You've probably gone far in life without knowing what a trust account really is, but a trust could serve you well in your financial planning, saving you or your loved ones a lot of money. There are different kinds of trusts with different purposes. Let's review them.
A trust is an arrangement where someone's assets are held, and perhaps managed, by someone else (the "trustee") on behalf of one or more beneficiaries. Better still, the trustee is held to a fiduciary standard, meaning that he must put the beneficiaries' interests first, before his own or any others. He must also respect the terms of the trust.
The simplest example of a trust account is an escrow account, where an account is set up at a bank or trust company so that institution, acting as trustee, can perform certain actions on behalf of the account owner. For instance, a trust account might be set up when you buy a home, in order to have your mortgage-lending bank pay your property taxes and home insurance.
There are lots of other kinds of trusts, and they can be especially useful in estate planning, as they generally bypass the probate process and can deliver assets to beneficiaries more quickly. They can also provide tax savings, more control, and privacy. (The probate process is public.)
Don't get trusts confused with wills, though. A trust will usually exist to cover one or more specific assets, such as real estate or an insurance policy, while a will covers everything else, down to the deceased's socks. A will can also include one or more trusts of a certain kind. We'll get to that shortly.
Kinds of trusts
There are two key kinds of trusts -- living trusts (also called "inter vivos" trusts) and testamentary trusts. Moreover, trusts can be revocable or irrevocable.
A living trust goes into effect while the person who created it is still alive, and it generally gets to bypass the probate process. A testamentary trust goes into effect when the creator dies; it does not bypass probate.
As you might have guessed, a revocable trust is one that can be revoked -- canceled -- or changed after it's finalized. An irrevocable trust, once it's finalized, is really final. Testamentary trusts are generally revocable until their creator (the "grantor") dies, since they don't go into effect until that time.
Here are some examples of common trusts:
- A revocable living trust: This is an arrangement that's often set up in order to have some assets avoid the probate process when the grantor dies. It will usually become irrevocable at that point. The grantor is often the trustee in these trusts, in charge of the assets until death, and a successor trustee can be named to carry on after that. This kind of trust remains subject to estate taxes and is not a way to avoid them.
- An irrevocable living trust: This kind of trust is often used in order to transfer assets to another person or entity. It removes the assets from the grantor's estate, thereby reducing or eliminating estate taxes. That's an appealing prospect, but it requires the grantor to give up control of the assets before death, and does not allow for changes to the arrangement.
- A testamentary child's trust: This is a common way that people leave assets (such as cash) for children, generally through a will. It involves designating a trustee to manage the assets until the child or children reach a certain age. Since it doesn't make sense for children to inherit a lot of money or other property while they're still children, this arrangement allows for assets to be managed for a while on their behalf.
The trust accounts above are not the only kinds that exist. There are "dynasty" trusts that skip generations, letting you bequeath assets tax free to beneficiaries who are at least two generations younger than you are, such as your grandchildren. There are also trusts that permit you to remove certain assets from your estate, such as life insurance payouts, or a home.
There are many other possibilities, each with a different purpose and different advantages and disadvantages.
The term "trust fund baby" might make you assume that trust funds are mainly for the rich. That's far from true. They're really for those who want to be strategic about their assets.
Consider consulting a financial planner or estate-planning professional to explore trust funds and accounts that might serve you well, saving you and/or your beneficiaries money and hassles.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.