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What Is a Trust? Types, Advantages and How They Work

Trusts aren't just for wealthy people. Here's how they work, how to get one and how to decide which type could work for you.
Sept. 23, 2020
Estate Planning, Investing, Taxes
What Is a Trust? Types, Advantages and How They Work
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Trusts aren’t just for rich people. They can be an important part of estate planning and can provide peace of mind by ensuring your assets will go to the right people. Here’s what trusts are, how they work and basic differences between living trusts, revocable trusts, irrevocable trusts and others.

Trusts can be complicated. This is only an overview; be sure to consult with an experienced financial advisor.

What is a trust?

A trust is a legal arrangement intended to ensure a person’s assets eventually go to specific beneficiaries. The person creating the trust puts assets in the name of the trust and authorizes a third party to administer those assets for the trust creator and the beneficiaries.

How trusts work: the basics

Trusts have three main players:

  • Grantor: The person who creates the trust and puts assets in it.
  • Beneficiary: A person who eventually receives some or all of the assets in the trust.
  • Trustee: The organization or person who administers the trust.

A primary goal of any trust is to transfer assets from one person to another. Trusts can hold different kinds of assets. Investment accounts, houses and cars are examples.

One advantage of a trust is that it usually avoids having your assets (and your heirs) go through probate when you die. Probate is a part of the court system tasked with deciding whether your will is valid (if you have a will) and then distributing your assets. That can take several months, and much of it is public record.

Advantages of a trust

  • Control. You can specify the terms of the trust, which means a trust can help you be strategic if you want to protect assets after a divorce, for example, or control when kids get your money, or control how people spend the money you leave them.
  • Privacy. Assets in trusts don’t have to go through probate. That process is public record, which can create drama if you’re disinheriting someone or making distributions that you don’t want to be public.
  • Time. Probate can take several months. Trusts can avoid probate and get assets to your heirs faster.
  • Potential tax savings. As we detail below, some types of trusts can lower your estate taxes. However, most people don’t have to pay estate taxes, so talk with a financial advisor before setting up a trust to avoid taxes you may not have to pay anyway.

Disadvantages of a trust

  • Cost. An estate attorney can do the paperwork involved in setting up a trust and transferring your assets into the trust.
  • Time. You’ll need to spend time dealing with paperwork. You may need to have uncomfortable conversations about who gets what.
  • Questionable tax savings. Some people can indeed save on estate taxes with certain trusts, but most estates aren’t subject to estate taxes in the first place.

What is a living trust? What is a revocable trust?

Living trusts are also known as revocable trusts. In these trusts, you can change the beneficiaries and assets as long as you’re alive and physically and mentally able to do so. You can even name yourself as the trustee and name a co-trustee or successor trustee. That way, if you’re diagnosed with a debilitating condition, you can get things in order before you’re unable to do so, and then when the day comes, the successor trustee takes over managing the trust for you.

What is an irrevocable trust?

In an irrevocable trust, you can’t change your mind. Once you put assets in the trust and name a beneficiary, it’s permanent. An advantage of irrevocable trusts is that you might be able to reduce your estate taxes — the assets in an irrevocable trust technically aren’t yours. The trust owns them.

Other types of trusts

You can tailor a trust to your needs. Here are a few examples:

  • Education trust: Beneficiaries can only use the money for educational expenses.
  • Spendthrift trust: When beneficiaries can’t make good financial decisions for themselves, the trustee decides how the beneficiary is allowed to use the money.
  • Charitable trust: An irrevocable trust from which assets go to one or more charities.
  • Special-needs trust: For families with children who have special needs, these trusts set specific rules for how the money will go to the beneficiary.
  • Qualified personal residence trust: An irrevocable trust in which you transfer a house to your heirs but get to live in it for a specified period first.
  • Generation-skipping trusts: A trust in which you transfer money to grandchildren or other people who are at least 37.5 years younger than you.

Taxes and trusts

This is a complicated area of the tax code, so be sure to consult with a qualified professional. Here are a few things to keep in mind:

    • Estate taxes. If you have a large estate, you may owe federal estate tax when you die. In 2020, the federal estate tax generally applies when a person’s assets exceed $11.58 million at the time of death. The estate tax rate can be up to 40%. Also, some states have their own estate taxes (and set their own estate size thresholds), so there could be two estate tax bills to pay: one to the federal government and one to the state.
    • Inheritance taxes. Some states have inheritance taxes, which are different from estate tax. The people who inherit the money pay the tax.
    • Income taxes. The assets in a trust might generate income, which could trigger income taxes or capital gains taxes. Who pays that tax depends on who legally owns the assets. If a charity gets the income directly, that donation might qualify for a tax deduction.
    • Time and effort. You may have some extra paperwork to do at tax time because trusts sometimes have to file their own tax returns.

How to set up a trust

There are three ways to go, in general.

  1. Hire a financial professional. Fees can vary widely.
  2. DIY. Some websites offer “do-it-yourself” trusts. They may be a low-cost option, but you may pay in time and effort.
  3. Do it through work. Some companies offer discounted estate planning services as part of their employee benefits packages.

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