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Trusts in the Estate Planning Process: What You Need to Know

Trusts in the Estate Planning Process: What You Need to Know

For many people, a trust an essential part of estate planning. However, confusion often exists about what exactly trusts are and how people can use them effectively to pass on their wealth. People often associate trusts with very wealthy families, but individuals of modest means can also benefit immensely from this financial vehicle.

Trusts can be used to accomplish a number of goals, from reducing tax liability to passing assets to children. In addition, trusts can be used to create a charitable giving legacy. Because of their diversity, trusts often become a cornerstone of estate plans.

In the most basic sense, a trust is a fiduciary arrangement that allows a third party, known as the trustee, to hold assets on behalf of a beneficiary. This arrangement can dictate exactly how and when assets are passed to the beneficiary.

Understanding the Difference between Revocable and Irrevocable Trusts

A number of types of trusts may be implemented depending on the ultimate goals of the person creating one. Understanding the different types available starts with knowing the difference between revocable and irrevocable trusts.

A revocable trust is also called a living trust. These arrangements help assets pass to a beneficiary without passing through probate and while allowing the grantor, the person who creates the trust, to maintain control while living. People can dissolve revocable trusts at any time, which is where the name comes from, although the arrangements become irrevocable once the grantor dies.

Individuals can name themselves as a trustee and maintain complete control over the trust with a provision for the appointment of a successor trustee in the event of death or incapacitation. While these trusts help avoid probate, they are still subject to estate tax.

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Irrevocable trusts transfer assets from the grantor’s estate and generally avoid both probate and taxes. However, once executed, the trusts cannot be changed. Individuals lose control of their assets upon signing and cannot change the terms. This type of trust is ideal for individuals looking to lower their tax burden, since they remove assets from an individual’s estate. Thus, the grantor is not liable for taxes on asset value or for any income generated by those assets.

Importantly, distributions through the trust will generally still have tax consequences, so it is important to have a clear understanding of tax law prior to executing the trust. Irrevocable trusts can also provide some protection in the event of a legal judgment against the grantor.

Appreciating the Range of Trusts Available during Estate Planning

While the major division between types of trusts is between revocable and irrevocable arrangements, many different types of agreements still exist. For example, people may have heard of A and B trusts.

A trusts are also called marital trusts. These arrangements provide benefits to a surviving spouse and are generally part of the taxable estate of the individual who survives. B trusts are also known as bypass or credit shelter trusts. These arrangements bypass the estate of the surviving spouse to tax full advantage of federal estate tax exemptions.

A similar arrangement is a qualified terminable interest property (QTIP) trust, which is also used to provide income for a surviving spouse. However, when the surviving spouse dies, the assets go to other named beneficiaries.

A number of trusts are also specifically designed to help pass along assets. For example, a generation-skipping trust helps assets pass to grandchildren or even later generations without incurring estate or generation-skipping taxes when the grantor’s children die.

A grantor retained annuity trust (GRAT) shifts future appreciation of assets to the next generation during the life of the grantor. Another option is the irrevocable life insurance trust (ILIT), which excludes life insurance payouts from the taxable estate of the deceased and helps them pass to beneficiaries like children.

Many trusts are also designed to aid charitable giving, such as the charitable lead trust and charitable remainder trust. The former divides benefits between charities and beneficiaries. The latter provides a designated income stream for a certain period of time with any remaining funds benefiting charity.

Integrating Trusts Effectively into a Holistic Estate Plan

Creating a trust does involve some research and planning. Ideally, individuals should work with a financial planner and an attorney when creating a trust. A financial planner can help determine the right type of trust based on goals and ensure that wealth gets passed on as planned. An attorney can ensure that the trust aligns with all federal and local laws.

Importantly, the rules about trusts can vary considerably between states, so it is critical to find someone with experience in this area. Individuals should also bring up any concerns they may have in terms of variations in state law to make sure the arrangement made is the ideal one. While the stakes are not as high with revocable trusts, irrevocable arrangements cannot be changed, so ensuring they are correct is extremely important.