Establishing a trust can be an effective way to help protect your assets, potentially reduce your exposure to estate taxes, and help ensure that your wealth-transfer strategy is carried out in accordance with your wishes.
But determining what kind of trust is appropriate for your situation is not always easy, and the complexities of trust law can be overwhelming. If you’re interested in taking advantage of this powerful planning strategy, take some time to familiarize yourself with the fundamentals of trusts so you can better articulate your needs to your tax or estate planning professionals.
What is a trust?
A trust is a legal arrangement between an owner of assets (the grantor) and another person or institution (the trustee). The grantor places their assets into the trust, which takes ownership of them. The trust is then administered by the trustee under the terms laid out in the trust document for the benefit of one or more individuals, charities, or other entities, called beneficiaries. Importantly, a trust may allow assets to pass outside of the grantor’s probate process and remain private. This may help the family avoid the costs (including attorney's fees) and delays associated with probate.
How to select the trustee of a trust
Selecting the right trustee is particularly important, as the role involves more than just carrying out the grantor’s instructions. Catherine Neijstrom, Vice President, Financial & Trust Planning Lead at Fidelity Investments, suggests being particularly thoughtful about your choice.
“Many people select family members or friends as trustees,” says Neijstrom, “and that may be fine given your circumstances.” But she cautions that it is important to remember that the role involves more than just carrying out the grantor’s wishes. It is a fiduciary responsibility that requires expertise in tax planning, investment management, accounting, and trust law. “While a layperson serving as trustee can hire experts such as accountants, financial advisors, and estate planning attorneys to help them, it may also be worth considering naming a professional trustee or trust company, who will have more experience in administering a trust. Another option might be be naming both a friend or family member and a professional trustee or trust company to serve together.” The structure of the trust may also dictate who can serve as a trustee. For instance, certain types of trusts require an independent trustee.
Learn more: Why naming the right trustee is critical
While there are many types of trusts, each serving a particular purpose, an important distinction between them is whether they are revocable or irrevocable.
What is a revocable trust?
With a revocable trust (also known as a living trust), the grantor has the option to change or even terminate the arrangement at any time during the grantor’s life (that is, the trust can be revoked). Because the grantor retains control of revocable trust property, trust assets will be included in the grantor's gross estate at the grantor's death and may be subject to estate taxes. Similarly, for income tax purposes, while the grantor is alive, all income and deductions appear on the grantor's personal income tax return.
“A revocable trust is something that practically everyone may benefit from, even people who aren’t concerned about estate taxes,” says Neijstrom. “A revocable trust can be especially beneficial in the event you become incapacitated. While the grantor is typically the trustee of their own revocable trust, a named successor trustee can swoop in to administer trust assets if the grantor/trustee becomes incapacitated. Similarly, when a grantor passes away, trust assets added during the grantor’s life can avoid the probate process. These aspects of a revocable trust can make things much easier on your family in a time of crisis.”
When the grantor passes away, a revocable trust becomes irrevocable.
What is an irrevocable trust?
As the name implies, and in contrast to a revocable trust, an irrevocable trust cannot be revoked by the grantor. When setting up an irrevocable trust during life, the grantor permanently relinquishes control of assets placed in the trust. Irrevocable trusts are often designed with a goal to exclude trust assets from the grantor's gross estate and reduce estate tax exposure.
“Irrevocable trusts can be useful when someone is looking to reduce their gross estate for estate tax purposes but prefers not to make an outright gift,” says Neijstrom. “In an irrevocable trust, grantors can put limits or conditions on the distribution of assets to beneficiaries, providing some degree of control over family assets into the future.” These restrictions may be useful when leaving assets to a beneficiary who is still a child, has special needs, or otherwise may not be able to manage the assets on their own. In addition to using irrevocable trusts to reduce estate tax, irrevocable trusts can be useful for specific purposes such as Medicaid planning.
Learn more: How to protect trust assets
An irrevocable trust may be established as a “grantor” or a “non-grantor” trust. In the former, the grantor is responsible for paying the tax on income generated by the trust while they are alive. This can allow trust assets to grow more than they typically would than if the taxes had to be paid out of the trust itself. In a non-grantor trust, however, the trust pays the taxes, and one of the main responsibilities of the trustee is to file the trust’s annual fiduciary income tax returns each year.
While assets in an irrevocable trust are typically not included in the grantor’s estate for tax purposes, the transfer of assets to an irrevocable trust during one’s lifetime would ordinarily be considered a gift for gift tax purposes. Any appreciation on those assets would then be excluded from the grantor’s estate at the time of death, bypassing estate tax in the grantor’s estate.
What is trust “situs” and why is it important?
A trust’s “situs” refers to where the trust is established—that is, what state it is legally “sited” in. “Because different states have different laws regarding trusts, where you establish your trust can affect what features and benefits may be available to you,” says Neijstrom.
For example, if you wanted to create a trust in which the beneficiaries’ rights to be informed about the trust are restricted (subject to certain limitations), you would need to have the trust’s administration governed by the laws of a state that allows for “silent” or “quiet” trusts, such as New Hampshire or Delaware.
Learn more: Should you consider a "silent" trust?
When choosing where your trust is sited, you may want to consider the potential exposure to state income taxes, any creditor protections that a particular state may provide, and any limitations a state may put on how long the trust can last.
Which type of irrevocable trust is right for you?
As mentioned previously, there are many different types of irrevocable trusts. They include, but are not limited to, the following:
- Spousal lifetime access trusts (SLATs)
- Intentionally defective grantor trusts (IDGTs)
- Grantor-retained annuity trusts (GRATs)
- Charitable lead annuity trusts (CLATs)
- Charitable remainder annuity trusts (CRATs)
- Qualified personal residence trusts (QPRTs)
Ultimately, the type of irrevocable trust you choose will depend on your particular circumstances, as each has particular benefits and potential trade-offs.
It’s important to note overall, however, that while an irrevocable trust may provide assurance that the assets held in trust are not part of your estate, you generally will lose access to that money should your circumstances change. By working with your attorney and your accountant, you can help ensure that the trust you choose will meet your long-term needs, for both your lifetime and your estate.