What is a Trust?

Many people have heard the term “trust” in relation to estate planning, but many only have a vague idea of what a trust is and how it works. You may have heard of living trusts, or perhaps you’ve heard that trusts can protect against things like lawsuits, or maybe taxes. As you create your own estate plan, it’s important to understand the difference between various types of trusts and what they can accomplish.

The Two Types of Trusts

A trust, broadly defined, is a legal entity that “owns” assets. You might think of it like a bucket – assets inside the bucket are afforded special protection, assets outside of the bucket are not.

There are two primary types of trusts: revocable trusts and irrevocable trusts.

Revocable trusts can be changed and are quite flexible. The other main type of trust, irrevocable trusts, are the exact opposite – they usually cannot be changed after their creation. These two types of trusts serve very different purposes, and while they can both be very useful, their utility depends on what you are trying to accomplish with your trust. Let’s take a look at each type of trust.

Revocable Trusts

Revocable trusts and living trusts are merely two different terms to refer to the same type of trust. They describe a type of trust which can be changed at any time. The trustee , or manager of the trust, can, at any time, designate new beneficiaries or remove old ones, and modify how assets inside the trust are managed, including funding and removing assets from the trust. These changes can take place even after the trust has been created. They offer a great degree of flexibility.

Living trusts are excellent tools for estate planning because they offer very specific options for the distribution of your estate upon your death, the designation of beneficiaries, and because they can do things like avoid probate. Because of the ability for the trustee to change the details of the trust with relative ease, you can change the trust to keep it updated with new laws, changes to institutions like banks, and changes in your life, like getting new beneficiaries (such as grandchildren) or new assets (such as buying a house or setting up a new bank account).

Because of this flexibility, living trusts lose a degree of protection. Since assets can be funded to the trust at any time, assets within living trusts aren’t shielded from creditors. If the owner is sued, the assets within the trust can be ordered to be liquidated by a court to satisfy judgements. Furthermore, the assets inside the trust are subject to taxes upon the death of the owner. (Keep in mind that estate taxes upon death apply differently in various states, but usually begin when the estate is worth several million dollars).

Irrevocable Trusts

The terms of an irrevocable trust are just that – irrevocable. The agreements within an irrevocable trust are essentially set in stone the moment the agreement is signed, and they cannot be changed except for rare circumstances. Whereas with living trusts you can make changes to the trust terms at will, irrevocable trusts require the consent of any and all beneficiaries to be modified in any way. This means that irrevocable trusts carry a degree of risk, as they cannot usually be changed to reflect changes in the owner’s life.

However, at the expense of flexibility, irrevocable trusts offer strong protection against taxes and lawsuits.  Irrevocable trusts remove the benefactor’s taxable assets, which means they are not subject to estate tax upon death. Furthermore, if sued, the assets inside an irrevocable trust cannot be liquidated or seized by a court.

Pros and Cons

Living trusts, as stated previously, are fabulous tools for estate planning. We recommend that most people have a living trust to ensure their assets avoid probate and to avoid legal traps and pitfalls that often come with less sophisticated forms of estate planning. While they do not protect against taxes or lawsuits, for most people this is not a large problem if they do not expect to be sued or if their estate’s value is below the threshold to be subject to the estate tax. Living trusts cost much less to create than irrevocable trusts.

Irrevocable trusts, on the other hand, are used in much more specific circumstances. Large estates may often be placed in irrevocable trusts to protect against taxes, and they may also be utilized by people who expect to be sued often, such as lawyers or people who practice medicine. The fact that irrevocable trusts cannot be modified after their creation means they must be crafted carefully by a legal expert familiar with trusts, and the reasons for the creation of the trust should be clearly identified. Because of the risks associated with irrevocable trusts they cost much more than living trusts.