What is a Trust and How Does it Work?

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A trust is created with a formal legal document to manage assets for beneficiaries. The trust is created by a person called the Settlor or Grantor, and a Trustee is appointed to follow and enforce the rules of the trust while managing its assets for the benefit of the beneficiaries.

Revocable Trust

A revocable trust is created during the Grantor’s lifetime for the Grantor’s benefit and passes trust assets to named beneficiaries upon the Grantor’s death. This trust can be modified or terminated during the Grantor’s lifetime because the Grantor maintains control over the trust. Income and capital gains in the trust flow through to the Grantor’s personal tax, and are reported on the Grantor’s tax return. Most people serve as trustee of their own revocable trust and use such trusts as a way to transfer assets at death.

Irrevocable Trust

Irrevocable trusts are generally not capable of being modified or terminated without court approval. The Grantor gives up control of the trust assets, so they are not included in the Grantor’s estate. Since the assets are not the Grantor’s nor the beneficiaries’, the trust is its own identity and must file its own tax return. A common type of irrevocable trust is the Irrevocable Life Insurance Trust (ILIT). The Grantor forms an ILIT, and gifts cash in the ILIT to purchase a life insurance policy on the Grantor. This moves the life insurance out of the Grantor’s estate, possibly reducing federal or state specific estate tax.

Testamentary Trust

A testamentary trust is a trust that is created through the last will and testament when the Grantor becomes deceased. This trust allows Grantors to take advantage of estate tax reduction through the unified credit shelter. This refers to the maximum amount of assets the IRS allows you to transfer tax-free during life or at death.

Why Set Up a Trust?

Aside from the estate tax benefits of an irrevocable trust, these trusts also provide asset protection from creditors and lawsuits. Even revocable trusts can allow you to control bequests to beneficiaries – something that is not always possible with a last will and testament. You are free to set terms for who receives what and when and under what circumstances. Trusts often avoid the probate process as well, and can be a useful tool for property owned in states outside the state of residence to avoid ancillary probate in other states.