The 5 Types of Trusts (and when they are used)

different types of trust

This week, Devin and John talk about the types of trusts, and when to use them. Obviously, you can’t cover everything in a podcast, even a long one! But we sure can learn a lot.

What Is A Trust

A trust is a legal entity, just like a corporation, or an LLC, or an individual person. All trusts will have an exchange of property and three categories of people:

  • the people who create the trust, called the grantors, or the settlors, or the trust-makers
  • the people in charge of the trust, usually called the trustees
  • the beneficiaries: the people who get the benefit of the trust

The fundamental idea of a trust is the transfer of property between one person and another person, for the benefit of a third person. All three of those people could be the same person, or two of the roles may be the same person, or there may be three different people. When you first set up the trust, the property transferred might be small, but that sets up the trust so that you can then add more property in the future.

Revocable vs. Irrevocable Trusts

Trusts can come in two forms: revocable or irrevocable. This is a little bit confusing.

Revocable is more clear, because the person who created the trust can revoke the trust.

An irrevocable trust doesn’t meant that it can’t be revoked, but generally it can’t be changed or revoked by the person who created the trust. That doesn’t mean that it can’t be changed or revoked, but it can’t be changed or revoked by the person solely by the person who created it. However, the grantor can give the trustee new beneficiary instructions, or the grantor can fire the trustee, depending on how the trust is worded.

Taxation of Trusts

Trusts can be taxed three different ways, and the taxation structure is reflected in the name of the type of trust. With the language in the trust, you can control the way the trust is taxed.

They can be taxed to the grantor. The grantor pays taxes on the income of the trust. These are generally called grantor trusts. All revocable trusts are grantor trusts.

The beneficiary can pay all the taxes. These are called simple trusts.

The trust can pay the taxes. These are called complex trusts.

Irrevocable trusts can be any of the three types: grantor, simple, or complex.

The Revocable Living Trust

This is the trust that most people will use for estate planning purposes. This is used as a will alternative, to avoid probate. The same person is the grantor, the trustee, and the beneficiary.

As long as the grantor is alive and competent, the grantor is 100% in control of the trust and benefits from the assets in the trust. The grantor designates who will take over if the grantor becomes incompetent, and also designates to whom the assets in the trust will go when the grantor dies. At death, all of the assets will transfer, according to the instructions trust, outside of the probate process.

You’re giving yourself a way to transfer all your assets to the trust while you’re alive, so that at the time of your death, things will be distributed as you want, without having to go through probate.

The benefit of this trust is that all the hard work is done up front; everything is laid out so that it happens simply and easily. Doing a will is simple for the person who is writing the will. All the work gets done by the survivors. Setting up a trust is a lot harder for you, but makes the process simpler for your survivors. Trusts also give you more opportunity to create specific conditions for the transfer of property.

Irrevocable, Income Only Trust

With this type of trust,  the person who creates the trust retains the right to the income, but not the principal. The grantor can still control the asset, including buying and selling investments in the trust.

This can be a very powerful tool, particularly for long-term care asset protection. It shields the value of the asset from any type of creditor. In particular, the value of the trust’s principal doesn’t count towards Medicare eligibility. 

Gifting/Inheriting Trusts

For a wide variety of reasons, you may want to give an asset to someone but you also want to protect that asset from outside creditors. This is an irrevocable trust.

You can use gift trusts as from a gifting standpoint, or you can put an inheritance into a trust. You can line out specific terms to the trust. You can basically set up any type of terms that you want, as long as they don’t violate public policy.

Tax Planning Trusts

Trusts are very powerful tools to deal with the estate tax. If you have assets that exceed the estate tax limit, putting those assets into a trust can shield those assets from the estate tax.

Two specific types of tax planning trust include Irrevocable Life Insurance Trusts and Intentionally Defective Grantor Trusts.

Special Needs Trusts

A special needs trust is a trust that holds assets for the benefit of a special needs person, without those assets counting towards their eligibility for government assistance.

This permits a quality of life over and above the resources provided by Medicaid and Supplemental Security Income (SSI).

You can set up a special needs trust for yourself, or for someone else. These can be critical to providing a good quality of life for a special needs person.

Do You Need A Will Or A Trust?

Doing a will is simple for the person who is writing the will. All the work gets done by the survivors. Setting up a trust is a lot harder for you, but makes the process simpler for your survivors.

You’re going to need to record a deed, transferring the ownership of property into a trust.
A younger couple, with a low risk of mortality and minimal assets, may find a will to be appropriate.
As you get older, you increase the amount of assets and the complexity of the assets. For older folks, a trust often makes more sense.

Highlights of this episode:

    • The hobo with $12 million in life insurance
    • John’s super-simple explanation of a trust
    • The tricks of putting an IRA into a trust

Resources mentioned in this episode:

Episode 82: The Right Way To Change Your Will

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