Types of Trusts

When you transfer property to a trustee for the benefit of a third person, this is called a “trust.” The trustee manages that property for the third person, or beneficiary, in accordance with your terms and instructions. These directions are included in the trust, which is a legal entity. In legal terms, the trustee maintains legal ownership of the property, while the beneficiary maintains a beneficial ownership of that property.

If you wish to create a trust, you have a number of decisions to make about what type of trust you want to create. You can create a trust in your will (a testamentary trust), or you can create a trust during your lifetime (a living trust). You can create a revocable trust (a trust you can amend or revoke), or an irrevocable trust (a trust you cannot amend or revoke). The following list provides a definition for each type of trust:

Testamentary trust: This type of trust, which is created and funded under the terms of your will, does not come into existence until your death. Assets transferred into this type of trust must pass through probate before those assets pass into the hands of the trustee. You can change the terms of the trust by amending your will; however, once you die that trust becomes irrevocable. A testamentary trust can be contingent, which means that it will be created upon your death only if certain conditions are present. For instance, if your children have grown, that trust you created for them as independents may not prove valid upon your death.

Living trust: This type of trust also is called an ‘inter vivos trust.’ You can create this trust during your lifetime and it can end or continue upon your death. Property in a living trust is distributed according to the terms of the trust, not according to terms within a will. This means that a living trust can avoid probate.

Revocable trust: You can revoke or amend the terms of the revocable trust or even dissolve it during your lifetime. You can change beneficiaries, trustee, add or remove assets and change provisions. When you die, the assets in your revocable trust do not pass by the terms of your will, and – therefore – do not need to pass through probate. The disadvantage to a revocable trust is that the assets in trust will be included in your gross estate for estate tax purposes; therefore, you cannot use a revocable trust to avoid estate taxes. You can, however, set the terms of the trust to change a revocable trust to an irrevocable trust when you die.

Irrevocable trust: You cannot change, amend or revoke an irrevocable trust once the trust is established. In essence, the irrevocable trust is the opposite of a revocable trust. The main advantage to setting up an irrevocable trust is that the assets in the trust, including any future appreciation, are not included in your gross estate for estate tax purposes. But, transfer to an irrevocable trust may be a taxable gift, and gift taxes may have to be paid at the time of the transfer. A secondary benefit of an irrevocable trust may be that the assets in the trust are beyond the reach of your creditors.

While the irrevocable trust is the least flexible of any one of the trusts mentioned above, this legal entity is invaluable as an estate planning tool. Since many people use this type of trust to save substantial amounts in estate taxes, you can choose from a variety of irrevocable trust options. You can arrange an irrevocable life insurance trust to hold an insurance policy; you can arrange a qualified personal residence trust to hold a personal residence; and, you can prepare a retained annuity trust to provide yourself with income.

Check with your financial planner or tax consultant to determine which type of trust is best for your age, income and what you feel are your personal responsibilities. When you transfer income-producing assets to certain types of trusts, you may be able to transfer income to those heirs who are in a lower income tax bracket than you. By doing this, you may be able to reduce your own income taxes while helping those heirs along.

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