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Understanding Trust Funds: How They Work and Who They Benefit

BY Spectrum Wealth Management | Mar 21, 2024

Setting up a trust gives you control over your money after your death, and sometimes even during your lifetime. Trust funds serve various purposes, from sheltering assets from estate taxes to paying yourself or your heirs an annual income to giving to charity.

You can be as specific and conditional as you like when it comes to when, how, and to whom your assets are distributed, and some trusts are more flexible than others. Because there are so many different types of trusts, there isn’t one single operational structure.

Here are the basics of setting up a family trust fund. 

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What is a trust fund?

A trust is a legal entity that can hold almost any asset, including real estate, bank accounts, investment accounts, business interests, and life insurance policies. They are often set up as part of your estate plan. 

“A trust is in place to establish control about who’s in charge of the money,” says Jaime Eckels, CFP and wealth management partner with Plante Moran Financial Advisors. “It provides the wishes of the grantor as far as who gets the money, when they get it, how they get it, and who’s in control of it.”

Trusts shelter assets from going through probate, or the legal process after a person dies, in which the courts handle the payment of debts and taxes and distribute the remaining property according to the will or state law.

The type of trust and trust documents stipulate exactly how and to whom your assets will be distributed, whether in the form of annual income paid to yourself or your beneficiaries, money or property to be transferred to your heirs, or gifts to charity at your death.

Three parties are involved in the operation of every trust:

  • The grantor: who opens and funds the trust
  • The beneficiary: who is the person, people, or charity receiving the assets
  • The trustee: the person, group of advisers, or organization that has a fiduciary responsibility to manage the trust now and after the grantor’s death.

In some cases, there will also be a remainderman. This person or organization (often a charity) differs from the beneficiary and inherits the remainder of the trust assets at the grantor’s death.

A trust fund can end when all the assets are paid to the beneficiary. However, assets will often continue to generate income. Rules vary by state for how long a trust fund can remain open, but many impose the “rule against perpetuates,” which says that a trust must expire no more than 21 years after the death of a potential beneficiary.

Some states allow dynasty trusts, which can last for many years and are a tool for avoiding estate and generational wealth taxes.

Note: In 2024, the gift tax limit is $18,000 for individuals ($36,000 for married couples). The current lifetime gift limit is $13.61 million. Gift contributions over the limit must file a federal gift tax return. 

Revocable vs. irrevocable trusts

There are two main types of trust (either revocable or irrevocable), which refer to the grantor’s ability to change the trust after it is set up and funded. They also have different tax implications. 

Revocable trust

Also known as a living trust, revocable trusts can be altered throughout the grantor’s life and even canceled. With this type of trust, sometimes a single person can act as the grantor, beneficiary, and trustee during their lifetime.

If a trust pays out a portion of its assets as income or holds assets that appreciate or generate interest income, such as real estate or stocks, then the person receiving the money must pay income taxes. In a revocable trust, this is typically the grantor.

The grantor still owns all their assets. When they die, the assets are considered part of their estate (although the trust is now irrevocable) and may be subject to estate taxes. Since the person is deceased, the trustee acts as their stand-in and pays the taxes using money from the trust.

Irrevocable trust

Once the grantor dies, a revocable trust becomes irrevocable and cannot be altered. Grantors may also be able to be an income beneficiary during their lifetime. Irrevocable trusts can be used to reduce estate taxes or protect assets from creditors.

When an irrevocable trust distributes income to a beneficiary, they are responsible for paying taxes. The trust will receive an income tax deduction if the income beneficiary is a charity. If the trust generates income that remains inside, it is taxed at the trust rates. 

Irrevocable trusts cannot be changed and, therefore, exist to remove assets from a person’s gross estate before death. In most cases, the trust is not responsible for estate taxes upon the grantor’s death, although there are at least two notable exceptions, 2503(b) and 2503(c) trusts, created for minors’ benefit.

Types of trusts

Revocable and irrevocable trusts can be opened as other specific trust types, including:

  • Testamentary trust: Otherwise known as a will trust, a testamentary trust created through a last will and testimony. Once the grantor passes away, the trust’s beneficiaries are guaranteed to receive access to trust assets only at a predetermined time. 
  • Totten trust: Sometimes called a payable-on-death account, this trust lets the grantor fund a bank account or other security to be set aside for a beneficiary once they die. 
  • Marital trust: One spouse creates a trust for the other spouse’s benefit. If one spouse passes away, any assets and income in the trust are passed to the surviving spouse. If any assets remain in the trust once the surviving spouse dies, the spouse’s heirs can get access to the assets but must also pay estate tax. 
  • Bypass or credit shelter trust: Like a marital trust, married couples establish this type of trust to reduce or eliminate the estate tax for heirs.
  • Generation-skipping trust: A trust for a grantor that wants the assets or income to be passed on to their grandchildren. This way, the grantor’s children don’t have to pay estate taxes but may still be able to access the assets. 
  • Charitable lead trust: In general, charitable trusts allow people to create a legacy of giving within their estate plans. With a charitable lead trust, grantors can designate a portion of assets to the beneficiary and certain assets to go toward select charities.
  • Charitable remainder trust: Folks with a charitable remainder trust can receive income from the trust’s assets over a set period. The remaining assets go to a designated charity. 
  • Life insurance trust: A type of irrevocable trust that holds life insurance proceeds so that when the grantor dies, the policy proceeds are transferred to the trust and can be accessed by the beneficiary. Also, by establishing a life insurance trust, you can help people avoid estate tax on life insurance payouts. 
  • Grantor retained annuity trust: A GRAT trust minimizes tax on certain financial gifts for a specific term. Grantors can contribute assets to the trust as a gift in exchange for a regular annuity payment. Once the term of the GRAT trust ends, the remaining funds are transferred to the beneficiary without tax obligations. 
  • Special needs trust: A trust designed to offer financial assistance and can be used for medical care for a family member who is disabled. It doesn’t affect the beneficiary’s eligibility to receive government disability benefits. 
  • Spendthrift trust: The purpose of this trust is to prevent misuse by the beneficiary by establishing restrictions on how the assets and income in the trust can be accessed. 

Common purposes of trust funds

Parents and grandparents commonly use trust funds as part of estate planning and a secure method of passing on inheritance. Not only are grantors able to dictate when and how beneficiaries receive assets, but trusts also offer protection against creditors. 

Grantors can set up payout schedules, establish specific milestones, and determine what age assets can be distributed. Moreover, the contents of the trust are managed by financial professionals familiar with dealing with large sums of money. 

Wealthy families may be able to use trusts to diminish the value of their estates and thus decrease tax rates on their children’s income, and save them a significant amount of money later on. Another way to avoid tax is by paying interest or dividends if transferred to an irrevocable trust. 

Trust funds are also commonly used to distribute wealth to one or multiple charities. You can even designate specific assets to be donated to specific charities at set points. 

Note: There can be significant tax implications of opening a trust that varies depending on the type of trust you establish. Consult with a financial advisor or RIA to familiarize you with any potential tax requirements and implications. 

How to set up a trust fund

You typically need to consult an estate planning attorney to set up a trust fund, although you may want to meet with a CFP first to discuss which type of trust is best for your situation. 

Choosing the right trustee

One of the most crucial elements of setting up a trust fund is choosing the right trustee (aka the person, group, or organization responsible for managing the assets). Like a fund manager, a trustee has a fiduciary duty to manage the trust’s assets for the good of the beneficiaries and put their interest first. 

A trustee can be an individual family member or trusted friend. Or, you can have your trust fund managed by a corporate trustee or trust company. Regardless of who it is, your trustee should be honest with good judgement and some kind of knowledge or experience in managing finanical assets. 

“There are a lot of benefits to having a professional trustee, but oftentimes, people don’t think a bank will know their family or the grantor’s true wishes,” states Eckels. “It feels less personal, so people naturally go to individuals they already trust and know. But often, we like the balance of both corporate and personal trustees.”

You can designate multiple trustees, or even backup trustees, in the event that the trustee is unable to perform their duties. 

Trustees must make investment decisions, file tax returns, manage the assets in the trust, and communicate effectively with the beneficiaries. Although a trusted friend or family member may feel like the most comfortable option, professional corporate trustees and trust companies will provide the most expertise and lack of biases. Professional trustees are also better for complex assets. But you may have to pay fees. 

Funding your trust fund

The grantor can fund a trust fund all at once or gradually over time with assets such as:

  • Cash
  • Stocks
  • Bonds
  • Real estate
  • Artwork and other collectibles

Benefits of trust funds

Trust funds are flexible estate planning tools for people to protect and manage their wealth. One of the main benefits of trust funds is that grantors get complete control over who the beneficiaries are, when they can access the assets, and how. So, if you’re worried about misuse, you can structure your trust according to what you want. 

If the beneficiaries lack experience managing complex assets, you can establish a financial expert or institution as the trustee to manage the funds and ensure they are being used responsibly. Another advantage is reduced estate taxes. Grantors can reduce taxes for themselves and their beneficiaries by lowering the taxable value of their estate. Moreover, you can avoid high probate costs. 

You’ll also avoid the probate process, a legal process of reviewing a deceased person’s will and distributing the assets.

“A trust can help you avoid the unnecessary cost and time-consuming process of probate,” says Eckels. “It’s important to not just have the trust documents in place, but make sure that all the assets are listed on your balance sheets and that beneficiaries are titled appropriately.”

Drawbacks of trust funds

Unfortunately, trust funds can be costly as you may have to pay trustee fees, tax filing fees, accounting fees, investment management fees, legal fees, and more. The initial cost of drafting a trust document can also be expensive. Therefore, trust funds are not generally ideal for fee-conscious individuals. 

However, the additional cost may be worth it, especially for people with larger estates.

“I tell people that are hesitant because it seems like a hassle or too much money that the consequences of not organizing things in your lifetime, and not paying those upfront costs, could lead to additional costs for your family later on,” comments Eckels. 

Remember that trusts are complex legal documents, so you’ll either need to be knowledgeable of how trusts are established to meet your goals or have an experienced estate planning attorney with you. There’s also always a chance of mismanagement, especially if the trustee is a friend or family member with poor decision making. 

Spectrum Wealth Management, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Additional information about Spectrum’s investment advisory services is found in Form ADV Part 2, which is available upon request. The information presented is for educational and illustrative purposes only and does not constitute tax, legal, or investment advice. Tax and legal counsel should be engaged before taking any action. The opinions expressed and material provided are for general information and should not be considered a solicitation for purchasing or selling any security.