There are dozens of types of trusts, and no one size fits all. They can be an invaluable tool for tax and estate planning, and they offer myriad of benefits to a wide range of people and for many purposes.
Broadly speaking, trusts can be established during a person's lifetime or after death—generally categorized as revocable or irrevocable. Revocable offers the grantor control over the trust during his or her lifetime, including making changes or revoking the trust entirely. Irrevocable requires relinquishing control in exchange for potential tax benefits and greater asset protection.
While trusts can vary depending on the type, they share a few things in common. When an individual, known as a grantor or trustor, establishes a trust, any assets that go into it belong to the trust; a trustee manages this trust following specific rules and guidelines established by the trustor. Beneficiaries receive any income or assets distributed by the trust, but decisions about how the trust is managed are out of their hands.
Below are seven widely-used trusts in America, some basics of how they work and where they may be useful.
Revocable Living Trust
These trusts are created during the trustor’s lifetime and can be modified until his or her death. The trade-off? Assets in the trust are still considered part of the trustor’s estate, and therefore subject to estate taxes and possibly fair game for creditors.
One of the key benefits of a revocable trust is that grantors can transfer legal ownership of their assets while still retaining control, and they are not subject to probate. In the event of the grantor's death, these trusts become irrevocable.
Like most other trusts, revocable trusts allow grantors to establish conditions and limitations that will be in place upon their death. A few examples of when revocable trusts are used include parents wanting to leave assets for children but with parameters on age and other conditions; or individuals caring for someone who is elderly or has special needs.
As with revocable trusts, these offer grantors the ability to manage and distribute assets with specific guidelines. These trusts come in many shapes and forms—some of which are described below—but in all cases they are permanent. The benefit: Because these trusts remove assets from a grantor's estate, irrevocable trusts offer potential tax savings and asset protection.
Domestic Asset Protection Trust (DAPT)
First established in Alaska in 1997, these irrevocable trusts allow trustors to be discretionary beneficiaries while still protecting the trust assets from creditors and legal claims. These asset protection trusts are available in about 16 states and with different degrees of protection offered in each state. While DAPTs have gained traction, they are complex and controversial.
These irrevocable trusts can be a terrific tool for transferring assets to a specific charity or a charitable fund without estate or gift tax limitations. These can be particularly useful for transferring securities to charitable organizations; rather than liquidate securities, pay tax and donate the net proceeds, benefactors can transfer securities to non-profits without creating a taxable event. Grantors are able to do more good with their assets—and also enjoy the added benefit of seeing some of their generosity put to work during their lifetime.
Special Needs Trust
Special needs trusts are designed specifically for beneficiaries who are disabled and receive government benefits. By establishing a Special Needs Trust, parents or other caregivers can provide their loved ones with financial support without disqualifying the beneficiary from Social Security, Medicare or other benefits. These trusts are permitted under Social Security rules and allow for disbursements related to specific special needs, which can include a wide range of expenses related to maintaining the happiness and comfort of a person with disabilities.
Qualified Personal Residence Trust
There are many trusts designed for transferring real estate ownership without selling the property. Among them, a Qualified Personal Residence Trust allows grantors to remove the value of their personal residences from their estate while still remaining in their home or accessing a vacation property. This can be valuable if the home is expected to appreciate in value before they pass away or if keeping the home will push the total value of the estate over the federal estate tax exemption.
Qualified Terminable Interest Property Trust
Marriage, divorce and remarriage can create a complicated picture for estate planning. As a solution, there are a number of trusts that make it easier for individuals to have more control over how their money is dispersed. In the case of a Qualified Terminable Interest Property Trust, for example, grantors can designate that their surviving spouses receive income from the trust until their death, but then provide specified beneficiaries—such as children from a previous marriage—with the remaining principal.
To be sure, there is no one-size-fits-all solution when it comes to estate planning, particularly when trusts are part of the picture. Because of the complexity, and the legal and tax ramifications that come with establishing and managing trusts, this is one aspect of finance that requires working with an experienced professional. Reach out to your financial advisor to discuss your options. Don't have an advisor? Learn more about Fifth Third Wealth Management.