What Is a Trust? How Does It Work?

Written by Meagan DrewUpdated: 30th Sep 2021
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When you hear the term “trust,” your mind probably jumps right to trust fund baby, and you have visions of Kevin at the beach popping bottles on Mommy and Daddy’s dime.

While that is certainly a reality of what happens to some trusts, trusts are extremely important and versatile parts of estate planning for anyone trying to reduce financial hassles for their loved ones at their passing.

What Is a Trust?

A trust is a legally binding arrangement. A trust establishes a trustee or third party with the right to hold and manage property and assets inside the trust.

The trust also establishes a clear distribution plan to be executed by the trustee at a predetermined time.

Trusts reduce confusion, save time, and, potentially, can reduce inheritance and estate tax implications. Probably the most beneficial outcome of a trust is avoiding that dirty word- probate.

How Does a Trust Work?

Establishing a trust is not as complicated as Kevin and his family would lead you to believe. Setting up a trust is a matter of creating a trust agreement and transferring assets into the trust to be held.

Trusts are considered legal vehicles, so they should have some legal oversight and shouldn’t be set up all willy nilly using a form you printed off the internet. There are DIY options, but a second look is always a good choice.

Trust Terminology to Know

  • Beneficiary: This is the individual who will eventually receive all or some of the assets inside the trust.
  • Grantor: This is the person who creates and funds the trust.
  • Trustee: This is the organization or individual who manages the trust.

What Is the Main Purpose of a Trust?

Bottom Line: trusts are to protect assets. Trusts allow the grantor to determine the fate of their assets even after their passing.

Trusts reduce tax implications in many instances and keep assets from entering probate. Trust can also prevent beneficiaries from accessing assets until they are ready to handle them adequately or to provide a stream of income for life.

Why Would a Person Want to Set Up a Trust?

A grantor could want to set up a trust for several reasons. They may want to establish a trust to prevent frivolous waste, keep their assets out of the court system, control the spending and future investments even after their passing.

Ultimately, a person who sets up a trust is someone who would like to have some control over the future of their assets.

What Are the Benefits of Setting Up a Trust?

Setting up a trust comes with many benefits to both the grantor and beneficiary.

Tax Savings

Trusts are taxed in a manner that behooves beneficiaries. Trust distributions must pay taxes on distributions of income and interest, but not on the return of principle.

The Federal Government assumes that any money invested in the trust has already been taxed, and they do not double-tap the taxes on that money even if Nanna actually put the principle in back in 1900.

You Are in Control

Grantors work with their legal team to establish the parameters inside the trust and allow for ultimate control over assets even after they’ve passed.

Type A individuals would certainly enjoy this amount of control over their hard-earned assets, but so do many people.

The trust helps to prevent waste or poor decisions and can help ensure generational wealth that might otherwise not be possible without an explicit plan in place.

Privacy

Since trusts are excluded from probate, their contents never go on any public record like they would if they went to probate.

This allows private matters to stay private and nosey Nelly’s to stay delightfully uninformed.

Protect Your Estate and Legacy

Trusts are a tool that helps create generational wealth. Parameters of the trust allow grantors to dictate what and how much of their assets are given to each individual.

By not allowing full and uncontrolled access to assets, grantors can rest in peace knowing that there will be wealth for generations to come if they so choose.

Probate Savings

Properly established trusts can greatly reduce the number of assets taxed at the 40% estate tax rate or completely eliminate the estate tax.

Types of Trusts

  • Revocable: Revocable trusts moonlight as living trusts. In these trusts, grantors can change beneficiaries and move around assets as long as the grantor is still mentally capable to do so. The grantor is the owner of the assets in the trust until their passing or their incapacitation.
  • Irrevocable: Irrevocable trusts are for grantors that aren’t just sure about the future of their assets but are sure. Once an irrevocable trust is established, the assets in the trust no longer belong to the grantor but the trust. These types of trust offer a reduced tax liability, but grantors need to be positive there is no circumstance in which they would ever need the assets again.
  • Marital or “A” Trust: Marital trusts are irrevocable until the first spouse passes, which triggers the trust to become revocable and the surviving spouse to receive assets in the trust tax-free. The assets inside the martial trust are off-limits until the first spouse’s death, and then the surviving spouse may access all the assets and their earned income. Upon the death of the surviving spouse, the martial trust may be passed on to children or other designated beneficiaries.
  • Bypass or “B” Trust: The bypass trust is an irrevocable trust or family trust that’s terms are firm, but a surviving spouse can draw income from during their remaining days. The surviving spouse can be both the beneficiary and the trustee of the B trust.
  • Testamentary Trust: A testamentary trust is outlined in a grantor’s will and is not established until their passing. It will still hold all or some of the grantor’s assets and asserts the same control as a trust established before their passing.
  • Charitable Lead Trust: Assets in a charitable lead trust are irrevocable. The assets are designated to a charity for a certain number of years, and the grantor can receive the tax benefits of the gift, reduced income, or tax deduction while still living.
  • Charitable Remainder Trust: These trusts pay beneficiaries an agreed-upon amount for a certain amount of time, and then upon fulfillment of that contract, the remainder of assets to go charity.
  • Credit Shelter Trusts: Credit Shelter Trusts are also called bypass trusts or family trusts. Whatever you call them, they allow grantors to promise an amount up to the estate-tax exemption and then pass the rest of the assets to a spouse. Funds in these credit shelter trusts are tax-free.
  • Generation-Skipping Trusts: These trusts allow grantors to transfer assets to beneficiaries that are at least two generations below them. Generation-Skipping Trusts skip right over the grantor’s children and are intended for grandchildren, great-grandchildren, and so forth.
  • Functional-Needs Trust: Functional-Needs Trusts are set up by a grantor to carefully allow the beneficiary in need of special dispensations to get money from the trust while still allowing them to receive government benefits.
  • Spendthrift Trust: Spendthrift Trusts allow parents to give different parameters to each of their beneficiaries. This means Spencer might be allowed to access their funds at 18, while Carson has to wait until they’re 27.
  • Education Trust: Beneficiaries of an education trust have access to the assets only when used for qualifying education expenses as defined by the trust.

Revocable vs. Irrevocable Trusts

Revocable trusts are also called living trusts because they are fluid. The grantor can make changes until their death or incapacitation.

Irrevocable trusts are permanent upon creation. These trusts do not allow grantors to change terms or assets as all assets no longer belong to the grantor and only belong to the trust.

Irrevocable trusts often offer better tax benefits since they are locked in from their inception and can’t be manipulated for creative tax evasion.

How to Create a Trust

The first step to creating a trust is ciphering down goals and assets for the trust.

Next, grantors must decide a structure for the trust and then prepare the documentation either in a DIY situation or with the help of a legal team.

The final steps in creating a trust are naming a beneficiary or beneficiary and trustee.

If you need help, then reach out to a financial advisor. They live and breathe helping consumers tackle life’s toughest financial decisions.

A few we recommend are Zoe Financial, Facet Wealth, and Harness Wealth. They bring years of experience to the table, thoughtful technology, and affordable solutions.

Frequently Asked Questions

Is a Trust Hard to Set Up?

Creating a trust is as simple as filling out the trust agreement and appointing a beneficiary and trustee.

The level of complication involved in setting up a trust has a lot more with what you want your trust to accomplish rather than the actual paperwork part.

Is It Safe to Use a Trust?

Trusts are very safe, but selecting a trustworthy trustee with a solid picture of your wishes is important.

Any questions that arise about the trust and how it is handled will default to the trustee at the grantor’s passing.

How Much Does It Cost to Set Up a Trust?

The cost to set up a trust varies from state to state and depends on the method chosen to set up the trust.

Grantors looking to receive assistance from an attorney can expect to pay a minimum of $1000 to $3000 per trust, whereas those filing online might only pay $300.

Bottom Line: What Is a Trust?

A trust is an agreement for a third-party trustee to hold, manage, and execute assets under specific parameters for a grantor’s beneficiaries.

Meagan Drew
Meagan Drew

Meagan Drew is a Senior Personal Finance Writer & Product Analyst with 7 years experience in wealth management. As a former Series 7 and 63 certified advisor, Meagan specializes in making financial topics relatable and consumable, no matter the reader’s experience level. She attended the United States Military Academy at West Point where she studied Nuclear Engineering. Meagan is a veteran, military spouse, and mom of 4 currently living in Colorado Springs. Her areas of expertise are military personal finance, credit cards, personal loans, investing, and wealth management.