Center for a Secure Retirement
How Does a Trust Fund Work, and When Should I Set One Up?

How Does a Trust Fund Work, and When Should I Set One Up?

Longer life expectancies, larger investment portfolios and more complex family structures are all positive indicators on their own. But they also mean more considerations to navigate during the estate planning process. Simply writing a will and setting up investment accounts with named beneficiaries might not be enough to grant your financial wishes.

Setting up a trust fund can help fill the gap and help you pass on your financial resources to your loved ones or your cherished causes. So how does a trust fund work? And what's involved in setting one up? Here's what you need to know.

What Is a Trust Fund?

A trust fund is a legal entity established to hold property or assets for a person or a group of people. A trust usually holds money, but it can also hold stocks, real estate, jewelry and other assets.

The person who funds the trust is the grantor. The neutral third party — sometimes a single person but often an organization such as a trust bank — that manages the trust is the trustee. The people who benefit from the trust are beneficiaries.

Contrary to popular belief, trust funds aren't just for rich people. Anyone can use a trust fund, and it can be a helpful estate planning tool.

How Does a Trust Fund Work?

A trustee manages a trust following the wishes of the grantor. Depending on the trust and how it was set up, beneficiaries receive a monthly income for a set period or indefinitely, a lump sum payment at a specified age or event, or other predefined benefits.

There are several types of trusts, and each suits different goals.

Trusts can be revocable or irrevocable.

  • A revocable trust, sometimes called a living trust, lets the grantor arrange for their beneficiaries to access the trust while the grantor is still living. The grantor can change it or even dissolve the trust, if they want. If the grantor dies while a revocable trust is active, their estate will likely be subject to estate taxes, although it might avoid probate fees.
  • An irrevocable trust is exactly what it sounds like. It can't be changed or dissolved once it's been set up and funded. When a grantor moves assets into an irrevocable trust, they relinquish control of those assets. Assets within an irrevocable trust are protected from estate and probate taxes.

Other common types of trust funds include:

  • Marital or Type A trusts, which support surviving spouses.
  • Credit shelter trusts, which help surviving spouses maximize estate tax exemptions.
  • Charitable remainder trusts, where income is distributed to beneficiaries for a set time and the remainder goes to charitable organizations.
  • Life insurance trusts, which receive the proceeds of a life insurance policy.
  • Special needs trusts, which benefit a dependent with special needs.
  • Spendthrift trusts, which protect beneficiaries from irresponsible spending of the trust fund assets.

How to Set Up a Trust Fund

Once you're familiar with how trusts work and how they apply to different situations, it's time to learn how to set one up. Here are the primary steps you'll want to take.

  1. Select the trust that fits your specific situation and goals.
  2. Draft a trust document. It should include specific information, such as the grantor (in this case, you), the trustee, your beneficiaries, the assets or income you're putting into the trust and instructions for managing and disbursing them.
  3. Apply for a taxpayer identification number from the IRS, if you don't already have one.
  4. Sign the trust and get it notarized.
  5. Register the trust with the IRS.
  6. Move your chosen assets into the trust.
  7. Arrange for the required recordkeeping of the trust's transactions.

You might think that you could save money by setting up a trust on your own, but creating a customized trust contract for your specific situation requires specific legal knowledge and expertise. Talk to your lawyer or financial advisor about setting up a trust so you can be confident that everything is in place.

7 Ways You Might Use a Trust Fund

If you're still not sure whether a trust fund can help you control your assets or if establishing a trust is the right fit for your finances, here are seven common situations where setting up a trust would be beneficial.

1. To Help Beneficiaries Manage Their Inheritance

Maybe you have a beneficiary with a mental illness or disability. Or maybe your beneficiaries don't have the interest or skills to manage your assets. With a professionally managed trust, you get the assurance that experienced wealth management professionals are managing the investments on your beneficiaries' behalf.

2. To Protect Assets from Creditors

Setting up a trust protects your assets from your beneficiaries' creditors. Assets within the trust are also protected from divorce rulings, so your beneficiaries won't lose their inheritance to your former spouse.

A trust could also protect vulnerable beneficiaries from making unwise financial decisions under the influence of inheritance thieves.

3. To Control the Distribution of Proceeds to Beneficiaries

If your beneficiaries include minors, consider a trust that protects their inheritance until they're old enough to manage it. Some trusts require beneficiaries to meet certain conditions, such as completing a college degree or getting a job.

If some of your beneficiaries have a history of financial mismanagement or spending problems, a spendthrift trust can protect them from frittering away their inheritance, as the trustee will control the funds.

4. To Maintain Financial Privacy

Because trust agreements are confidential, some people set up revocable trusts to keep their financial matters, such as property ownership, private.

5. To Make Ongoing Philanthropic Contributions

Some trusts are set up to generate investment income to fund regular charitable contributions and scholarships. Charitable trusts can be active while the grantor is alive and after they're dead.

6. To Prevent Challenges to a Will

People sometimes set up trusts to prevent challenges to their wishes for their estate — for example, when there could be a contentious relationship with or between beneficiaries. Talk to your legal or financial advisor about your situation before setting up a trust for this reason.

7. For Tax Savings

Moving assets into an irrevocable trust can reduce your tax burden and might help you avoid probate taxes, depending on where you live. A tax professional can walk you through the tax implications.

A trust lets you customize how your assets are distributed to your beneficiaries. Although it's more complex than a will, a trust provides additional benefits that can help you meet your estate goals. Talk with your financial advisor or estate lawyer to make a plan that fits your financial wishes and maximizes the gift you're passing on to your loved ones or cherished causes.

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