What is a trust and how does it work?

A trust can be one of the most powerful components of an estate plan. It can help you protect assets, maintain your privacy, and avoid probate. Most importantly, it can help give you control of how your money and your assets are managed and distributed following your incapacity or death. As part of a broader estate plan, trusts can give you peace of mind, protect what matters most, and ensure your family is taken care of for years to come. Here's all you need to know about the different types of trusts, how they work, and which one is right for you.

What is a trust?

A trust is simply an arrangement that changes how an asset, such as cash, an investment, real estate or another type of asset, is held or owned. A trust is a separate legal entity that acts as a container to hold money or property. It doesn’t change the asset or piece of property. Instead, it changes who has the right to own, control, and use the asset or piece of property.

Reasons to create a trust

There are many reasons to create a trust. The type of trust you choose will depend on what you are looking to achieve. Here are the primary reasons people establish and fund trusts.

Avoid probate

Probate is a court-supervised process that validates a will and establishes an orderly process for distributing assets. A trust bypasses the time-consuming probate process; saves time and money.

Create privacy

Although the probate process requires that all assets are recorded and made public, a trust doesn’t have that requirement. A trust can help you keep your personal and family affairs private.

Protect assets

Depending on the type of trust you have, assets transferred to it can be protected from creditors.

Minimize estate taxes

In rare cases, trusts can be great tools to minimize an individual or family’s estate taxes. This requires very careful planning with an attorney.

Maintain control of assets

Because trust documents contain the terms for managing and distributing assets, those terms continue even after the owner of the trust passes away.

There are some disadvantages to establishing a trust.

• May cost a few thousand dollars to set up
• May require that you give up control of the assets placed in the trust (depending on the type of trust)
• Trust income can be taxed at higher tax rates than the rates individuals face.
• In some cases, it can be harder to change how an asset is owned or managed if it’s held in a trust

How does a trust work?

A trust has three main parties:

1. The grantor

The person who creates the trust and transfers or gifts assets into it. The grantor changes the ownership or title of each asset from their name into the name of the trust.  For example, a home titled in Bob Smith’s name would be transferred to the Bob Smith Trust.

2. The trustee(s):

The person (or persons) responsible for administering the trust, managing the assets, and distributing assets and income per the instructions provided in the trust agreement.

3. The beneficiary(s): 

The person (or persons) who eventually receive the assets (sometimes called the trust principal) or the income generated from the trust.

Establishing a trust is pretty straightforward. Here's how the process works:

• The grantor, working with an estates and trusts attorney establishes the trust by signing a legal document: the trust agreement
• The trust agreement creates the new entity, which acts as the container.
• The grantor then transfers ownership and title of the selected assets to the trust.
• The trustee named in the trust agreement is then responsible for handling all aspects of administration, management of assets, and distribution to beneficiaries.

The type of trust determines how all of this works, as outlined below.

Understanding types of trusts

There are many types of trusts including revocable, irrevocable, and testamentary trusts.

Revocable Trust

What is it?

A revocable trust (also called a living trust) is established and funded by the grantor while they are alive. The trust remains in the control of the grantor, so they can still manage or use the assets and receive income from them. As its name suggests, the trust can be changed or dissolved (revoked) at any time by the grantor.

When is it used?

Revocable trusts are primarily used to avoid the probate process following the death of the owner and to maintain privacy of individual or family finances. Revocable trusts do not minimize estate taxes or provide creditor protection.

Irrevocable Trust

What is it?

Unlike a revocable trust, an irrevocable trust cannot be changed or dissolved once it is established and funded. In general, you can’t remove assets, change beneficiaries, or freely rewrite the terms established in the trust agreement. When assets are transferred to the trust, the trust becomes the owner and the grantor releases control.

When is it used?

Irrevocable trusts make sense when people want to remove assets from their estate for tax purposes, avoid probate, keep their financial affairs private, and protect assets from creditors. Irrevocable trusts are not great tools for people who want to maintain flexibility with their finances because of their irrevocable nature.

Testamentary Trust

What is it?

This type of trust is established after you pass away as part of the probate process. The trust language is included as part of your will. You name the assets that are to be transferred to it, and the executor of your estate will handle the administrative duties to make this happen. Once established, it works very much like other trusts, with a trustee to oversee the assets and beneficiaries.

There are also several types of specialized trusts designed for a specific goal, such as making charitable contributions, providing for a child with special needs, and other purposes. 

Who should consider a trust?

Trusts can be powerful planning tools, but they aren’t right for everyone. Typically, trusts are utilized by people with a:

• Desire to protect their assets and create privacy
• Need to maintain control of how assets are managed and distributed to their beneficiaries
• Need to find other options to reduce estate taxes