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The Heritage Law Center, LLC Blog

Common Trusts and How They Work

POSTED ON: October 1, 2013

Often clients tell me they’ve heard their friends or relatives talk about incorporating trusts into their estate plans but aren’t entirely clear how or why they should do the same. This is often because there is a lot of information out there about trust planning and, quite frankly, it can be confusing. There are many different types of trusts, each with different benefits and drawbacks. However, you should not be intimidated by trust-based planning. With the help of a knowledgeable advisor, trusts can be an extremely beneficial component of a thorough retirement and estate plan.

What is a Trust?

First of all, it is important to understand what a trust is. Every trust has four basic parts:

1. Someone must decide to create the trust. This person is usually called the grantor, although some people might refer to the person as the donor, the settlor, or the trustor.

2. Some person or entity must agree to hold the assets that will go in the trust for the benefit of someone else, called the trustee. There may be more than one trustee, and a trustee can be an individual or a corporate entity, such as a bank.

3. The trust must be funded with some assets (money and/or property), called the trust principal or corpus. The principal of the trust will likely change over time; depending on the trust purpose it may be spent or invested and may change in value or be exchanged for different assets.

4. Someone must benefit from the trust, called the beneficiary. There may be more than one beneficiary and they can benefit equally or in different amounts and times.

Aside from these four basic requirements, trusts can vary greatly depending on the manner in which they are created, what the assets are, and the purpose for which they are created.

Types of Common Trusts

Trusts generally break down into two main categories: living trusts and testamentary trusts. A living trust, also known as an “inter vivos” trust, is set up during a person’s lifetime and avoids the probate process. A testamentary trust is set up in a will and established only after the person’s death. It is subject to review and accounting to the probate court.

Living trusts can be divided further into two main types: revocable and irrevocable. A revocable trust allows you to retain control over all of the assets in the trust and revoke or change the terms of the trust at any time. This flexibility does have a cost, however. A revocable living trust does not protect assets from creditors because you still directly control the property in the trust, although it can help to reduce expenses and avoid probate upon death.

An irrevocable trust, by contrast, generally cannot be revoked by the grantor once it has been created, however, you can specify the beneficiaries of the trust, how it will function, and who will serve as trustee. Because the assets in an irrevocable trust are no longer considered part of your estate, the assets in the trust are not available to certain creditors, including Medicaid. Irrevocable trusts also avoid probate and can be used to protect property from the claims of your beneficiaries’ creditors as well.

Advanced Trust Planning

In addition to the basics trusts described above there are a variety of different trust planning options designed to deal with specific scenarios. Here are a few of the most common:

    Irrevocable Life Insurance Trusts

(ILITs). These trusts can be used to remove your life insurance from your taxable estate. The proceeds from the policy can then be used to pay estate costs and provide your heirs with tax-free income. However, once you have transferred your life insurance policy into this type of trust, you can no longer borrow against the policy or change the named beneficiary.

    Credit Shelter Trusts

(also known as Bypass Trusts, A/B Trusts or Family Trusts). These trusts can be used to avoid or substantially reduce estate taxes. The grantor will leave assets up to the estate tax exemption to the trust through a provision in his or her will, then pass the rest of the estate to his or her spouse tax-free. As an added benefit, even if the money in a credit shelter trust grows, it is never subject to estate tax.

    Special Needs Trusts

(also called D4A Trusts or Supplemental Needs Trusts). Parents and family members of someone with special needs can establish this type of trust to provide for the well-being of the disabled family member while preserving the individual’s eligibility for government benefit programs.

If you have questions about trust planning and how it might be incorporated into your estate plan, you should consult with an estate planning attorney. Call the Heritage Law Center for a free consultation today.