By Claire Wood
As another calendar year comes to a close, you may be starting to consider your family’s financial plan for the coming year as you spend time together. The turn of a new year is a great time to re-focus on the future. One often-overlooked and underutilized way to prepare for what’s to come in the years ahead is estate planning, specifically, preparing a trust. The use of trusts have sometimes been associated as something only for the wealthiest of individuals, but the truth is that that families from all socioeconomic backgrounds can (and often do) benefit from financial trusts. A trust is for anyone who would like to protect their assets and to specify the way in which they are handled.
What is a trust and how does it work?
There are many kinds of trusts, but they can typically be described as types of financial containers or “boxes” that hold certain assets, such as property or funds, that you decide to place inside. Although a trust can take the form of all sorts of legally binding financial agreements, from IRAs to certain court settlements, we’re especially focused on trusts as they relate to topics such as estate planning, inheritance, and life insurance. These are the areas where trusts are perhaps most commonly associated.
The use of trusts is an important facet of good financial planning and wealth management, and you should consider them when you think about potential retirement inheritance, estate planning, and tax liabilities. According to Investopedia, “A trust is a legal entity with separate and distinct rights, similar to a person or corporation. In a trust, a party known as a trustor gives another party, the trustee, the right to hold title to and manage property or assets for the benefit of a third party, the beneficiary.”
To put it another way, a trust is a type of legal relationship in which you “give” certain assets to a trustee (who can be an actual person, a business, or another entity) for specific purposes. That’s why even though you, as an individual, don’t directly “own” what you place in a trust, the assets inside are considered “held in trust” (hence the name) to be used according to your instructions.
What are the main types of trusts?
Trusts are widely considered one of the best tools for asset protection. When describing different categories of trusts and their characteristics, four of the most commonly used terms: living, testamentary, revocable, and irrevocable. While there are certainly subcategories among these types, each with its own restrictions and rules, these four are the most common.
A living trust is created while you are still alive and it enables an efficient transfer of assets to beneficiaries. It avoids probate (court proceedings to distribute assets after your death), and can potentially reduce taxes for your beneficiaries.
A testamentary trust is set up after your death according to your last will and testament. Since your will can be adjusted at any time up until your death, terms and conditions can be changed, making this type of trust typically more simple and flexible than others.
A revocable trust is a living trust because it is created while the trustor/grantor is still alive. It is revocable in that this type of trust can be changed or revoked during the trustor/grantor’s lifetime.
Conversely, an irrevocable trust means that once established, it cannot be altered or changed until the obligations or purposes of the trust have been fulfilled. Most of the time, irrevocable trusts are used in order to transfer taxable assets out of the trustor/grantor’s estate and keep them from being taxable to the estate upon death.
Within each of these types of trusts there are many other subtypes including charitable giving trusts, property, annuity, life insurance, generation-skipping, and special needs trusts. Another nuance is that these terms are also not always mutually exclusive. For example, an irrevocable life insurance trust is both a living trust and an irrevocable trust. It is always advisable to speak with a certified financial planner or an attorney to see which type best fits your needs.
What are the benefits of a trust?
With so many potential advantages for using trusts, you might be wondering which are the most beneficial? Some of the most popular reasons people decide to use a trust as part of their estate planning include the protection and preservation of assets, control and customization of wealth or asset distribution, minimizing tax penalties, taking into account special family dynamics such as divorce, blended families, or those with members who have special needs or ongoing healthcare concerns, and as a way to aid in the management of financial affairs for other family members.
Another great benefit of a trust is that it allows a third party to help oversee and implement financial plans professionally and from a distance, during what can be a time of heightened emotion, intensity, or grief surrounding a family loss.
What are the drawbacks?
While various trusts do offer plenty of benefits, it is also important to understand the disadvantages and drawbacks of trusts. One of the most widely accepted reasons that people don’t take advantage of trusts in their estate planning is that trusts can be costly to set up and administer. There are usually fees associated with managing trusts and for those with minimal or basic assets, the costs may not outweigh the benefits.
Another downside to using a trust is that they can often feel limiting and restrictive. Due to the limitations, legal requirements, and other complexities associated with directing funds at “arm’s reach” as it’s sometimes described, trusts aren’t always easy to understand. The same legal “distance” that can help protect assets inside a trust from lawsuits, taxes, and other liabilities is also what can make them sometimes feel restrictive since they always involve handing over a certain level of control to an outside entity in the form of a trustee.
Your Next Move
As you start to think about the best way to take care of your military family’s future, don’t overlook the value a trust in your financial and estate planning. Trusts are an excellent tool to consider if you would like to ensure that your assets are safely managed according to your pre-planned wishes. Trusts can help you make sure those wishes are executed efficiently, that you avoid some taxes and probate costs, and most importantly, that your heirs are taken care of.