What Is a Trust?

Trusts and wills are key estate-planning documents used to pass money and property on to beneficiaries at death. If you’re married, own a home, or have kids, a will is a must-have — a crucial first step in ensuring your heirs receive your estate as you wish with minimal hassle and cost.

But trusts are like wills on steroids. They offer a lot more advantages and benefits than wills. And there are many types available to suit specific needs and circumstances.

Among the major reasons wealthy folks use them over wills is that they afford greater control in minimizing estate taxes and protecting against heirs blowing their inheritances. However, working- and middle-class families and individuals of any age can benefit from them, too.

How Does a Trust Work?

A trust is a legal entity, based on state law, that exists only on paper. Its basic infrastructure consists of three main components: grantor, beneficiary, and trustee.

You (the grantor) set up the trust to hold your assets, such as cash, investments, real estate, and personal property, on behalf of your spouse, daughter, grandson, or really anybody else, family or not. This is the beneficiary.

The beneficiary also could be your favorite charity, community church, or local library.

Lastly, it will be managed by a person or organization (the trustee). They can be set up to invest and borrow money, operate businesses, and pay taxes.

Many of us have heard of trusts before. “Trust funds” are a perfect example. For instance, an individual can create a trust fund for their child and stipulate that they won’t get a dime until they graduate from college, climb Mt. Everest, and quit smoking pot.

It is all about controlling how the beneficiary should enjoy (or not enjoy) the inheritance. The trust typically is dissolved once the beneficiary dies and/or the assets are depleted.

Why Are Trusts Superior to Wills?

That million-dollar trust fund set up for a beneficiary is something that can’t be done with a will.

After you die with a will, a probate court judge should sign off on it (if everything is kosher), and your assets will immediately transfer to your beneficiaries, who can pretty much use the assets as they please.

But a trust allows for the gradual transfer of assets based on certain conditions or factors (like graduating college or passing a drug test).

Many are written to address a family's problem, “black sheep” children who can’t be trusted to manage inherited property or money. After all, by giving money to your children, you are creating a legacy that you hope will last for generations.

Here are some other examples of why people use them over wills:

1. Avoiding Probate Court

With a will, you can’t avoid probate if you’re passing on real estate and personal property or any other assets that don’t allow you to designate beneficiaries (unlike retirement and investment accounts). But probate can be very expensive and time-consuming. A trust can bypass this BS, allowing your heirs to gain much faster access to your assets.

Other reasons to avoid probate? Your case is a matter of public record, so forget about maintaining privacy.

And any disgruntled hack can contest a will, but a challenger must go through civil court and pay all costs and fees.

2. Protecting Against Creditors

The money you bequeath to your kids or other loved ones in a will isn’t protected from any creditors they might have due to a bankruptcy, lawsuit, unpaid credit card bill, or a divorce. A trust walls off creditors by keeping the assets out of the name of the beneficiary.

3. Reducing Taxes

A will has no real affect on estate taxes. Certain trusts allow you to transfer your money and property to a trust, so those assets won’t be considered part of your taxable estate.

A trust can also be used to avoid paying the federal gift tax, which allows you to give money to your kids or grandkids. Any money above $15,000 is taxed, but they allows you to gift more money tax-free. These examples are just the tip of the iceberg of what they can do to minimize or even avoid taxes.

4. Protecting Beneficiaries With Disabilities

Here’s another problem with using a will: If you give a chunk of money in your will to a disabled person who receives government benefits like Medicaid or subsidized housing, that beneficiary could lose those and other benefits because that person will be tagged as having too much in assets.

That won’t happen if you use a special-needs trust, the best option to ensure these benefits remain preserved when an inheritance is transferred. Plus, like other types, these are protected against creditors.

Categories of Trusts

There are several types, and each is designed to meet specific financial, generational, and marriage needs and situations. But before discussing the varying types, you must understand the difference between two categories: revocable and irrevocable trusts.

Revocable Trusts

Also called living trusts, these can be rewritten, updated, or shut down by the person who set up the trust (the grantor). They’re the next best thing beyond using a will.

Your beneficiaries avoid probate court while getting creditor protection for their inheritances and a mindful distribution of your assets. These work well for folks who have a complex mix of assets, especially if they're held in more than one state. However, revocable trusts won’t earn you a tax break.

Irrevocable Trusts

An irrevocable trust works best if your central aim is to reduce the amount of your estate subjected to estate taxes and to avoid probate. Basically, you move your assets into the trust to shrink your tax footprint.

But there's a tradeoff: The terms of the trust, once executed, can never be altered, and you lose control of your assets. But you still get creditor protection and control over how your beneficiary spends the inheritance.

The Most Popular Types of Trusts

You don’t need to be a millionaire to start a trust, although many are designed for rich families with complex finances, business arrangements, etc. Others are basic, straightforward, and easy to understand. There are nearly 40 different trusts to choose from. Here are three popular versions::

1. Credit Shelter Trust

Also called a bypass trust, this allows you to pass on your assets to the kids and your spouse to avoid estate taxes. If your spouse has her own estate, this revocable trust will prevent her assets from being taxed as well when she dies.

2. Irrevocable Life Insurance Trust

This type is used to remove the proceeds of your life insurance policy from your taxable estate at death. The insurance money can be kept in the trust for years and doled out gradually to beneficiaries.

3. Charitable Remainder Trust

You can fund this with cash, stock, or property, providing you a lifetime income stream and an immediate charitable tax deduction. When you die, your money in this irrevocable trust goes to your favorite charity.

Can You Trust a Trust?

They aren’t perfect. Setting one up can be costly if you use a lawyer. Expect to pay well over $1,000. But keep in mind that as with a will, you don’t need an attorney, although it might not hurt to tap one just to be safe.

You need to understand that a trust is a legal entity and can be taxed on the income it generates.

But the biggest consideration is picking the trust’s trustee. It can be an individual like a family member or best friend. It could also be your financial adviser or even a soulless corporation. Above all, choose someone you believe in, but know that you might have to pay the person for the work involved.

The trustee is a fiduciary, meaning that he must act in the trust’s best interest. A trustee can also be a beneficiary, but precise instructions can prevent any abuses.

When You Need Both a Trust and a Will

Trusts deal with money and property. Wills also deal with money and property, but they also deal with the kids. If you have minor children or dependents, you need to name a guardian who will raise them until they reach adulthood. You also need to name a conservator who will manage their inheritances. And you can only do that with a will, not a trust.

That said, when it comes to estate planning, trusts are clearly superior to wills. It’s all about having the control to ensure — when you’re dead and gone — that your money lasts for generations.