Trusts and Estate Planning: The Basics

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What is a trust?

A trust is a legal arrangement where someone (the “trustee”) has title to property (that is, legal ownership of the property), but must manage it for the benefit of someone else (the “beneficiary”). For example, a cash gift to a young child might actually be left to a relative who will control the property as trustee and manage and distribute it for the benefit of the young child. The person who gives property to a trust is called the “grantor” or “settlor”.

Some people have the idea that trusts are just for rich people (they think of the phrase “trust funds”), but that’s not right; trusts, especially revocable living trusts, are an estate planning device used by all kinds of people.

Types of trusts

Different types of trusts may be appropriate for you depending on your specific needs. Below are some of the more common trust types.

Living trusts

Living trusts (also called “inter vivos” trusts) are created while you are still alive and immediately go into effect. There are two main kinds of living trusts: revocable and irrevocable. The main difference being the ability or inability to revoke (cancel) the trust.

Irrevocable living trusts

As the name implies, an irrevocable trust is one that, generally, cannot be canceled, modified, or amended. Once an irrevocable trust is created, the terms are essentially set in stone.

Many people choose to create an irrevocable trust because it can protect assets from creditors and avoid estate taxes in certain cases. However, these benefits come at a price. Once you transfer property into an irrevocable trust (more on that below), you can’t take the property back. Because you no longer own it — your trust does — your creditors cannot come after that property.

Revocable living trusts

A revocable living trust is one that can be revoked and that is made while the grantor is living. It is a popular tool for probate avoidance that works as follows.

Imagine someone owns a home, some jewelry, and some antiques, and he wants to leave it all to his three children, but he doesn’t want them to have to go through probate. Also, he doesn’t want to give up these things today — he thinks he may be around for a while yet. He can create a revocable living trust to hold this property. While he is alive, he will be both the trustee and the beneficiary, and he can do whatever he wants with the property (after all, the trust is revocable). When he dies, though, the trust’s estate planning purpose takes effect. Another trustee, designated by the grantor before his death, steps in (privately — no probate) and distributes the property to the grantor’s children, who are the new beneficiaries. The trustee who steps in (the “successor trustee”), can be a regular person (for example, your spouse or loved one), or can be a professional who works at a financial institution (an “institutional trustee”). Trustees have a legal fiduciary obligation to act properly for the beneficiaries.

Regardless of the terms of a revocable living trust, its key feature is that property in the trust will not have to go through probate.

Testamentary Trusts

A testamentary trust is a trust that is established by your will. It is common for large gifts made in wills to be made in the form of a trust. A dying grandmother who wants to pay for college for her young grandson probably won’t just leave him the money outright; she may leave the money to his parents as trustees.

Unlike living trusts, a testamentary trust goes into effect only upon the creator’s death. By definition, all testamentary trusts are irrevocable because they’re not established until after their creator’s death. So by the time it goes into effect, no one with the legal authority to change the terms of a testamentary trust is still alive.

However, the person creating a testamentary trust can amend their will while still alive and change the terms of the testamentary trust before their death causes it to become effective. Thus, a testamentary trust can effectively be revoked before it ever exists, but once the creator dies, the trust is effective and cannot be revoked.

Other trust types

You may hear the names of more specific trust types that each serve their own purpose. These more specialized trusts are just subsets of the trust types above. Meaning all trusts are considered to either be a living or testamentary trust, as well as being considered either a revocable or irrevocable trust.

One common type of specialized trust is the “spendthrift trust”. A spendthrift trust is a type of living trust which includes specific provisions that prevent the beneficiaries from liquidating all the assets in the trust or prematurely withdrawing the any funds in the trust. For example, a grandmother leaving a large sum of money to her 19 year old grandchild could use a spendthrift trust to prevent the grandchild from getting all the money at once.

How a trust works

Creating a trust

A trust is usually created with a legal document called a “declaration of trust”. In the declaration of trust, you would include the terms of your trust such as the names of the beneficiaries, the trustee, and any conditions that should apply to the trust property.

Unlike wills, which are submitted to a probate court and are meant to be carried at out once (over several months) under the court’s supervision, the directions of a trust are carried out privately, so trusts can get more creative and stretch over an indefinite period of time (for example, until a child reaches age 30, or has a first child of his own, but only if the trustee believes he’s being a good person).

Funding the trust

In addition to the declaration of trust document, which creates the trust, property must be transferred into the trust. This is called “funding” the trust. A trust cannot accomplish its purpose without having assets transferred into it, which it can control.

In the case of real estate, the transfer is done by a deed. Generally, some kind of transfer deed (either a “quit claim deed” or “beneficiary deed”) will be created, and that transfer deed will name the trust as the owner of the home. While the trust will technically “own” the home, it is the trustee who controls it, subject to the terms of the trust. For the transfer to be effective, the transfer deed must be recorded in the same county as the real estate to which it corresponds.

Transferring other kinds of property into the trust depends on the property. For example, to transfer a bank account into a trust, the title owner of the account would need to be changed to the trust.

Once property is in the trust, it is considered a “trust asset” and will be managed by the trustee according to the terms of the trust. This continues until the trust is either revoked or all trust assets have been distributed to beneficiaries.

Signing a trust

A trust must be signed according to state law in order to be valid. If the document is signed improperly, it’s as if no trust was created at all.

The exact requirements for signing a trust vary by state. However, most states require that the grantor and trustee both sign, as well as having the document notarized. Additionally, many states require that the document be signed in the presence of two witnesses who also sign the document in each other’s presence.

A signed declaration of trust should be stored in a safe place by the grantor or provided to the trustee (if someone other than the grantor). This way, the document can be accessed and the terms of the trust can be followed.

Revoking a trust

The ability to revoke or change a trust depends on whether it is a revocable or irrevocable trust. As mentioned, a revocable trust can be modified or canceled during the trust creator’s life time. However, a revocable trust automatically becomes irrevocable upon the grantor’s death because at that point, they are no longer around to make changes or revoke it. Generally, it is recommended to modify a trust rather than completely revoke it, but some situations may warrant a complete revocation.

To revoke a living trust, the grantor first has to re-title or re-deed any and all assets in the trust back into his own name. This effectively removes the assets from the trust and makes the grantor the legal owner again. Once the property is transferred out of the trust, the grantor will need to create a legal document known as a “revocation of living trust”. This document will explicitly refer to the trust that is being revoked and state that it should no longer be in effect. The revocation of living trust must be signed and notarized to be valid and for the revocation to take effect.

Unlike a revocable trust, an irrevocable trust usually cannot be modified or canceled after it is created. Despite this general rule, there are some limited circumstances in which irrevocable trusts can be altered. In most states, altering an irrevocable trust requires obtaining consent from every person involved with the trust, specifically, the beneficiaries as well as the trustee. Making a change to an irrevocable trust this way requires a court hearing and even then, it is not guaranteed that the trust will be changed as the court will consider whether the change goes against the purpose of the trust.

Is an attorney required to create a trust?

It depends on the type of trust you wish to create. For the the vast majority of people who simply wish to avoid probate, a revocable living trust will suffice. A revocable living trust can be created using online software that tailors the documents to your specific needs and the laws of your state. The best online estate planning softwares will allow you to create your revocable living trust in a matter of minutes and have it fully customized to your wishes.