"My wife and I have a living will which ... distribut[es] our assets."

So began a recent question on the Rule Your Retirement discussion board. Mistakenly, the writer had confused the terms "living will" and "living trust." That's an easy thing to do. But the two terms are oceans apart in their meaning. A living will is a document that directs doctors and hospitals to cease heroic, life-sustaining measures when there is no reasonable prospect of your permanent recovery from an injury or disease. A living trust is an estate-planning tool that lets you direct how your property will be handled in life as well as after your death. It takes its name from the fact it is effective during life as well as after death.

Known formally as an inter vivos trust, a living trust is often sold to folks as a way to avoid a long and public probate process after death. While a living trust does avoid probate, it doesn't do a number of things that many folks often assume it does do. For instance, it does not:

  • Eliminate the need for a will.
  • Avoid the need to pay income, estate, or inheritance taxes.
  • Protect assets from creditors.
  • Cost less than the legal fees found in the ordinary probate process for most people.
  • Prevent challenges from dissatisfied heirs.
  • Make it easier to qualify for nursing-home care under Medicaid.

Don't get me wrong -- I'm not against living trusts. If I were, I wouldn't have one myself. But I do think they are overmarketed to the elderly and are inappropriate for many. They can cost up to $3,000 to develop, an expense that may not be justified for those with modest assets. And sadly, there are many charlatans out there who prey on the elderly, selling virtually worthless living-trust kits. Thus, in the long run, a living trust is often not cheaper than a will is; however, a living trust can still provide a benefit to some.

What a living trust can do for you
When properly constructed, a living trust can ensure that estate and inheritance taxes are minimized, so that heirs receive more of the deceased's estate. Consequently, a living trust makes sense for those with assets exceeding $1.5 million, or $3 million if married. That's not so true for those with smaller estates, because those estates will not be subject to federal estate taxes anyway. For the latter, the length and cost of probating assets may decide the necessity for a trust. And even in the absence of probate, the living trust's trustee must still ensure that all final bills and taxes have been paid before the assets may be distributed -- a process that can take 90 days or more.

To be effective, your assets (home, car, personal property, investments, checking accounts, etc.) must be transferred to, and titled in the name of, the trust. That's called "funding" the trust. On transfer, those assets are owned by the trust instead of you and are controlled by the trustee(s). However, you may be both the trustee and the beneficiary of that trust, and if so, you may use those assets just as you have always done.

Regrettably, no one except those who are absolutely fanatical about details will ever remember to transfer all assets to a revocable living trust; therefore, you must still have a "pour-over" will. That's to take care of those forgotten asset transfers during the probate process so that they are disposed of in accordance with your wishes. The need for a "pour-over" will means that most folks still don't avoid the probate process totally. And for income tax purposes, nothing has changed. You still pay your taxes as before, to include those resulting from the income-producing assets now owned by the trust.

Creditors may still lay claim to trust assets, and those assets will be counted as available to you in any Medicaid-eligibility determination. The important point to remember, though, is that an unfunded trust isn't worth the paper on which it's printed. For the trust to be effective, you must go through the time and expense of transferring asset titles to it. In doing so, you should also expect some heavy resistance from mortgage companies and often (for checking and savings accounts) your bank. These agencies almost always want a living, breathing human (not an inanimate though legal "person") as the title holder or owner of such accounts.

If the only purpose behind obtaining a living trust is to avoid probate, then there may be cheaper means to do so. How you hold title to your assets determines that. Assets owned jointly, as tenants by the entirety, or designated as "Transfer on Death" to a named beneficiary also pass outside of probate, and they do so far more cheaply than the cost of a living trust.

A living trust will allow a guardian to be appointed to manage your assets should you become mentally or physically unable to do so yourself. But the guardianship provisions of a trust, while effective, can also be accomplished more cheaply through a durable power of attorney. And while it's true that a trust makes it harder for someone to contest its provisions as compared with a will, it still can be contested by a dissatisfied heir on grounds of fraud, the maker's lack of mental capacity, or the undue influence of the trust provider or someone else. Thus, a revocable living trust is not infallible in that regard, either.

I believe that most folks do not need a revocable living trust, but that issue varies from state to state and from person to person. If you think you need or want this document, there are many "trust mills" operating across the land and on the Internet that will be happy to sell you one. The trusts are also available in modestly priced software packages or from an estate-planning attorney in your area.

All three of these sources can provide you with an effective and valid trust. But of the three, your best assurance of a legally binding and valid product in your state will come only through the use of an attorney.

In this Fool's opinion, it really doesn't pay to forgo the services of a qualified lawyer when dealing with a trust. The savings of a few bucks today may cost your family far more after you're gone.

Fool contributor David Braze is a retired financial planner who contributes articles and answers (to subscribers' questions) to the Motley Fool Rule Your Retirement newsletter service.