Understanding the 3 Primary Classes of Trusts

When people think about estate planning, a will is usually the legal document that first comes to mind. In reality, an effective estate plan should include additional elements, such as a trust, power of attorney, healthcare directives, and beneficiary designations. This article focuses on how trusts operate and which type of trust might be right for your estate plan.

What Is a Trust?

A trust is a legal entity created to hold assets on behalf of another person or entity (the beneficiary or beneficiaries). Trusts are usually created as part of your estate plan to give you more control over how you distribute your assets after you pass away. Whether in the form of a bank account or a simple legal agreement, trusts can be powerful tools for determining who gets what from your estate and when.

How Trusts Work

Trusts are established when the grantor (also known as the settlor or trustor) creates the trust and transfers assets into it. Various types of assets can be transferred to a trust, including real estate, bank accounts, investments, life insurance policies, business interests, and other items of value. Once those assets become property of the trust, they are administered by a trustee appointed by the grantor. Trustees are under a fiduciary duty to manage the trust in the best interests of the grantor and beneficiaries.

For their part, the beneficiaries are the individuals or entities who will receive income generated by the trust’s assets after the grantor’s death. This can include spouses, children, charities or other organizations chosen by the grantor.

Primary Classes of Trusts

Depending on what you are trying to accomplish, there is likely a specific trust that meets your needs. Before we look at some different types of trusts, however, it’s helpful to understand the three main categories that almost all trusts fall into:

Revocable Trusts / Living Trusts

A revocable trust is one that can be altered—or even terminated—at any time during the grantor’s lifetime. Because this class can be so flexible, revocable trusts are also known as “living trusts” (or “inter vivos trusts”).

 Being able to alter the trust can be beneficial if you experience unexpected changes later in life—such as health care changes or a late-in-life marriage/divorce. Revocable trusts may also help your heirs avoid a potentially lengthy, expensive, and public probate process (probate is the legal process of administering your estate and transferring assets).

A revocable trust can be especially effective if you own property in multiple states. For instance, if you own a home in Iowa and have a cabin in northern Minnesota, you may be subject to probate in both states when you pass away. However, if those two properties are owned inside of a revocable trust, you may be able to avoid probate entirely, making it quicker and less costly to administer your estate.

Irrevocable Trusts

Unlike revocable trusts, the terms of an irrevocable trust cannot be amended or terminated after the trust has been established. This applies to any assets you place inside the trust, which means they cannot be accessed until the terms of the trust have been met.

While the more rigid nature of this class of trust may make it seem less attractive, irrevocable trusts offer other benefits. For instance, by transferring assets to these trusts, you relinquish control over them—effectively removing those assets from your estate. This may protect your assets from estate taxes, creditors, and lawsuits.

Many different types of trusts are considered irrevocable trusts. This class encompasses:

• Common spousal trusts, which are trusts specifically established for the benefit of a spouse, such as credit shelter trusts and qualified terminable interest property (QTIP) trusts.
• Irrevocable life insurance trusts (ILITs), which are trusts that hold one or more life insurance policies whose death benefits can be paid out to your heirs or be used to help cover the costs of administering your estate without incurring any taxes.
• Special needs trusts, which offer financial support to a beneficiary with a disability.

Testamentary Trusts

Rather than creating and funding a trust immediately, it’s possible to create a trust that goes into effect upon your death. Known as a testamentary trust, this type of trust is created through a will or revocable trust, and the terms of the trust are spelled out within the will.

Testamentary trusts are often used to provide for minor children or a surviving spouse. Although assets used to fund a testamentary trust may be subject to probate, these trusts also deliver a level of flexibility and control that may outweigh their costs. For instance, testamentary trusts are often the preferred way to preserve assets for children from a previous marriage, provide your spouse with lifetime income or benefit a charitable cause.

Making An Informed Choice

Adding a trust to your estate plan can deliver a range of benefits, from potentially avoiding probate to helping mitigate estate taxes. However, they can also be costly or complex. 

 This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

 Trust services offered through Wealth Enhancement Trust Services, LLC, a trust company chartered under South Dakota law.

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