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What is a trust and how does it work in estate planning?

by Legacy Plan
October 27, 2023

Trusts are used in estate planning for various reasons, each contributing to a comprehensive strategy to manage one's assets during their lifetime and dictate how those assets are distributed upon their death. There are several reasons why trusts are a critical component in estate planning. Some of those reasons include:

  • Avoiding probate. Trusts allow assets to bypass the often lengthy and expensive probate process, enabling beneficiaries to gain access to these assets more quickly than they might with a standard last will and testament.

  • Tax benefits. Certain types of trusts can reduce estate and gift taxes. By removing assets from an estate, the trust can help lower the estate's overall taxable value.

  • Asset protection. Trusts can offer protection from creditors or legal judgments against the grantor or beneficiaries. They are also useful in preserving assets for beneficiaries, as the assets in the trust are typically not accessible to satisfy personal debts.

  • Control over asset distribution. Trusts allow the grantor to specify terms for asset distribution, which can be especially important if beneficiaries are minors, have special needs or might not use the inheritance wisely. The grantor can set conditions on when and how assets are allocated.

  • Privacy. Unlike wills, which become public record during the probate process, trusts offer privacy because the details of the trust aren't published or exposed to public scrutiny.

  • Management of assets during incapacity. If the grantor becomes incapacitated, the successor trustee can step in and manage the trust's assets, eliminating the need for a court-appointed guardianship.

  • Provision for special needs. A special needs trust can be established to provide for a loved one with disabilities without jeopardizing their eligibility for government benefits.

  • Charitable intentions. Charitable trusts can be used to leave a legacy for charitable causes and, at the same time, take advantage of tax breaks associated with charitable giving.

  • Reduced family conflict. By clearly outlining the distribution of assets and appointing a trustee, trusts can help minimize potential conflicts among family members over an inheritance.

  • Continuity across generations. Some trusts, like dynasty trusts, are designed to benefit multiple generations, preserving wealth within a family for a very long time while providing estate tax benefits.

Each type of trust has its own unique benefits and drawbacks, so it's important to speak with an experienced estate planning attorney to determine which type of trust is right for you.

There are many types of trusts that can be used in estate planning, but some are more common than others. In this article, we'll look at three common types of trusts: revocable trusts, irrevocable trusts and life insurance trusts.

How does a revocable trust work?

A revocable trust, also known as a revocable living trust, is a legal entity created to hold ownership of an individual's assets during their lifetime and to distribute those assets after their death. The term "revocable" means that the person who creates the trust, known as the grantor, can alter or cancel the provisions of the trust at any point during their life as long as they are mentally competent.

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The process of creating a revocable trust begins with the grantor working with an attorney to draft a trust agreement, a legal document that outlines all the specifics of the trust, including beneficiaries and what happens to the assets upon the grantor's death.

Once established, the trust must be funded by transferring assets into it. This can include savings accounts, real estate, stocks, bonds and other assets. The assets technically change ownership from the individual to the trust, though the grantor maintains control.

While the grantor is alive and competent, they often serve as the trustee, managing and investing the assets as they see fit. They also appoint a successor trustee who steps in to manage if they become incapacitated or pass away.

Upon the grantor's death, the successor trustee will manage or distribute the assets according to the terms set in the trust agreement without the need for probate, the court-supervised process of validating a will and distributing assets.

One of the primary advantages of a revocable trust is that it allows the grantor's assets to bypass the probate process upon death, facilitating a quicker and often more cost-efficient asset distribution to beneficiaries. Since the contents and terms of a trust are not made public, unlike a will, a revocable trust maintains the privacy of the grantor's financial affairs and how the estate is distributed.

Should the grantor become incapacitated, the successor trustee can manage the trust's assets, helping avoid the need for a court-appointed guardian or conservator.

Because it's revocable, the trust can be altered, amended, or revoked entirely as the grantor's wishes or circumstances change.

Revocable trusts provide a plan for the management of the grantor’s assets in case they become mentally incapacitated before death. This pre-planned change in management can avoid a court-appointed guardianship, provide a smooth transition and ensure that the grantor’s assets are managed as they would want, even if they are unable to communicate their wishes.

While revocable trusts offer numerous benefits, they do have limitations. For instance, they don't provide protection against the grantor’s creditors, and the assets held in the trust are considered part of the taxable estate, meaning they might be subject to federal estate taxes upon the grantor's death. As such, when considering a revocable trust, it's wise to consult with an estate planning attorney or financial professional to fully understand the implications based on personal circumstances.

How does an irrevocable trust work?

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An irrevocable trust, in contrast to a revocable trust, is a type of trust that once established, cannot be altered, amended or revoked by the grantor, the person who creates the trust. Due to this characteristic, the assets transferred into the trust effectively exit the grantor's estate and are no longer considered personal property.

Just like any trust, the process begins with the grantor creating a trust document. This document outlines all terms of the trust, names the trustee who will have control over the trust and designates the beneficiaries who will benefit from the trust. Since the trust is irrevocable, the grantor must understand that changes cannot be made once it is established.

The grantor transfers assets into the trust, a process known as funding the trust. This might include investments, real estate, cash or other property. Unlike a revocable trust, in an irrevocable trust, the grantor relinquishes ownership and control over these assets.

Once the assets are in the trust, control of those assets shifts from the grantor to the trustee. The trustee manages the assets for the benefit of the beneficiaries according to the terms set by the grantor in the trust document.

Upon a specified event, often the death of the grantor, the trustee then distributes the assets in the trust to the beneficiaries, following the directives outlined in the trust document.

Assets held within an irrevocable trust are not considered part of the grantor's estate for tax purposes. Therefore, placing assets in an irrevocable trust can significantly reduce the size of a person’s estate, potentially lowering estate tax liability.

Assets that have been transferred into an irrevocable trust are generally protected from creditors. This is crucial for individuals who may be at a higher risk of lawsuits, such as business owners, doctors and other professionals.

Irrevocable trusts are often used in planning for Medicaid eligibility. Transferring assets into an irrevocable trust can help an individual qualify for Medicaid, which can provide for long-term care needs, while preserving the individual's assets for their beneficiaries. (Assets must be transferred at least five years before a Medicaid claim is made.)

Though the grantor gives up control over the assets, they dictate the terms of asset distribution. This can be particularly important for grantors who want to establish specific terms for beneficiaries, such as minor children or family members who may not be financially responsible.

Irrevocable trusts also can be set up to provide a benefit to a charitable organization while offering tax benefits to the grantor.

While irrevocable trusts offer several estate planning benefits, particularly concerning tax implications, asset protection and precise distribution directives, they require careful consideration and planning due to their permanent nature.

How does a life insurance trust work?

A life insurance trust is a type of irrevocable trust that is created to hold a life insurance policy. The purpose of this type of trust is to ensure that the death benefit of the policy is paid out to the beneficiaries in a tax-efficient manner.

An irrevocable life insurance trust, known as an ILIT, effectively removes the policy from the insured's taxable estate. Estate taxes can be avoided by having the life insurance policy owned by the trust rather than the individual.

A life insurance trust is established by the grantor, the person creating the trust. This irrevocable trust then becomes the owner of the life insurance policies that the grantor transfers into it.

The grantor appoints a trustee who manages the trust. This trustee has the responsibility of maintaining the policy, including paying the premiums, which are often funded through annual gifts made by the grantor to the trust.

For the trust to pay the policy premiums, the grantor contributes funds to the trust. These contributions are often subject to gift tax rules, but they may qualify for annual gift tax exclusions if the trust beneficiaries are given specific rights, known as "Crummey" powers, to withdraw the contributions for a limited time.

Upon the death of the insured, the insurance proceeds are paid to the trust, not the estate, and are distributed by the trustee according to the grantor's specified instructions.

If an individual owns a life insurance policy upon death, the proceeds, while free from income tax, are countable as part of the taxable estate. When a life insurance trust owns the policy, it ensures the death benefit is not included in the estate's value for estate tax purposes.

Also, because the policy is owned by the trust and not the deceased, the proceeds bypass the probate process, allowing for a more efficient and private distribution to beneficiaries.

Potential benefits of trusts in estate planning

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There are many potential benefits to using trusts in estate planning. One key benefit is that trust assets avoid probate. Probate is the legal process of validating a person’s last will and testament if one exists and distributing a decedent’s assets that don’t have designated beneficiaries. It can be a long, expensive and burdensome process, so avoiding it can be a big advantage.

Another potential benefit of using trusts is that they can help to protect assets from creditors. If your beneficiaries have creditors, they may be able to claim their inherited assets if they are received directly. However, if your assets are in a trust, they may be protected from your beneficiaries' creditors – and your creditors as well if the assets are in an irrevocable trust.

Trusts can also help to ensure that your assets are distributed the way you want them to be. If you have young children, for example, you may want to set up a trust to make sure that they are taken care of financially if you die. You can also use trusts to protect your assets from spendthrift heirs.

There are many reasons why someone might want to create a trust. One of the most common is to provide for minor children in the event that something happens to the parents. In this type of situation, the trustee would be responsible for managing the assets in the trust for the benefit of the children until they reach adulthood.

Another common reason for creating a trust is to deal with the complexities of a blended family. In a blended family, there may be children from previous marriages, as well as stepchildren. Creating a trust can help to ensure that everyone is provided for in the event of death or disability.

Trusts can be used to address numerous circumstances in life, such as divorce or spendthrift situations. Often, property settlement agreements will include provisions for trusts to be created in order to protect assets from being divided in a divorce. This can be especially important in cases where there are significant assets at stake.

Here are some other situations where the use of a trust can be helpful:

  • Asset management. A trust can be used to help manage assets intended for your beneficiaries after your death. For example, a trust can be used to manage assets for a child or grandchild who is not yet old enough to manage the assets themselves.

  • Providing for special needs. A trust can be used to provide for someone with special needs. For example, if you have a child with special needs, you can create a trust that will provide for their care after your death and still maintain their eligibility for needs-based government assistance, such as Medicaid or Supplement Security Income.

  • Marriage planning. A prenuptial agreement or postnuptial agreement can be used to create a trust that will provide for your spouse in the event of your death. This can be especially important if you are married to someone who is not a U.S. citizen and you want to make sure that they will have access to your assets after you die.

A trust is a powerful estate planning tool that can be used to achieve a variety of objectives. If you are considering using a trust in your estate plan, it is important to consult with an experienced estate planning attorney who can help you determine whether a trust is right for you and how to properly establish and fund the trust.

Naming a trustee for your estate plan

When you’re creating your estate plan, one of the most important decisions you’ll make is who to name as your trustee. Your trustee will be responsible for managing your assets and distributing them according to your wishes if you become incapacitated and after you die.

There are a few things to keep in mind when you’re choosing trustees. First, you should choose someone you trust implicitly. This person should be responsible and level-headed, and you should feel confident that they will follow your instructions to the letter.

You should also consider choosing a trustee who lives close to you. This will make it easier for them to manage your assets and deal with any issues that may come up.

Finally, you may want to consider naming more than one trustee. This can be helpful if one trustee is unable or unwilling to serve. It can also help to have more than one person managing your assets, as they can provide checks and balances for each other.

Whatever you decide, be sure to communicate your wishes to your trustees. Give them a copy of your estate plan and make sure they understand your instructions. With the right trustees in place, you can rest assured that your assets will be managed according to your wishes.

How do I create an estate plan?

There are numerous options and scenarios to consider when developing an estate plan that protects your legacy and achieves your objectives, and important decisions should be made with the advice of qualified lawyers and financial experts. Membership with Legacy Assurance Plan provides members with valuable resources and guidance to develop comprehensive estate plans that take life's contingencies into consideration and leave a positive impact for generations to come. Legacy Assurance Plan members also receive peace of mind that a team of trusted, experienced professionals will assist them in developing legal, financial and tax strategies that will meet their needs today and for years to come through periodic reviews.

This article is published by Legacy Assurance Plan and is intended for general informational purposes only. Some information may not apply to your situation. It does not, nor is it intended, to constitute legal advice. You should consult with an attorney regarding any specific questions about probate, living probate or other estate planning matters. Legacy Assurance Plan is an estate planning services company and is not a lawyer or law firm and is not engaged in the practice of law. For more information about this and other estate planning matters visit our website at legacyassuranceplan.com.

Phone - 844.445.3422
Email - info@legacyassuranceplan.com
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