Whether you’re the recipient of a trust fund or you’re setting one up for the benefit of someone else, it’s important to understand the basics of how trusts work. Trusts can be complicated, but they’re also helpful estate planning tools that allow people to pass their wealth down, while in many cases bypassing the expensive and time-consuming probate process.
Keep in mind that I am not a lawyer and this post is for informational purposes only. Also, trusts are state-specific, so it’s important to reach out to an estate planning attorney in your area for your specific estate planning needs.
What Is a Trust Fund?
A trust fund allows a person (the grantor) to set aside assets like cash, investments, real estate, and life insurance for the benefit of one or more beneficiaries. The trust is managed by a trustee, who can be a professional (financial institution, attorney, or financial advisor) or someone the grantor knows personally. Professional trustees are paid for their management services out of the trust.
The grantor works with an estate attorney to select the terms of the trust: Will assets be distributed to beneficiaries while the grantor is still alive, or after they pass away? Will the grantor maintain the right to continue making changes to the trust, or will they give up all ownership of the assets placed into the trust? Will the trust pay out a certain sum of money to charities in addition to a beneficiary?
These decisions all affect whether or not the assets in the trust are considered part of the grantor’s estate when they pass away, and whether or not they’d be subject to estate taxes as a result.
There are two types of trusts with important qualities that affect the grantor’s control of the assets in trust, as well as the tax ramifications to the grantor’s estate:
- Revocable trusts allow the grantor to keep control over the assets in the trust and change beneficiaries. They can even undo the trust entirely! The grantor can also name a successor trustee to manage the trust for them if they become incapacitated. However, the grantor is still considered the owner of all the assets, so when they pass away, the assets are subject to estate taxes. Also, if they die with debts, the assets may be used to pay those debts off.
- Irrevocable trusts can’t be undone by the grantor, who can’t make any changes to the trust terms or the beneficiaries once it’s created. The grantor is no longer the owner of assets placed into an irrevocable trust, so they wouldn’t be subject to estate taxes when the grantor passes away, and creditors can’t go after those assets to pay off the grantor’s debts.
Both revocable and irrevocable trusts avoid probate. Keep in mind that this is just a high-level explanation. There are different types of trust within these two types, and some revocable trusts become irrevocable upon the grantor’s death. That’s why working with an estate attorney in your state is so important!
One of the big choices to make when setting up a trust is deciding how the assets should be paid out. Here are a few of the main ways a beneficiary can receive their trust fund assets:
Receive the Trust All at Once in a Lump Sum (or a Few Large Payouts)
The most straightforward way to come into a trust fund is to get all of the assets at once. The grantor may stipulate that the beneficiary receive the assets when reaching a certain age or life milestone (such as turning 30 or graduating from college).
Another way to receive money from a trust is in several large payouts. For example, if you are the beneficiary of a trust, some of the proceeds may have been used to pay for your college. Then the rest of the money might be paid out over the next few decades. I’ve seen clients have the following set up: at age 25 they receive 25% of the trust, at age 30 another 25%, and at age 35 the remainder of the trust.
Getting a large amount of money or investments at once can be a blessing and a curse. On the one hand … you get a lot of money! On the other, figuring out what to do with so much money (and any emotions that come along with it, depending on your relationship with the grantor) is not easy. I’ve had quite a few clients have conflicting feelings about inheriting assets. It can be helpful to work with a financial planner to figure out how to honor this money in a way that makes sense for you in your current life stage, as well as setting aside a portion for your future self.
Receive Smaller Payments From the Trust Over a Period of Time
The grantor may divide up the trust fund payout into even smaller increments. One example would be a monthly payout from the trust for the rest of your life. Often times, trustees are able to distribute trust assets to beneficiaries for “general well-being.” One distribution method is so common it is often referred to as “HEMS”, which stands for: health, education, maintenance, and support.
Grantors may choose to dole out many smaller payments to beneficiaries instead of one large one as a protective measure. Maybe they worry the beneficiary will blow through a large trust fund payment quickly, or they don’t want the beneficiary’s spouse to have a claim to half the money should they get divorced.
For the grantor, the upside of structuring trust payouts in this way is that you help the beneficiary treat the trust as more of a source of income than a windfall. The downside is that the trust will need to be managed by a trustee for a longer time, which adds to the administrative costs of the trust.
How Trust Fund Payouts Are Taxed
How a trust is taxed depends on how it’s structured. First, it helps to understand the sources of trust payouts: the principal and the income. A trust’s principal is the value of the original assets — the cash deposited or the price paid for the investments, for example. The principal may generate an income in the form of interest paid on the principal.
Simple trusts may not hold onto the income earned by the principal, so they must distribute that income to beneficiaries (you can’t distribute the principal — also called the trust corpus — or pay money out of the trust to a charity). Complex trusts may hold onto earned income, distribute income or principal to beneficiaries, and make distributions to charitable organizations.
I turned to Catherine Moseley, a CPA in Ohio, for some expert advice on how trusts are taxed.
“Well, the answer is, ‘it depends,’” she said. “How the trust funds are paid out, be they principal and earnings (interest, dividends, capital gains, other, etc.), depends on the dictates of the trust document. Some are written that the trust will pay the income taxes, but most are silent on this issue. In that case, the trustee makes the decision as to if the trust or the beneficiaries will be liable for the income tax payment.”
If the beneficiaries are liable to pay taxes, anything they receive from the trust is taxed at their income rate. If the trust pays the taxes, the trust is taxed at trust income tax rates.
For 2019, the estate tax exemption is $11.4 million per person, up from $11.18 million in 2018. For a couple, that amount doubles to $22.8 million. That means that you can inherit up to that amount as a beneficiary before owing any federal estate tax. However, you may be subject to a state estate tax in your state since those amounts are usually much lower.
I’d Like to Set Up a Trust. What Do I Do?
As you can see, there are many options available when it comes to creating a trust. If you’re considering setting up a trust, consult an estate attorney in your state. Do not try to use an online solution for complex estate planning needs. A trust will allow you to avoid probate when you pass away. If you don’t have a trust and you die, your assets could be subject to probate, which means that they become public knowledge. A trust can help protect your legacy while giving your loved ones privacy during a difficult time.
If you’ve begun to receive payouts from a trust, it’s an excellent time to work with a financial planner. They can help you apply a lump sum of money toward your big goals like paying down debt or buying a home, or help you adjust your budget to accommodate monthly payouts from a trust.