A trust fund is used by some as part of the estate-planning process to maintain privacy and minimize taxes when passing on assets. There are a number of trusts available, each of which comes with its own structure, rules, advantages, and drawbacks. While many associate trust funds with ultra-wealthy families, there are actually many scenarios where they could make sense regardless of income or net worth.
What is a trust fund?
A trust fund is an estate-planning tool for individuals who want to transfer wealth to their selected heirs after they pass away. It is an entity in which assets are held to avoid the probate process and minimize taxes for beneficiaries.
Assets that may be held in a trust fund include:
- Investments (like stocks, exchange-traded funds, or mutual funds)
- Real estate
- Private business
- Other assets of value
Trust funds are designed to offer more specific stipulations than a will. The person creating the trust is able to designate who gets what assets and under what conditions.
How does a trust fund work?
There are three key parties involved in the execution of a trust fund:
- Grantor. The grantor, or trustor, is the individual who creates the trust. They determine the rules for the trust and transfer their chosen assets into the entity.
- Trustee. The trustee administers the trust fund as a third party and distributes funds in accordance with the rules.
- Beneficiary. This is the recipient of the assets within the trust. Instead of owning the assets outright, they are often subject to certain rules or stipulations. These could include things like reaching a certain age or only being able to withdraw a certain amount of funds each year.
The value of a trust may continue to grow depending on its assets. If the trust holds cash in an interest-bearing savings account, that earned interest will be applied to the balance. If the trust fund holds a collection of stocks, the value of the fund will fluctuate alongside the market price of those investments.
Each state has its own rules about how long a trust fund can last, but many maintain a maximum of 21 years after the grantor’s death.
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Advantages & disadvantages of trust funds
There are many benefits of a trust fund, as well as drawbacks to consider.
The assets held in a trust fund can be designated to specific beneficiaries, so individuals can ensure those assets reach the people for whom they’re intended. Trust funds also provide for the grantor to include stipulations for use of the funds.
Common rules include:
- Create a minimum age for receiving access to the funds (such as 18 or 21, or even older).
- Place restrictions on how the money may be used (such as education or starting a business).
- Spread out distributions according to intervals (such as every five or 10 years).
- Pass on private business ownership or profits.
A trust fund keeps the assets private. Unlike a will, trust funds do not go through probate, the judicial process by which a will is approved in court, and remain private.
Finally, trust funds receive different tax treatment than other income sources. Taxes must be paid on any income created in the trust, but not on distributions made from the trust’s principal balance.
There are some drawbacks that individuals should consider before opening a trust fund.
- Complexity. The process can be complex, particularly when someone wants to include multiple stipulations for the trustee to navigate.
- Cost. It can also be expensive to start a trust fund. In addition to start-up costs, there may also be ongoing maintenance costs to pay the trustee, who administers the trust.
- It doesn’t replace a will. A will allows an individual to name beneficiaries, but also choose an executor, who administers the will, and a guardian for any minor children.
When someone wants to transfer investments to a minor child, another option is a UGMA/UTMA custodial account. The child owns the assets within the custodial account, but cannot access the funds until they reach a certain age, usually between 18 and 25.
Types of trust funds
There are a variety of trust fund definitions to understand when weighing the options.
- Revocable trusts. A revocable trust, also known as a living trust, allows the grantor to make changes while they are still alive. Common uses include passing on assets to family members and having a trustee manage the grantor’s finances in case they become incapacitated.
- Irrevocable trusts. Once an individual opens an irrevocable trust, they no longer own the assets and cannot change the terms of the trust. The trustee holds the funds until the conditions for disbursement to the beneficiary are met.
- Asset protection trust (APT). A type of irrevocable trust, this option protects the assets from creditors. The process is complex. Domestic APTs may be opened in 17 states, but may still be subject to court orders. Foreign APTs can be opened in offshore accounts and do not adhere to court judgments by the US.
- Blind trust. A blind trust allows for greater privacy while removing potential conflicts of interest from a situation—such as a business executive who wants to avoid insider trading. The fund is managed by a trustee, and the grantor and beneficiaries do not know what the account holds.
- Charitable trust. This allows the grantor to receive a tax deduction, then distributes some or all of the assets to a charity of choice. Stipulations may be made for how the funds are used.
- Generation-skipping trust (GST). The assets are passed on to the grantor’s grandchildren rather than their children in order to avoid estate taxes.
- Grantor retained annuity trust (GRAT). The grantor pays tax upon opening this account. The beneficiary receives an annuity for a set number of years, then receives the assets tax-free.
- Individual retirement account (IRA) trust. An IRA cannot be directly placed in a trust during the grantor’s lifetime. Instead, the trust is named as the beneficiary, with rules put in place for how the assets will be distributed.
- Land trust. A land trust passes on property by avoiding probate and keeping the transaction private.
- Marital trust. This type of family trust transfers assets to the surviving spouse when one spouse dies. When the surviving spouse dies, the trust transfers to the couple’s children.
- Medicaid trust. This helps individuals qualify for Medicaid by gifting assets to the trust at least 2.5 years before they want to qualify for Medicaid.
- Qualified personal residence trust. A QPRT reduces the gift tax by removing a personal property from the individual’s estate. The grantor can continue to live at the property for a set period of time.
- Special needs trust. It provides income to a special-needs person while protecting the assets from disqualifying them from benefits programs.
- Spendthrift trust. The trustee remains in control of the assets, protecting them from the beneficiary’s creditors.
- Testamentary trust. This trust is created based on the contents of an individual’s last will and testament. It is used to ensure a professional handles the assets.
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