Leaving children an inheritance may be a goal for many parents. One way to accomplish this is through estate planning and setting up a trust. This is a unique legal document for parents to designate how they wish for cash, real estate, investments, and other assets to be held and distributed to their heirs (in this case, children) after their death.
The assets are placed in a trust fund, and avoids probate, making it a private legal process, unlike wills. There are different types of trusts, with various benefits and downsides to weigh.
What is a trust?
A trust is an estate planning tool that creates a fiduciary relationship between a designated trustee and the trust beneficiaries—meaning the trustee must act in the interests of the beneficiary. The trustee is the person or entity that manages the trust and its assets. The trustee may be a family member, friend, or an entity, like a bank. The beneficiaries are the individuals that inherit the assets.
The person who creates the trust is typically known as the grantor, but depending on the state’s statutes, may also be called the settlor or trustor. The grantor may also act as the trustee.
If a parent decides to create a trust, they can name their children as beneficiaries, and deed and title some or all of their assets in the trust’s name. Assets may include checking and savings accounts, brokerage accounts, and real estate. Retirement accounts like an individual retirement account (IRA) can be held in a trust, too.
4 Categories of trusts
There are four main types of trusts, each appropriate for different scenarios.
1. Testamentary trust
A testamentary trust is one that is created from a will, a document that specifies how to dispose of the property and assets of a person upon their death. The grantor’s will must go through probate, which is the process of going to court and distributing assets, before passing assets to the trust. The trust is not formed until the grantor dies, and the grantor may specify when and how the inheritance is distributed. For example, a grantor could set age benchmarks at which beneficiaries may receive certain assets. This trust may be used when assets are passing to minors or an incapacitated person.
2. Living trust
As its name suggests, a living trust is one that a grantor creates during their lifetime. A living trust is also known as an inter vivos trust, meaning between living people.
If a grantor becomes incapacitated and cannot make decisions, the trustee of the living trust can continue the grantor’s wishes. If the grantor was the trustee, the alternate trustee named in the trust would take over control of the trust. A trust avoids the need for a conservatorship over the incapacitated family member since the trust can manage the person’s assets and debts.
When the grantor of a living trust dies, the trust assets automatically pass to the beneficiaries without the need to go through probate. Probate is a court proceeding that distributes assets. It can be a lengthy process lasting years that delays heirs or beneficiaries from receiving their inheritances. Note that this benefit does not apply to testamentary trusts. Probate also makes assets and debts public information.
Since living trusts avoid probate, this type of trust may be used when a grantor wants to make sure there is no delay in passing assets to beneficiaries, and when a grantor wishes to keep the inheritance information private. A living trust can be revocable or irrevocable.
3. Revocable trust
A revocable trust is one in which the grantor can control and change during their lifetime. The grantor can also act as the trustee of the trust. Acting as the trustee allows the grantor to continue to control the assets. The difference with this trust is it provides protection if the grantor were to become incapacitated or die; another trustee can act for the benefit of the grantor and beneficiaries.
4. Irrevocable trust
An irrevocable trust is one in which the grantor no longer owns the assets and has no control. Rather, the trustee has control of all the assets in the trust. Once created and signed, an irrevocable trust, in most instances, cannot be changed. One purpose of the irrevocable trust is to protect the grantor’s assets from creditors.
With irrevocable trusts, the grantor may be able to act as the trust’s trustee, which allows them to carry out the trust provisions themselves (until they pass away, at which point another designated person becomes trustee). If the grantor acts as trustee, their assets may still be protected from creditors. However, these aspects of irrevocable trusts depend on state law.
Benefits of leaving inheritance in a trust to children
Trusts entail several benefits, which make them good estate planning tools, including:
- Offers tax advantages. Depending on the type of trust and state laws, leaving an inheritance in a trust may shelter the assets from estate taxes. Assets in an irrevocable trust are technically no longer owned by the individual, therefore, estate taxes may be lower or eliminated.
- Protects beneficiaries’ inheritance from creditors. A trust may shield the beneficiaries’ creditors from reaching the assets of the trust.
- Greater control of assets. A trust, in a way, allows the grantor to continue controlling their assets after passing away by establishing limitations in the trust for when beneficiaries can receive assets. For example, the grantor may decide their child must graduate from college before receiving their inheritance. Once the grantor dies the beneficiary does not automatically receive the inheritance since there is a limitation in the trust that the grantor set.
- Protects children’s inheritance. Leaving a child’s inheritance in a trust protects the assets for them until they reach the age of majority, the age of 18 in most states, or another age or milestone chosen by the grantor, such as age 25 or when the beneficiary purchases a home. The trust can provide the assets outright or in increments over a period of time.
- Less likelihood of challenge. Compared to a will, a trust ideally has undergone greater legal scrutiny when set up so it could stand up in court if contested.
Drawbacks of leaving inheritance in a trust to children
Although there are benefits of a trust, there are also notable downsides to leaving an inheritance in a trust. They include:
- Costs. Having a law firm prepare a trust is considerably more expensive, typically $1,600 to $3,000, compared to a will, which can cost a few hundred dollars. Additionally, there can be costs to have property titled and deeded in the name of the trust, resulting in added expenses and administrative paperwork.
- Record keeping. The trustee is required to maintain meticulous records of assets transferred in and out of the trust, as well as expenditures, disbursements, and income the trust receives.
- Assets are not always protected from creditors. In a revocable trust, a creditor can seek payment by filing a lawsuit. With a will, when assets go through probate, there is a limited time for creditors to file claims; after that period expires, they are no longer allowed. This claim period does not exist with trusts since the assets do not pass through probate.
- Difficult to understand. Even after a trust is created, it may be difficult to understand the trust and how it works. Income taxes may be due on any trust earnings. Also, acquiring new assets through a trust can create additional administrative burden and fees for the beneficiaries. For example, depending on the lender, taking out a mortgage or refinancing a house in a trust may require removing the house from the trust and re-deeding it back to the trust after the loan process. There may be additional recording fees each time a property is retitled in the trust’s name.
- May need additional estate planning. A trust may not include all of a person’s assets, so additional estate planning vehicles such as a will and healthcare power of attorney for healthcare decisions may also be necessary.
Key consideration before putting money in a trust
Certain types of trusts, such as irrevocable trusts, leave the grantor without control of the money and assets. Before handing over control of all assets to a trustee, consider current and future personal finance needs—and income. For example, living costs as a person grows older may change. There may be unexpected health costs in retirement like in-home care and nursing home stays. While Medicare does cover home health services, it doesn’t cover all, such as 24-hour at-home care. And higher income individuals can expect to pay higher premiums under Medicare, as well. Or, if there are plans for travel in retirement, these may be costlier than expected.
If a grantor created an irrevocable trust and costs of living expenses increased later, it would be the trustee’s decision based on the terms of the trust whether additional funds would be disbursed. Although it may not be possible to plan for every expense, these are among the considerations when deciding to create a trust and the type of trust to create.
The bottom line
A trust is an estate planning tool that can safeguard children’s inheritance. There are different types of trusts such as living revocable trusts, irrevocable trusts, and testamentary trusts. Each accomplishes different goals. The benefits of a trust include avoiding probate, keeping finances private, and having control over the assets for children in the future. There are also downsides to leaving money in a trust, including the costs to establish one and detailed record keeping that can be costly and administratively burdensome. Before deciding whether a trust is right for you, consider how much income you may need and the rising healthcare costs.