Tutorial: The Nuts and Bolts of Trusts
There are many estate planning goals that cannot be accomplished without using a trust. To do comprehensive financial planning, it is important to understand what a trust is and is not. Trusts are complex financial arrangements and should not be entered into lightly. You should know when a trust is warranted and the importance of funding the trust. Trusts can be created while you are alive, or through the actions of your final will. A trust can be a useful financial planning tool if it is set up correctly and used for its intended purposes.
Understanding Trusts: Terms and Concepts
A trust is a creature of the law in which one party—the trustee—manages any form of property that has been transferred to the trust by the person establishing the trust—the grantor or settlor. Think of a trust as an empty vessel into which the grantor "pours" property. The property is known as the trust principal, or corpus.
- Trusts Can Be Living or Testamentary.
- Living trusts are created during the creator's lifetime, while testamentary trusts are created by wills.
The Trustees and Beneficiaries
The trustee has the very highest of legal obligations: a fiduciary duty to manage the property prudently and see that it is used only in a manner, and for the purposes, established by the grantor.
The persons or institutions (e.g., charities) who benefit from the trust are its beneficiaries, named by the grantor in the trust document.
Two Types of Trusts
Trusts can be:
- Living: meaning only that they are established during the grantor's lifetime, or
- Testamentary: established by the action of a will.
More about Living and Testamentary Trusts
A living trust can be revocable—subject to termination or modification at any time by the grantor, for any reason—or irrevocable (unchangeable).
- A grantor has the right to remove and replace the trustee for poor performance or to make other changes.
Testamentary trusts are created by the action of a will through the probate process. Since the deceased grantor is unable to change the terms of a trust created under his or her will, these trusts are always irrevocable. However, while living, the grantor is certainly free to change his or her will, including any provisions for a testamentary trust that it creates. Testamentary trusts may be accountable to and have to report to the court under state law. The administration of a living trust does not require a trip to probate court, even after the grantor dies.
If a trust is irrevocable, the grantor is unable to end the trust, modify its primary terms, or take back assets if plans change, even in emergencies. If that is an unacceptable condition, then don't even consider an irrevocable trust.
A Grantor's Rghts
The grantor, however, may reserve the right (personally, or for others down the line) to remove and replace the trustee for poor performance or to make other, small, administrative changes.
The Irrevocable Trust: A Separate Legal Entity
Depending upon how it is structured, an irrevocable trust can be independent from its grantor, under the law. It is a separate legal entity that must obtain its own tax identification number from the IRS. It also is essential that the grantor and trustee recognize that an irrevocable trust cannot be used as the grantor's "piggy bank." Any potential tax benefits could be jeopardized if the grantor has a significant interest in, or control of, an irrevocable trust.
The discussion of trusts involves terms and concepts quite unfamiliar to most of us. That's why it is wise to consult an experienced estate planning professional if you are considering this useful estate planning tool.
How a Simple Living Trust Works
Let us examine how a typical simple living trust works during the grantor's lifetime. In this example, we'll look at the needs of a married couple, but note that a trust can easily be drafted to suit the needs of a single person or an unmarried couple.
- A grantor can terminate the trust at any time.
- When using separate trusts for the husband and wife, jointly owned property must be split up.
An Example of a Simple Living Trust
A single, "family trust" is often used for a married couple whose only children are those they share. In this example, the spouses are co-grantors as well. This is a simple living trust and is revocable at any time. (If the trust were revoked, the spouses could take back any property that had been transferred to it.) The grantors initially transfer ownership of any or all of their assets to the trust. Such a transfer may be made, for example, by changing the family joint checking account to the name of "Mom and Pop Jones, trustees of the Jones Family Trust."
Very often, Mom and Dad serve as their own trustees, at least initially. In any event, the trust document gives the grantors complete control over the trustee and all property in the trust. They continue to use and deal with trust property just as they did before the trust. Meanwhile, a successor trustee—perhaps an adult child or a financial institution—has been named in the document as a backup in case the grantors become disabled.
The grantors, of course, also can terminate (revoke) the trust at any time, and for practical purposes, it is "business as usual" for the grantors while alive and healthy. Indeed, the IRS refers to this kind of trust as a "grantor trust" and completely ignores it. The assets of any trust the grantor controls are regarded as the grantor's property for both estate and income tax purposes.
Separate Trusts for the Husband and Wife?
Some planners recommend using separate trusts for the husband and wife. When this is done, jointly owned property must be split up so that half can be transferred into each trust. The principles of trust operation are not different when each party—married or not—has his or her own individual trust. The chief advantages of using a simple living trust are not dependent on marital status.
Planning for a living trust involves a little time and effort, not to mention an attorney's fee. The living trust has several features that may make it useful in meeting your estate planning needs.
The Advantages of a Simple Living Trust
For most people, the key benefits of a simple living trust are supervision of fund distribution and effective management of trust assets. Some find avoiding probate court is also a benefit, since probate proceedings can be expensive and are a matter of public record.
- A trust could require certain preconditions.
- Simple living trusts can be very flexible with their funds.
- The living trust is an extremely useful tool in planning for possible disability.
Concerns About Leaving Assets to People Unable to Handle the Responsibilities
Many people who establish trusts (the trust grantors) are concerned about the possibility of leaving money or property to persons unable to handle the responsibilities—young children, for example. This is a major motivator when choosing to use a living trust over a simple will. A simple will of a married person usually leaves everything to the surviving spouse—if there is a survivor—and names the children as secondary beneficiaries after the death of both parents. If both parents die while the children are minors, a guardian must be appointed over the children's inherited assets and over the children themselves. This is a cumbersome form of property ownership. More importantly, guardianship usually ends at age 18, and the assets must be handed over to the kids. While guardianship of the children should be handled by will, the management of assets is better handled by trust.
Using Preconditions in a Trust
A trust could provide for a number of preconditions. One could arrange it so large distributions are made:
- When children reach a specific age—perhaps 21 or 25, when they are more grown up.
- For certain worthy purposes—to pay for college, plan a wedding, or pay for a first home.
- Only under certain conditions—e.g., to receive an amount when they turn 18 and enroll in college, and additional funds for each semester thereafter.
If the grantors are willing to give the trustee broad discretion, almost unlimited flexibility can be achieved in the day-to-day management of trust funds. Such flexibility could help the trustee deal appropriately with the unique abilities and opportunities (or disabilities or misfortunes) of each child. This is the approach most parents take while alive.
If little Sally, for example, showed exceptional promise on the piano, the trustee might decide, all things considered, to spend the money to send her to music school. If 21-year-old Jethro got kicked out of college, the trustee might decide to give him no more spending money. But if the young man agreed to an inpatient drug abuse program, the trustee would likely decide that would be money well spent. In family situations like these, the parents call upon the trustees to make the same kinds of judgments they would make if they were there and able.
In Cases of Disability
Property and money management are important in another context—disability planning. Although the grantors of a revocable living trust are initially capable of managing their own affairs, that may not always be the case. The living trust is an extremely useful tool in planning for possible disability. Assets in the trust are already under the control of "the trustee," whoever may be serving at a given time. So, if the grantors initially serve as co-trustees, but become disabled, the successor can step in without interruption. The grantors' resources can then continue to be managed and used for their benefit.
Backup Trustees Are Important
Usually, family trusts are set up so that either one of the spouse-grantors can independently act as trustee if the other is disabled. But it is imperative that a backup trustee be named in case something happens to both grantor-trustees. A living trust can help avoid lengthy legal proceedings, such as waiting for a court-appointed guardian, or court supervision of financial decisions.
Remember that since a testamentary trust is created in a will, it can't help you plan for disability.
Not everyone needs a simple living trust. For many people of even modest means, however, this tool can deal with a wide variety of potential concerns and issues.
Living Trusts Continue to Work After Death
In the case of a married couple with children, when one spouse dies, the living trust usually remains as-is. (We are using the single trust approach here for illustration.) The survivor could stay in control as sole trustee.
- When a survivor of a trust dies, there are some options to consider.
- A living trust becomes irrevocable when the last surviving grantor dies.
- A will that accompanies a living trust is sometimes called a pour-over will because it "pours over" any assets that were not transferred during life.
Options and Responsibilities When the Survivor Dies
When the survivor dies, there are several options: assets could be divided into equal shares for each child (distributed outright or remaining in trust), or they could remain in one fund for the benefit of all the children, until total or partial distribution occurred. The trustee manages the assets as directed by the trust document, bypassing probate court completely.
A living trust becomes an irrevocable trust when the last surviving grantor dies. For this reason it is important that a good successor trustee be named. Often this is a responsible adult child or a financial institution. The successor trustee will handle post-death affairs and property distribution. The successor trustee uses a copy of the death certificate and a certified copy of the trust document as proof of authority to handle the deceased grantor's property and accounts. If no successor were named, one would have to be appointed by the court.
Some trusts are designed so the principal is fully distributed immediately and the trust simply ends. Others can last for many years, with the trustee exercising discretion and making distributions according to the trust document.
The Importance of Having a Will Along With a Trust
A will generally should accompany a living trust. It is sometimes called a pour-over will because it "pours over" into the trust any assets that the grantor has neglected to formally transfer during life. But the pour-over will should be regarded as a back-up measure, because any property subject to this will still has to go through probate. The will should also be used to appoint a guardian for minor children should the circumstances warrant. A guardian cannot be appointed by the trust.
The less property subject to being poured over, the better. Any poured-over assets are co-mingled with other trust property, or otherwise handled as the trust directs.
Although it is called a "living" trust, the advantages of this estate planning tool are often not apparent until the creator of the trust passes away.
Choosing a Trustee for Your Living Trust
It is important for the trust creator (grantor) to choose not only an appropriate trustee to serve initially, but also a successor trustee, to be prepared for a variety of future scenarios. Grantors of a revocable living trust may be uninterested in or become unable to serve as trustees. Using a third party or institution as trustee, however, does not mean loss of ultimate control. The grantor can issue orders to the trustee—or fire him or her—if necessary. During life, therefore, a bad trustee choice can be corrected, at least while the grantor is mentally competent to do so. The decision of who will serve as trustee deserves a lot more thought than it usually gets.
- The trustee must be prepared for several possible scenarios.
- In the absence of an appropriate person, an institution such as a bank or trust company can act as a trustee.
- Sometimes an adult child is well suited to the role of trustee.
A lawyer can draft a document with almost any kind of conditions to guide, dictate, or limit the use of trust funds, but the grantor needs to find a party willing and able to make sure things run smoothly.
There are two very different aspects to the trustee's duties:
- Managing the assets wisely from an investment point of view.
- Applying the funds as called for by the trust, and only in that way.
Furthermore, even if the grantor serves initially as his or her own trustee, a qualified successor trustee will ultimately be needed, unless the grantor lives forever.
An adult child as trustee
In some families, an adult child is well suited to the role of trustee (or successor). Unfortunately, however, that choice often is made without consideration of a very practical matter: this child is probably also a trust beneficiary. Therefore, he or she is immediately presented with at least the opportunity to cheat the other beneficiaries. Even this perception could fuel family disharmony during a very stressful time. If this possibility appears even remotely likely, the grantor should confront it and another successor trustee should be named.
If there are no other appropriate trusted friends or family members, an institutional trustee should be considered. Generally, this is a bank, credit union, brokerage, or trust company. Most institutional trustees use trust committees to make investments and monitor subsequent performance. For many trusts, besides the investment committee, there is a trust committee to determine the needs of the beneficiaries and appropriate use of trust funds.
The Trustee's Fee
Most institutions will charge an annual trustee's fee in the neighborhood of 1% to 3% of the property under management. The fee will depend on the nature and size of the trust principal under management and the day-to-day involvement required of the trustee's employees. If less than $250,000 were involved, it probably wouldn't make sense to use an institutional trustee.
The Downside of Institutional Trustees
The downside of institutional trustees, however, is that a group of strangers cannot be expected to have the same insight and sensitivity a family member or friend would offer your heirs. One solution might be choosing a family member or friend as co-trustee or advisor to the institution, to provide input and advice with a personal touch.
Living trusts can be drafted with a wide assortment of terms and conditions. Regardless of the details, however, experts agree: it is important to choose the right trustee for the successful management of a living trust.
Summary of The Nuts and Bolts of Trusts
If you are concerned about the management and distribution of your estate upon your death or disability, a trust can be drafted to help. Trusts can be a key component of your estate plan, working in conjunction with your last will to provide for your loved ones after your death. Living trusts can also care for you if you become incapacitated.
Trusts are valuable financial planning tools, but you need to fully understand what they can and cannot do before entering into them. They also require transferring assets into the trusts or they won't work at all.
Practical Ideas I Can Start With Today
- Set up an appropriate trust to protect my assets.
- Choose an appropriate trustee for my trust.
- See an attorney for more complex planning if my situation is out of the ordinary.
- Estimate my potential estate tax liability. Use this calculator.
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