A trust can serve many purposes, and you do not have to be wealthy to benefit from it. A trust can be established to, among other things, reduce probate costs, protect your assets from creditors, reduce your tax burden, provide for a special-needs child, and establish a line of inheritance.
Follow along as we learn what a trust fund is, how to create one, and how it works.
What is a trust fund?
A trust fund is a way of managing and protecting your assets. It mainly involves three parties:
- Grantor: The person who funds the trust is called the grantor. You, as the grantor, decide how the assets will be used and who will receive them. All of this is spelt out in a legally binding document known as the trust document or trust deed.
- Trustee: The individual whose job is to make sure all the conditions outlined in the trust document are fulfilled. The trustee ensures the assets are handled and distributed appropriately.
- Beneficiary: The person who will receive the assets held in the name of a trust. This could be your children, close family members, or a charity.
Think of a trust fund as a legally-binding template for the distribution of your assets. It itself does not hold your assets per se. Rather, it determines:
- how your assets will be managed
- who will have access to them
- how they will be distributed to your beneficiaries.
People usually fund a trust with one or more of the following assets:
- real property (like jewelry or heirlooms)
- real estate
- brokerage accounts
- business interests
Financial advisors recommend against putting assets such as retirement accounts and life insurance in a trust fund. These accounts usually have beneficiaries and consequently do not have to pass through probate — the process of validating a will.
However, if your beneficiary is a minor, you may benefit from including your life insurance policy and retirement account in the trust fund.
While minor children can legally be named as beneficiaries, they cannot receive an inheritance until they reach the age of majority. If your beneficiary is a minor when you die, the trustee will manage the funds until your children reach the age of majority.
Reasons for Creating a Trust Fund
There are numerous reasons for setting up a trust, the most common ones being:
- To avoid probate
Like most people, you probably want to leave as much of your assets to your heirs as possible — and you also want them to receive their inheritance as soon as possible after you die. That is where a living trust (a trust established during the grantor's lifetime) comes in.
A living trust ensures that your assets are distributed directly to your beneficiaries, eliminating the need for probate court. That means your heirs will receive more of your money sooner, as probate can significantly delay estate distribution.
- To protect beneficiaries
The term “trust fund baby” often has a negative connotation, with many people associating it with rich kids who have everything without having to work. While this may be true in some cases, it is far from the norm. The goal of establishing a trust for your children is to ensure their well-being after your death. If your children are not of legal age or mature enough to manage assets, a trust fund may be an option.
For example, in Canada you cannot leave an inheritance directly to a minor. In this case, the best way to secure your child's future is to place assets in a trust and appoint a trustworthy trustee. You can have your children receive all of the money when they reach adulthood, or you can limit what they can withdraw money for until they reach a certain age, such as 25.
- To protect assets
Nobody plans to divorce, but couples do separate. When this occurs, hard-earned assets may be transferred to a divorcing spouse. If you are not yet married but want to protect certain assets from a possible future divorce, consider putting them in a trust.
Assets placed in a trust fund are no longer yours legally and will not be considered matrimonial assets in the event of a divorce. The assets will be managed and controlled by the trustee, but you and your beneficiaries (such as your children and grandchildren) will benefit from them.
- To reduce tax liability
Everyone, especially high-net-worth individuals, wants to reduce their tax liability. Setting up a family trust is one way to reduce your tax liability. By splitting income with family members in lower tax brackets, you can reduce the overall family tax burden and ensure more wealth is available.
- To provide for a disabled beneficiary
People with a disability are often eligible for disability benefits. The amount of benefit they receive depends on their income. If you have a disabled child and want to leave them an inheritance, establishing a trust can protect their disability benefits.
- To establish a line of inheritance
A spousal trust may be an option if you want to support your spouse or common-law partner for as long as they live and then pass the remaining assets to designated beneficiaries upon their death.
Consider the following scenario: Mr. Miles has two daughters from his first marriage, and he is a university professor. Mrs. Miles, his second wife, is a stay-at-home mother.
Mr. Miles wishes to ensure that Mrs. Miles is taken care of after his death. He also wishes to protect the estate for his daughters. In this case, he can set up a spousal trust to provide financial support for his wife for the rest of her life while still controlling how his estate is distributed in the end.
With a proper estate plan, the estate will be divided among his daughters following Mrs. Miles' death. That cannot be changed by her actions during her lifetime or the instructions in her will.
How Does a Trust Fund Work?
A trust fund is a legal entity that holds assets for the benefit of a beneficiary in the future. The trust document, also known as the trust deed, specifies how the trust's assets will be managed and distributed. It also specifies who will be in charge of managing and administering the assets.
When you place assets in a trust, you are considered the grantor. As the grantor, you get to choose the trustee, who acts as a custodian for the assets. If you wish, you may appoint more than one trustee. Beneficiaries can include one or more family members, a charitable organization, or a corporation.
You can also name yourself as the trustee, but the grantor and trustee are usually two separate entities. The grantor can also name themselves as a beneficiary, which happens occasionally, though they are usually different. Trusts can be established in a variety of ways, depending on the type of trust that is best for you.
There are various types of trusts, each designed to meet specific needs and with varying degrees of complexity. However, trusts are broadly classified into two types: revocable and irrevocable.
A revocable trust is one that you can change or cancel at any time during your lifetime. At its most basic, it specifies how your assets will be distributed following your death. Assets can include cash, valuable possessions, investments, real estate, bank accounts, and life insurance.
A revocable trust can be a good option if you want:
- To skip probate: A revocable trust allows you to skip the probate process.
- To avoid conservatorship: This kind of trust can help you avoid having to go to court for control over your finances if you become ill, disabled, or too old to take care of yourself and/or your finances.
- Flexibility: You can amend or change a revocable trust until your death.
- Privacy: Want to keep information about assets private after death? Consider a revocable trust in that case. Unlike a last will and testament, the contents of a revocable are not made public after you pass.
Keep in mind that a revocable trust will not help you avoid estate tax, because it is included in your estate. If you want a tax benefit, consider establishing an irrevocable trust, instead.
An irrevocable trust is exactly that: irrevocable. You cannot cancel or change it once it has been created. Only a beneficiary has the authority to do so.
While revocable trusts are more common because the grantor has more control, irrevocable trusts are appropriate in some situations.
If you want to avoid estate tax and lower your tax bill, consider establishing an irrevocable trust. Assume you own a home that generates income. You will no longer have to pay taxes on that home once it is placed in an irrevocable trust. Why? Because the trust is now the owner, not you. For the same reason, you will no longer be subject to estate tax.
If you have debt, an irrevocable trust may benefit you and your heirs. Creditors can go after your estate after you die to recover what you owe. An irrevocable trust, on the other hand, may shield your estate from creditors (such as your home and bank accounts).
Apart from revocable and irrevocable trusts, these types of trust are pretty common:
- Marital trust: It is an irrevocable trust that allows tax-free transference of assets to a surviving spouse.
- Charitable trust: A type of trust where the trustee may only use the assets to benefit charities or non-profit organizations.
- Insurance trust: A type of irrevocable trust, an insurance trust allows a policy owner to control when and how the insurance proceeds will be used after her death.
- Generation-skipping trust: A generation-skipping trust, as the name suggests, skips a generation when it comes time to distribute your assets. The majority of people leave their assets to their spouse or children. A generation-skipping trust, on the other hand, transfers assets directly to grandchildren, great-grandchildren, or great-great-grandchildren.
- Special needs trust: This type of trust is set up for the benefit of a physically or mentally disabled or chronically ill person. Its main purpose is to allow you to pass on assets to a beneficiary while preserving their eligibility for public benefits.
Process of Setting up a Trust Fund
You can establish a trust by following these six steps:
- Decide the type of trust you need
The type of trust you require is determined by your goal for establishing it. A family trust, for example, is required if you want to reduce your tax burden. A spousal trust, on the other hand, is the best option if you have a blended family and want to protect the interests of both your current spouse and your children from a previous marriage.
Once you have decided the trust type, determine how you want to set it. You can set up a trust by consulting with a legal and financial advisor, using an online estate planning service, or doing it yourself. However, the last option is only recommended if you have legal experience.
- Create a trust document
A trust cannot exist without a trust document. It is a legal document that designates the following:
- the grantor
- the trustee
- the beneficiary
- trust property (assets that are held in the trust, like cash, real estate, securities, etc.).
- Sign the trust document
You must sign the trust document to make it official. Depending on your provincial laws, you may also have to get the trust document notarized.
- Create a trust bank account
A trust needs a bank account. The easiest way to do this is by either creating one in the trust’s name or registering a current bank account to it.
- Transfer assets to your trust
Simply mentioning the assets you want your beneficiary to receive on the trust document is insufficient. Those assets must be transferred to your trust. Transfer procedures will most likely differ depending on the type of asset. For example, to transfer a property in your name to your trust, you will need to create a new property deed. Transferring bonds or stock certificates involves reregistering them in the trust's name.
- Designate the trust as beneficiary for certain assets
The transfer procedure for retirement accounts and life insurance policies is slightly different than for assets mentioned above. If you want the trust to receive the proceeds of your retirement account and/or life insurance plan, you name it as the beneficiary.
How Long Does it Take to Set up a Trust Fund?
Establishing trust typically takes two to four weeks. The amount of time required is largely determined by the complexity of the trust agreement and the speed with which the grantor and advisors move.
If your estate is complicated, you may require both legal and financial assistance. All of this takes time. After speaking with an estate planning advisor, you will have a good idea of how much time it will take to set up your trust.
Why Set Up a Trust Fund?
Trusts have been around a long time and are used to meet various financial needs. People create a trust for many different reasons. Here are the most common ones.
- You want to avoid probate
The main advantage of trusts is that your assets can be distributed to your heirs without going through probate. If you die, any assets that are not in a trust fund must go through probate before your heirs can receive them.
- You want to save tax
To reduce tax liability, family trusts are frequently used. Let us say you are a high-net-worth individual, but some family members, like your grandchildren, have little or no taxable income. If you create a family trust with such family members, the trustee will be able to effectively split the family income, lowering your family's overall tax liability and protecting assets.
- You have kids from a previous marriage
If you have a blended family, estate planning may be difficult. You want to secure your spouse's future while also ensuring that your assets eventually go to your children. A spousal trust could be useful in this situation. Your spouse would receive the income generated by the assets left in the trust's care. However, after your spouse's death, the capital held by the trust will be distributed among your heirs in accordance with your instructions.
- You want to pass assets to a minor
You want to financially protect your minor child after you die, but the law prohibits you from directly passing assets to them until the age of majority. Thankfully, you can get around the problem by setting up a trust.
The trust will hold your assets and be managed by a trustee until your child reaches the age of majority. If you do not want the beneficiary to receive the entire amount when they reach the age of 18, you can have the trustee follow a predetermined schedule. That is, your beneficiary would receive money gradually — at specific ages and/or for specific purposes, such as paying tuition or a down payment on a home.
For beneficiaries who have trouble controlling their spending, a spendthrift trust may be more appropriate. The beneficiary does not have direct access to the funds in this type of trust. Instead, one or more trustees have complete discretion over how the trust capital is spent for the benefit of the beneficiary.
- You have a special-needs or disabled child
If you have a special-needs or disabled child, a trust can ensure he or she will be provided for when you die. The trust will protect the assets of your beneficiary, while preserving the eligibility for collecting public benefits.
Will or Trust Fund – What is the Difference?
There are many estate planning tools out there, with the two most commonly used being wills and trusts. While these two do have overlaps, they are significantly different tools. Understanding their pros and cons will help you pick the right estate planning tool and plan better for the future.
A will allows you to:
- designate an executor for your estate
- designate a guardian for your minor children and/or pets
- designate who all will receive your assets and how much each beneficiary will receive
- specify your wishes for your funeral or memorial service.
At their most basic, a will and a trust are both ways to specify how your assets will be distributed. Both of them are also legally-binding. The similarities, however, end there. Let us now examine the key differences between the two.
- When they come into effect
A will is only effective after your death. A trust, on the other hand, takes effect immediately after it is established.
A trust can be used to manage and distribute assets both while you are alive and after your death. A will, on the other hand, provides instructions for asset management and distribution only after death.
Assets held in a living trust can skip probate. A will, on the other hand, must go through the probate process, which takes at least six to eight weeks and sometimes several months. As a result, using a trust to transfer assets takes less time than using a will.
- Tax benefits
Certain types of trusts, like a family trust, can help reduce your tax liability. A will, however, cannot be used as a tax planning tool because it simply expresses your wishes for estate distribution after death.
Unless challenged, information about trust assets remains private. A will, on the other hand, becomes public when it goes through the probate process.
- Complexity and cost
Wills are less complex and you can make one without any legal or financial help. Generally, a will costs anywhere between $0 and $400. A trust is a more complex — and powerful — tool. Creating one typically requires expert advice from a trust attorney and entails an expense of at least $1,000-$1,500.
Drawbacks of Trust funds
The main drawback of establishing a trust fund is the associated cost. To establish a fund, you will typically require legal and financial advice. The fee for an estate planning attorney is usually not cheap. The cost of transferring assets into the trust must also be considered. In addition, once the trust is established, there will be ongoing costs, such as trustee fees for managing the trust and the cost of filing the trust income tax return each year.
The bottom line is that establishing a trust will cost you money. How much is it? This is determined by the type of trust required, the complexity of the trust document, and the value of the assets held by the trust. The good news is that some of the upfront costs can be offset later by lowering or eliminating probate costs.
A trust is an extremely effective estate and tax planning tool. There are various types of trusts, and which one is best for you depends on your financial situation. You can transfer a variety of assets to your trust, including cash, real estate, high-value assets such as jewelry, stocks, and life insurance.