What Is a Trust Fund and How Do They Work? Interested in setting up a trust fund? Read on for more on what a trust fund is, how they work, how to set one up and more.
By Entrepreneur Staff •
A trust fund is a financial tool to provide financial support for a beneficiary. With trust funds, there are three key participants:
- The Grantor: the person who creates the trust and owns the assets.
- The Trustee: the legal entity that manages the assets and carries out the requirements.
- The Beneficiary: the person for whom the trust was created and will receive assets according to instructions of the trust.
Trust funds do not always deal exclusively with money. Common assets provided in a trust can also be:
- Real estate property.
- Investment accounts.
- Business.
- Any combination of these three.
Related: 5 Ways Business Owners Can Use Trusts to Benefit Their Company
How does a trust fund work?
When a grantor is ready to allocate assets to a beneficiary, they consult a trustee and set up a system by which the beneficiary will receive those assets.
Trust funds can be distributed to the beneficiary while the grantor is still alive or after the grantor's lifetime. Once it is time for the beneficiary to receive the assets based on the trust's instructions, the trustee will do so.
The trust instructs how to beneficiary should receive the assets, which can happen in manners like:
- Lump sum.
- Installments.
- Real estate property deeds.
- Physical item transfers.
Related: 7 Ways to Pass Wealth to Your Heirs
Types of trust funds
There are several different types of trust funds for people's different needs and purposes. If you're contemplating opening a trust, look at the options below to see which might be right.
Revocable
A revocable living trust is generally created for assets to pass without a probate process. Probate is the legal process that recognizes a last will or trust and appoints an executor or trustee to administer the estate to the beneficiary.
Probate laws vary by state, so it is vital to understand the intricacies of each. However, because revocable trusts do not require probate, they are more flexible and allow you to change the trust details as you wish.
Irrevocable
An irrevocable trust is not as flexible, as you cannot make changes once it is formed. However, the benefit of an irrevocable trust is that assets are protected from creditors and estate taxes even through generations.
Living trust
Most living trusts are a type of revocable trust. A living trust is intended to be used while the grantor is still alive. Grantors who choose this option can make assets available to the beneficiary at a particular time, like a milestone birthday.
Because this is a type of revocable trust, the grantor can change the terms during the fund's life as long as it is before distribution.
Spendthrift
A spendthrift trust allows the grantor to distribute assets to the beneficiary over time.
Generally, these distributions are handled through an independent trustee and are used to help the beneficiary make more responsible decisions than they might when dealing with a lump sum distribution.
Testamentary
A testamentary trust is commonly known as a will, which beneficiaries receive after the grantor's death. Testamentary wills used to be quite common; however, as probate laws have changed, they have become less popular.
Living trusts have become more popular, as they can be structured similarly but are immune to probate.
Bypass
Bypass trusts are most commonly used between spouses in estate planning to avoid federal taxes. For example, with a bypass trust, when one spouse dies, their assets will be designated to their surviving spouse as their beneficiary.
The spouse will inherit that property without having to pay federal estate tax. In addition, the designated beneficiaries who receive the estate after both spouses have passed (usually a child) will also be exempt from federal estate taxes.
Related: Why the Rich Need to Stop Worrying About Being Taxed
Charitable
A grantor can set up two different types of charitable trusts. Some charitable trusts qualify for tax deductions.
- Charitable Lead Annuity Trust (CLAT): the grantor designates a certain amount of assets to go to one or more charitable organizations, and the remainder is allocated to beneficiaries.
- Charitable Remainder Annuity Trust (CRAT): the grantor designates income to the beneficiary for some time, and the remaining income or assets are allocated to one or more charitable organizations.
Related: How to Make Charitable Giving a Winning Business Strategy
Special needs
When a grantor has a family member with special needs requiring lifelong care, they can set up a special needs trust. The trust ensures that the beneficiary with special needs has funding to continue receiving their care for the rest of their life, even after the grantor dies.
This type of trust is a safer option than other trusts, as it can keep the beneficiary's Supplemental Security Income from being impacted.
Supplemental Security Income is a federal program that provides supplemental income to provide clothes, shelter and food to those with various disabilities.
How to set up a trust fund
When the time comes that you are ready to set up a trust account, there is a step-by-step process to follow. See below for five steps on how to set up a trust fund.
Related: Digital Wills in times of Covid-19 crisis: Legal or not?
1. Set a purpose and create goals.
Trusts are documents that should not be made lightly. They are legally binding; it's essential to be intentional when it comes time to create one. When you have a set purpose for the trust, it can be easier to set clear goals, terms and assets that you'd like to provide to your beneficiaries.
As you set your purpose, it is also imperative that you are specific with your trust assets. Which assets are going to which beneficiary? How much money is going to which person and when? Do the funds need to be used for a specific purpose?
2. Choose the correct type of trust.
The great thing about opening a trust is that you have options. There is a trust that is the perfect fit for just about anyone, and you can create your terms and specifics based on what is suitable for you and your loved ones.
For some, life insurance policies can be a better estate planning tool than any trust due to tax benefits and the grantor's financial situation. Take another look at the types of trusts above to determine which is the best for your intended purpose.
3. Establish terms of the trust.
There are three critical components to establishing the terms of a trust: choosing a trustee, determining distributions and setting provisions. They each have their specifics that deserve detail and attention.
- Choosing a trustee: The person or organization you decide to trust your money and assets with matters. The trustee is the one who manages and oversees everything that has to do with the trust, so it should be someone you trust and generally someone who has legal authority.
Some trusts allow you to make yourself the trustee, enabling you to oversee all assets, but you need to ensure you have a successor should anything happen to you.
- Determining distributions: As you decide on distributions, you need to be extremely specific and clearly define your assets.
- Setting provisions: Once you've defined the beneficiaries who will receive your assets, you need to set provisions for how those distributions will occur. This includes which beneficiaries receive what, how much and when.
4. Draw up trust documents.
For this part, it is important to consult legal counsel, as different states have different trust laws and requirements.
Many states require signing legal documents in the presence of witnesses or a notary to make the trust legal and binding. Estate planning attorneys can help navigate these legal arrangements and processes.
Related: You've Got a Complicated Financial Life. Find Out if You Should Ditch Your Robo Advisor for a Human
5. Link assets to trust.
Once you have decided which assets to include in your trust, you need to include them through legal documentation. It is not enough to note that your house goes to one beneficiary, and your vehicle goes to another.
You must contact the institutions and obtain proper paperwork like deeds and titles to ensure the trust is carried out when it's time.
Related: 12 Things Your Kids Actually Might Want to Inherit
What to know about trust funds
Many people associate a trust fund with the upper class. However, opening a trust does not require wealth. It may indeed cost you money in the form of legal fees and documentation, but people in all kinds of financial situations can leave anything in a trust that is of value to them.
Taking your time and being thoughtful when creating a trust to guarantee the proper beneficiaries receive the right assets based on your wishes is essential.
For more information on personal finance, visit Entrepreneur.com.
