So what exactly is a trust?
I have had two conversations about trust this week. The first was with a friend about the importance of trusting your advisor. Obviously without trust there is no basis for a good working relationship, but as faithful readers, you already know about the importance of working with a fiduciary--someone you can confidently place your trust in, knowing that they will always be looking out for your best interests. The other discussion about trust came when I was speaking with a client, who told me that he had not realized just how much there was to learn when it comes to financial literacy. He mentioned that he had thought he could handle his own finances, to which I told him that if I tried to DIY my financial planning, I would be the Wreck-it-Ralph of the retirement world, creating chaos within whatever fund or policy I touched. During the course of our chat, he told me that he had never realized there were so many different types of trusts, had believed that there was simply a trust, you created one only if you were wealthy, and that was that.
So what exactly is a trust? Put simply, it is a legal arrangement that allows a third party, called the trustee, to hold assets on behalf of a beneficiary. Trusts are a commonly used estate planning tool for transferring assets to beneficiaries. Despite what this client believed, there are many different types of trusts. Which one is selected depends upon both the wishes and financial priorities of the trustor (the individual who creates the trust) or benefactor (creator of an irrevocable trust).
There are four primary types of trusts:
LIVING TRUST:
This is created while you are still alive and aids in the efficient transfer or assets to beneficiaries. A living trust accomplishes this because it avoids probate, which is the court proceedings for distributing assets after death. Avoiding probate can save time and court fees, and it can also potentially reduce estate taxes for beneficiaries.
TESTAMENTARY TRUST:
This type of trust is set up after death according to the last will and testament. Since the terms are established in your will and those terms can be changed at any time up until death, this trust can be simpler and more flexible than a living trust.
REVOCABLE TRUST:
This is a living trust, as it is created while the grantor is still alive. As the name alludes to, the terms of the trust can be altered during the grantor's lifetime. The main purpose of a revocable trust is to bypass probate for the transfer of assets after death.
IRREVOCABLE TRUST:
The terms in an irrevocable trust cannot be altered after the trust is created. This trust is created when the benefactor (trustmaker) want to transfer assets out of their taxable estate. Income from the assets is no longer taxable to the benefactor during their lifetime and the assets are not taxable to the estate upon the death of the benefactor.
Trust Subcategories
While the above four trusts are the four main types of trusts, there are further subcategories with a range of terms and potential benefits. Below are some of the types of trusts that are commonly used in estate planning. There are many others, far too many to mention here, so if you do not see one that would suit you, please feel free to give us a call and we will find a trust that will work for you:
CHARITABLE TRUST
This is an irrevocable trust that will simultaneously benefit you, your beneficiaries, and a qualified charity under IRS Rules. There are two primary types of charitable trusts:
Charitable Lead Trust: this is also called a charitable lead annuity trust, or CLAT. It is set up to provide financial support, through an annuity, to the chosen charity or charities for a specified period of time. The remaining assets eventually go to the beneficiaries.
Charitable Remainder Trust: this is also called a charitable remainder annuity trust, or CRAT. This will create an income stream for you and for beneficiaries with an annuity for a specified period of time, with the remainder of assets going to charity. Reading closely, you may notice that this trust is the opposite of the CLAT.
SPENDTHRIFT TRUST:
This trust protects inherited assets from the potential financial irresponsibility of the beneficiary. Since the assets included belong to the trust, the beneficiary and the beneficiary's creditors do not have direct access or control of the trust assets. The trustee has the discretion to decide how the assets will be distributed, for example through a yearly allowance or through spending only with permission of the trustee.
SPECIAL NEEDS TRUST:
This type of trust allows the trustee to decide and direct how the assets of the trust can be used for a beneficiary. This type of trust is commonly used for dependents with special needs, such as a child or other family member who is disabled or otherwise unable to provide for their own financial needs.
GENERATION-SKIPPING TRUST:
This type of trust will skip over the children of the grantor to the generation following them. for example, if you want to provide for the financial well-being of your grandchildren, this trust would pass directly to them and is never owned by the generation it is skipping.
QUALIFIED TERMINABLE INTEREST PROPERTY TRUST:
a qualified terminable interest property trust, also known as a QTIP, is set up to provide income for a surviving spouse and for the grantor to control assets after the death of a spouse. QTIPs may be useful when beneficiaries exist from a previous marriage and the grantor dies before the subsequent spouse.
GRANTOR RETAINED ANNUITY TRUST:
a grantor retained annuity trust, or GRAT, is an irrevocable trust that is set up for a certain period of time to minimize taxes on large financial gifts to family members or other beneficiaries. The trustor pays the taxes on the assets when the trust is established and receives an annual annuity payment for the term of the GRAT. When the established term ends, the beneficiaries receive the remaining assets.
IRREVOCABLE LIFE INSURANCE TRUST:
Life insurance proceeds will usually avoid probate but for some wealthier individuals, a life insurance benefit may be included in the estate for tax purposes. An irrevocable Life Insurance Trust, or ILIT, can be used to exclude life insurance proceeds from the taxable estate and to transfer the death benefit immediately to beneficiaries.
In Summary
A trust, when created for the right reasons, can be a valuable part of the estate planning process. Keep in mind that trusts can be complex and not each type is appropriate for each person who is planning. Remember that other form of trust when thinking about creating a trust and work with someone in whom you have the utmost confidence and in whom you can place the highest degree of trust.
I trust that you will all have a wonderful weekend, as you enjoy our spring-like temperatures. My son talks about skiing; I look out the window and think about gardening and spring colors. Whether you enjoy this extra bit of warmth we are experiencing or you sit back and wait anxiously for the snows and windstorms to arrive, enjoy the articles that I have attached, with you in mind. Until next time...
Warmly,
Kimberly Wolf and Your Team at Pacific Financial Advisors