Which Type of Trust is Best for You?
Revocable Trust, Irrevocable Trust, Specialty Trusts
By Austin Coyan, CPA, CFE
The decision to put your assets into a trust to ensure that they pass to your heirs according to your wishes requires an understanding of what trusts do and how one may help you achieve your personal goals.
To ensure that assets are passed on to chosen heirs — and oftentimes to sidestep hefty estate tax bills — many people choose to create trusts. Over time, different types of trusts have been developed, some for general purposes and some specialized to serve specific functions.
With numerous options to pick from, which type of trust is best for you in order to achieve your goals?
What is a Trust?
First, what is a trust? In its simplest form, a trust is a fiduciary relationship in which one person holds the title to assets or property for the benefit of another. This means that with trusts there are generally three parties involved:
- The Trustor – This is the person who owns the trust. He or she is using the trust to transfer assets or property that were put into the trust for the beneficiary. The trustor is also referred to as the settlor or the grantor.
- The Trustee – This is the individual charged with managing the trust according to the rules established by the trustor. The trustee manages the transfer of the assets or property from the trustor to the beneficiary.
- The Beneficiary – This is the person who benefits from the trust. The beneficiary is given the property or assets by the trustee from the trustor, according to the terms of the agreement. A trust may have more than one beneficiary.
Generally, trusts fall into one of two categories:
- Revocable trusts, like the name implies, can be revoked. Also referred to as “revocable living trusts,” during the lifetime of the trustor the terms of the trust can be changed or dissolved, and the owner maintains control of the assets. The trustor can even name him- or herself the co-trustee or self-trustee, provided a successor trustee is named to take over in the event of his or her death. Revocable trusts are useful because the transfer and handling of assets specified by the trustor does not become permanent until he or she dies. Additionally, upon the death of the trustor, the trust is not subject to probate, so it is more private than a will.
- Irrevocable trusts, on the other hand, are designed to not be modifiable once established. The transfer of assets or property from the trustor to the trust cannot be undone or modified unless certain circumstances and procedures are followed. The lack of flexibility of irrevocable trusts is helpful because any assets in the trust are safe from the claims of creditors or beneficiaries. Additionally, items in the irrevocable trust are sheltered from estate and gift taxes.
Beyond these two general categories of trusts, there are many specialty trusts:
- Marital trusts (“A” trusts) are trusts where the trustor is one spouse and the beneficiary is the other. Using this type of trust allows the beneficiary to avoid paying estate taxes on the assets it retains during their lifetime. That said, the inheritor of the surviving spouse’s estate will have to pay taxes on the trust assets upon the surviving spouse’s death.
- Tax by-pass trusts (“B” trusts) are also called credit shelter trusts. These are a type of irrevocable trust used to reduce estate tax for non-spousal heirs. When one spouse dies, the beneficiary spouse does not receive the assets. Rather the assets remain managed by a trustee. When the second spouse dies, his or her heirs can receive the assets without paying estate tax.
- Charitable trusts exist in two forms, charitable lead trusts and charitable remainder trusts. With a charitable lead trust, the trustor specifies certain assets for a specific charity or charities. With charitable remainder trusts, the trustor can receive income from the assets for a set period of time. After that, the assets or income go to the designated charity.
- Constructive trusts, also known as implied trusts, are trusts established by a court after it determines that there was an intention to establish a trust, even if there was no formal declaration of one. The court considers a variety of facts and circumstances in making its determination.
- Special needs trusts are designed to provide financially for a special needs dependent without disqualifying them from receiving government benefits based on their disability. The money contained within this type of trust can be used for a variety of expenses, such as medical care and day-to-day needs.
- Spendthrift trusts are trusts for which the trustor specifies how and when the principal trust assets can be accessed by the beneficiary. The goal is to prevent what the trustor would consider misuse or waste of the assets by the beneficiary.
- Totten trusts are also referred to as payable-on-death accounts. For this type of trust, a trustor puts money into a bank account or other security. Upon their death, the money is given to the trust’s named beneficiary. Distributions from a Totten trust to beneficiaries are not subject to federal tax, but the interest accumulated in the trust is taxable as income, either to the beneficiary or the trust itself.
- Generation-skipping trusts are used to transfer assets to grandchildren rather than children. This allows children to avoid paying estate taxes. While the assets and property in the generation-skipping trust are designated for grandchildren, their parents — your children — may still access income that the assets generate. While a generation-skipping trust escapes estate taxation, there is a “transfer tax” applied to trusts that exceed a certain amount at the time of transfer. Indexed for inflation, that amount is $11.58 million in 2020 in the case of an individual decedent.
- Life insurance trusts are a type of irrevocable trust created to hold life insurance proceeds. The trust is listed as the beneficiary on a life insurance policy. This allows you to circumvent estate taxes on life insurance payouts. Generally, life insurance proceeds paid to a beneficiary on the death of the policyholder are not taxable as income and do not have to be reported. However, in certain circumstances interest payments related to life insurance policies are taxable.
- Testamentary trusts, also known as will trusts, are established via a last will and testament. They become irrevocable upon the death of the trustor. Beneficiaries of testamentary trusts may only access trust assets at a predetermined time.
Trusts can be used to help you accomplish a variety of goals. The first step begins with thinking through what you’re trying to accomplish – whether that be taking care of family members, loved ones, or cherished charities. Start by scheduling an appointment with your attorney and Adams Brown advisor to begin planning which type of trust may help you accomplish your goals.