Most people think of trusts as something that only the super-rich need: a mysterious legal trick to evade taxes (and rack up tons of attorneys' fees). In reality, trusts can be helpful for folks at any income level and are much more commonplace than most people realize. For example, if you've ever listed your spouse or child as a beneficiary on a bank account, you've technically set up a simple trust. The three types of trusts discussed below can help you protect your assets.
What is a trust?
A trust is a tool for dividing ownership of property between legal title and beneficial enjoyment. The holder of legal title is called the trustee and is responsible for managing the property based on the terms of the trust for the benefit of the named beneficiary of the trust. Some trusts are revocable, because you can change your mind at any time about who the beneficiaries are, or you can take the property out of the trust entirely. Trusts that don't allow you to change the terms once the trust has been established are irrevocable trusts. The distinction between revocable versus irrevocable trusts is very important, since some types of trusts won't work if you set them up with the wrong kind of revocability.
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1. Asset protection trust
An asset protection trust is designed to protect your money from creditors. You transfer ownership of cash or property to a trustee, who manages the cash and property for you. The idea behind the trust is that because the property is now owned by someone else, your creditors arguably can't arrange to have those assets seized. These trusts must be irrevocable to work, so make sure that you have yours set up exactly the way you want before you pull the trigger.
Not all states allow asset protection trusts. If you live in a state that bans them you could still set up such a trust by the laws of another state, but it's not 100% certain if this approach will stand up in court should a creditor challenge it. Also, it's important to transfer the property to the trust before you run into creditor trouble, or the transfer may be disallowed in court. You can see a list of the 16 states that currently allow asset protection trusts here.
2. Bypass trust
A bypass trust is designed to help married couples avoid unnecessary estate tax liability. Each spouse sets up their estate planning documents to leave property up to the maximum allowed under the estate tax exclusion to the bypass trust, then bequeaths the rest of what they own to the other spouse. Property left to one's spouse qualifies for a marital deduction to the estate tax, so when one spouse dies, the other can get the bequeathed property tax-free.
Meanwhile, the property left to the trust is covered by the estate tax exclusion, but it's also not subject to estate tax in the surviving spouse's estate, so as the property increases in value, it can safely grow above the exclusion amount without incurring potential estate tax at the death of the surviving spouse.
The terms of the bypass trust generally allow the surviving spouse to get support from the trust, although it's typically better to spend down other assets that will be included in the surviving spouse's estate. When the surviving spouse dies, the contents of the trust go to the named beneficiaries, who can then get it without facing an additional round of estate taxes.
3. Totten trust
Remember the example of a bank account set up with a beneficiary? That's a Totten trust, and it's generally used to avoid probate. Totten trusts work for assets such as bank accounts and securities accounts, but not for "real" property such as a house or a car, for which you'll need a specialized trust. Setting up a Totten trust can be as simple as filling out the beneficiary paperwork and handing it in to your bank or brokerage.
Specialized trusts
The above three trusts are the most common and can be useful for a wide range of folks, but there are also other, more specialized types of trusts that can be helpful in certain situations. For example, spendthrift trusts can help protect money for financially irresponsible beneficiaries, while charitable trusts can let you make charitable gifts while ensuring an income stream for the donor, and special needs trusts can let you provide for the support of a family member receiving government benefits without disqualifying that person on grounds of income. If you think that a one of these trusts might be a good idea for you, consult with a local attorney experienced in setting up trusts before you proceed.
