Trust Funds Explained

Whenever you hear the word trust fund, you might envision some spoiled kid who’ll never have to work a day in their life. You might think trust funds are just for the ultra-wealthy. But as with so many personal finance topics, it’s more complicated than that.

Trusts can actually be helpful estate planning tools. If you want to preserve your wealth and potentially avoid having the state divide your assets upon incapacitation or death, funds held in trust might be of interest to you and your family.

What is a trust fund?

The term trust fund refers to assets that are held in a trust. In essence, the trust has funds or assets that are created by a grantor, managed by a trustee and eventually distributed to beneficiaries. Assets that can fund a trust vary and could include one or more of the following:

• Cash

• Stocks and bonds

• Real estate

• Life insurance

• Business interests

• Brokerage accounts

• Tangible personal property

A trust is a rulebook of sorts that determines how your wealth and assets will be distributed to beneficiaries in a specific way and at specific milestones.

The trust itself doesn’t hold any assets, per se, but it does determine how they are handled and who has access to them. People use trusts to avoid probate, reduce taxes, preserve privacy in asset transfer and give to charitable causes.

Knowing more about trusts will help you determine if this is an estate planning tool worth exploring for your personal use.

Who needs a trust fund?

Although you might think trusts are for the mega-rich, you’d be surprised at how accessible and appropriate they may be for anyone’s financial planning needs. There are different types of trusts that might be best for varying degrees of net worth and asset types. The administrative costs related to setting up and maintaining each type of trust vary, too.

You should consider a trust if you have a substantial amount of assets in terms of cash, stocks bonds, real estate, and business interests. If you’ll want to reduce your tax exposure and avoid the probate process while transferring your assets to your heir, then you should consider creating a trust.

How does a trust fund work?

A trust is a legal entity that is set up to manage and distribute your assets. It works through legally binding terms that dictate how your wealth is managed at various points in your life. One way to think of a trust is as a “mini corporation” that handles your money. The terms of the trust are like the corporation by-laws that determine how the trust should operate.

If you are the person setting up the trust you are considered the grantor, or trustor. As the grantor, you designate a trustee which is a neutral third party who administrates the fund’s operation and distribution of assets to beneficiaries. Beneficiaries can be your individual heirs, a group of people, a corporation, or a charity.

Depending on the type of trust you have, can also be the trustee or designate one. The trustee could be one of your beneficiaries or you can choose a corporate trustee. A corporate trustee can be a trust company that has vast knowledge on matters pertaining to managing a trust.

A child can be named trustee although they would likely still need support regarding tax, accounting, and legal issues. Either way, professional help is needed to set up and administer the assets of trust. The costs associated with the management of a trust should also be considered and discussed with your financial advisor and estate lawyer.

Trusts operate differently based on the type of trust you decide to set up. Though there are many types of trust, the most common distinction is between a revocable trust and an irrevocable trust. A revocable trust remains in effect while the grantor is alive and can be changed, terminated or altered while the grantor is alive. In this case, the grantor can also be the trustee and beneficiary until their incapacitation or death. An irrevocable trust cannot be changed during the lifetime of the grantor nor cannot it be terminated upon the grantor’s death. A revocable trust becomes irrevocable once the grantor dies.

The type of trust you will need is based on your goals. Formerly, a revocable trust was desirable when it came to protecting an estate from taxes. However, recent changes in the U.S. tax code have made this issue somewhat moot for the vast majority of people, as the current exemption on estate taxes is $11.4 million per individual.

Consequently, the best use for the revocable might be in the case of incapacitation. If this were to occur, you could use this type of trust to designate a trustee to act on your behalf when you are unable to do so. Another benefit of this type of trust is that it may not be subject to the probate process, allowing you to transfer assets to your beneficiaries without court involvement.

An irrevocable can be used to protect assets from creditors, taxes and even claims of beneficiaries. This type of trust can also remove assets from your estate to reduce or eliminate estate and gift taxes. This type of trust would be ideal if you’ve got a sizable estate—perhaps in the multi-million dollar range or more.

When setting up trusts you need to be mindful of the costs it takes to create and administer them. Because a trust can be cost-prohibitive on many accounts, you need to make sure that you’ve got a sufficient amount of assets to help cover those costs. You’ll also want to make sure the administrative costs don’t erode the value of your estate, either.

Not all trusts are expensive. For example, a simple land trust can be just a few hundred dollars to create and much less than that to maintain it on an annual basis. There are other types of trusts that you should know about, as well:

• Marital trusts: This trust is designed to transfer assets from one spouse to another. The benefit of this type of trust is that assets can be transferred to a surviving spouse without tax consequences.

• Charitable trust: This trust can accomplish philanthropic goals. The charitable trust allows you to give money to causes you care about when you pass away. There are different ways to set up this type of trust such as giving a lump sum or a series of payments over a certain amount of time.

• Generation-skipping trusts: This trust is designed to transfer assets to your grandchildren. It will help you avoid paying estate taxes when assets pass to your children and then again to your grandchildren.

• Insurance trust: Another type of irrevocable trust, is set up to be the primary beneficiary of a life insurance policy. Upon your death, the proceeds of the policy are held in trust and distributed to the beneficiaries named in the trust in increments over their lifetime or until the funds run out.

• Special needs trust: This trust will ensure your special needs beneficiaries are taken care of in the case of your death. Having this trust in place should not hinder their ability to receive their government benefits.

• Spendthrift trust: Ideal for beneficiaries who might be at risk for squandering their inheritance with imprudent spending habits. This kind of trust can remain in existence for a period of time after the grantor dies so that funds can be distributed over a period of time to beneficiaries rather than all at once.

How to set up a trust fund

Once you determine that you’ve got enough assets that warrant the establishment of a trust, it’s a good idea to put your trust in place.

To set up a trust, you’ll want to engage the help of both a financial planner or advisor and an estate lawyer. Your financial advisor can help you identify some financial goals along with desires you might have for your wealth once you die. They can also give you information on the various types of trusts to choose from along with ideas on what might work best for your situation.

An estate lawyer can capture these desires in the provisions of the trust known as the trust agreement. In this agreement you’ll need to outline:

• Who your trustee will be

• Who your beneficiaries will be

• How and when the funds and assets in the trust are disbursed (or held)

Wills vs Trusts

A will is another estate planning tool that can help carry out your desires for distributing your assets upon your death. A will can be much less expensive to prepare and administer but it may not have the same flexibility as a trust.

For instance, even if you have a will, a will, unlike a trust, must be “proved” in probate court upon your passing. You should also be aware that the probate process is documented on public record. As each stage of the probate process goes on, these records are updated in the jurisdiction wherein the probate proceedings take place. For some, this lack of privacy can be unsettling—especially those who expect to pass on large sums of wealth to their beneficiaries.

A trust is ideal for people want to transfer assets with privacy and with the least amount of tax exposure possible.

In some cases, a will and trust can work together. For instance, it’s not uncommon for people to take title to real estate in a land trust, then give more detail around what they want to happen with the trust in the language of their will. This can work with other asset classes as well but real estate is probably the most known example of how a will and trust can work in tandem.