.
The basics: What are trusts?
Trusts are legal entities, much like corporations, which are considered distinct from the various parties involved. Trusts come in many forms, but in essence they are fiduciary arrangements in which, as the IRS states, one person (the trustee) holds title to property or assets…for the benefit of another (the beneficiary). Sometimes the grantor of the assets is actually the trustee, while in other cases the trustee is a third party. Trusts can be used to dictate the flow of a person’s assets during life, after death, or both.
There are many reasons people and organizations choose to employ trusts as a part of their financial and estate strategies. For one, trusts are typically not subject to probate, the process triggered upon a person’s death which involves the administration and validation of their will. This process can be time consuming as well as expensive – and the contents of the will in question will be made public. So, those wishing to keep the assets of their estates private, often place them in a trust.
Revocable vs irrevocable trusts
The two primary types of trusts are revocable – those that can be altered by the grantor during their lifetime – and irrevocable – those in which the grantor relinquishes all control over the trust once it’s been enacted. These two primary types of trusts have different pros and cons.
Pros and cons of revocable trusts
Revocable trusts can be changed anytime during a grantor’s lifetime, and the grantor continues to have access to the assets in the trust, making them more flexible than irrevocable trusts. Revocable trusts are typically used for planning purposes as well as peace of mind (knowing that should the grantor become incapacitated or incompetent, there will be a successor trustee to step in and help manage their affairs). They are also used to avoid probate when the grantor dies. However, while they offer a greater level of flexibility, they do not remove assets from the grantor’s taxable estate, and thus are not as effective in reducing tax liability.
Pros and cons of irrevocable trusts
As the name implies, irrevocable trusts cannot be altered once established. They are generally used to take money out of a grantor’s estate and permanently give it to a beneficiary, thus lowering the tax liability of the grantor while providing for the beneficiary.
Here are a few of the commonly used trusts in estate planning:
Grantor retained annuity trusts: GRATs
A grantor retained annuity trust allows the grantor to put appreciable assets in a trust and receive an annual payment from assets against the principle, while the rest of the fund continues to realize interest. At the end of the specified time of the GRAT, the remaining interest will be transferred to the beneficiary without impacting the grantor’s lifetime gift tax. The Journal of Accountancy has some great examples of how this can work.
Spousal lifetime access trusts: SLATs
The spousal lifetime access trust is an irrevocable trust in which one spouse (the grantor) puts assets into the trust that the other spouse (the beneficiary) can then access. This takes the assets in question out of the grantor’s taxable estate but still allows the spouse to access the funds at will. It’s implied that the grantor may also be able to access those funds through their spouse, thereby giving the couple the flexibility to make use of the money when needed while keeping it out of the taxable estate or the reach of creditors. Spouses will often create dual SLATs, where they give assets to each other.
Irrevocable life insurance trusts: ILITs
In an irrevocable life insurance trust, a grantor puts a life insurance policy in a trust, so it is then fully “owned” by that trust and no longer considered a part of his or her estate for tax purposes. When the trust is created, it will outline how benefits will be distributed upon the insurer’s death – or sometimes upon a second death (a spouse). Once an ILIT is created, being an irrevocable trust, it cannot be altered.
Charitable remainder trusts: CRTs
In a charitable remainder trust, a grantor makes a tax deductible donation to the trust, which is then distributed to designated charities at a fixed point in the future. While the trust is active, the grantor receives a fixed annuity back from the trust (which is considered a taxable part of the grantor’s estate), and at the trust’s termination all remaining assets are given to charities designated in the trust.
For more advanced estate planning strategies, visit 10 Diagrams to Explain Advanced Estate Planning Strategies.
Simplifying the complexities of estate planning
There are many kinds of trusts, and it’s not uncommon for people to use several different trusts as a part of their estate plans. It can get complicated to understand the implications and the flow of funds. That’s why it’s important to work with a top-notch financial advisor and estate attorney, bolstered by the right technology. Vanilla can help by enabling you to visualize the full scope of your balance sheet and estate, using easy to understand graphs and charts to show the flow of funds and highlight opportunities. Financial advisors interested in Vanilla can schedule a demo to learn more.
Vanilla is the Estate Advisory Platform, purpose-built to enable financial advisors to build deeper relationships with their clients and empower clients to build and protect their legacy. From robust and easy-to-understand visualizations of complex estates, detailed diagrams of how assets transfer to future generations, to ongoing estate monitoring, Vanilla is reinventing the estate planning experience, end-to-end. Learn more about Vanilla at https://www.justvanilla.com/.
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This article is for educational purposes only and should not be considered legal advice. If you feel that the information in this article is pertinent to your situation, you may wish to consult a qualified attorney for advice tailored to your circumstances.
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