What Is a Trust and How Does It Work?

by Team eLocal
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Reviewed by Carina Jenkins, J.D.

A trust could be a good option if you're considering estate planning and want your beneficiaries to be able to access your assets without the hassle of probate.

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Setting up and managing trusts can be complex, so it's essential to understand how they work. So, what is a trust, and is it the right option for you?

What Is a Trust?

A trust is a type of fiduciary arrangement where a party known as a trustee holds and manages assets for a beneficiary on behalf of another party.

There are many types of trusts. The primary advantage of placing assets in a trust is that you can decide how and when your beneficiaries can access the assets. You can also use a trust to avoid going through probate.

Trusts can be relatively expensive to create and maintain. However, placing assets in a trust could be a good option if you have complex wishes about distributing your assets.

When Are Trusts Typically Used?

There are many reasons why someone might place assets in a trust instead of handing them over to a family member or leaving them to a beneficiary in their will. Setting up a trust provides significant legal protection, as your chosen trustee is legally obliged to manage and distribute your assets according to your wishes. As trusts bypass probate, your beneficiaries may be able to access funds in a trust faster than assets left in a will.

Alternatively, you could use a trust to plan for your own future. For example, keeping some of your wealth in a trust can allow you to make financial decisions in advance if you later become unable to manage your money.

Holding assets in a trust can also have tax advantages. Beneficiaries usually pay less tax on assets from a trust than they would if you gifted them the assets. However, it's worth consulting an independent tax advisor to help you understand the implications of a trust versus leaving assets in your will or giving them away during your lifetime.

Some people use trusts to transfer assets to children under 18. They could also be a good option if you want to protect the assets from your beneficiary's creditors or retain control over how your beneficiary accesses the assets. For example, you may be concerned that your beneficiary will mismanage the funds or spend them too quickly. Alternatively, you may wish to use a trust to support someone who lacks the capacity to manage their financial affairs.

Sometimes, using a trust is simply a matter of maintaining privacy. Wills may become public after probate completes, which means anyone can view a copy. Trusts are private instruments, meaning only the trustees and beneficiaries will know the details. Some people also place funds in trust to become eligible for Medicaid.

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What Are the Different Types of Trusts?

It's essential to understand the difference between a revocable and irrevocable trust.

Revocable trusts allow you to change your instructions for distributing your assets, and you can also choose to dissolve the trust at any time. For example, you may wish to change your instructions if your marriage breaks down or you buy a second property.

Irrevocable trusts are permanent from the moment you create them, which means you can't change your instructions or dissolve the trust later. While these trusts are less flexible than revocable trusts, they can help protect your assets from estate taxation and prevent creditors from claiming them.

Which type of trust you should create depends on your circumstances and goals. The most common types include:

Marital Trusts

A marital trust leaves assets to one spouse after the other passes. These are generally used for tax advantages and to ensure money stays in a family. For example, if a surviving spouse remarries, the funds in the trust may then pass to the children of the deceased.

Credit Shelter Trusts

Credit shelter trusts, also known as bypass trusts, are irrevocable trusts that transfer assets to your surviving spouse. However, unlike a marital trust, your spouse doesn't assume direct ownership of your assets. Instead, the assets remain in the trust, so your spouse's beneficiaries don't pay estate taxes.

Life Insurance Trusts

Life insurance payouts can be liable for estate taxation, but you can avoid this by naming an irrevocable life insurance trust as the policy's beneficiary. When you pass away, the payout goes directly to the trust, and your trustee then distributes the funds following your instructions.

Spendthrift Trusts

The primary purpose of spendthrift trusts is to restrict how and when your beneficiaries can access your assets. For example, you could instruct that your beneficiary receives regular payments over their lifetime instead of accessing the money in a single lump sum. Spendthrift trusts could be a good option if you're concerned your beneficiary may mismanage a large windfall.

Testamentary Trusts

Testamentary trusts, also known as will trusts, are usually revocable until your death. They allow you to stipulate when your beneficiaries may access the assets held in the account.

How Does a Trust Work?

The person who sets up a trust is known as the grantor. The grantor decides how they want their assets distributed and names one or more beneficiaries, who will inherit the trust when the grantor passes away.

Grantors must also select a trustee to manage the account during their lifetime and distribute the assets after their death. If you're the grantor, you can also act as the trustee, but it's essential to name one or more successive trustees to manage the account when you pass away. You can choose anyone to act as the trustee, including friends, relatives or a financial professional. The beneficiary can sometimes be the trustee if they're a legal adult.

The assets in a trust can often accumulate interest, and trusts may need to pay taxes on interest earned. Trusts are generally able to deduct distributions made to beneficiaries when calculating taxes, but the beneficiaries may owe taxes on the money they've received from a trust.

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