How Does a Trust Fund Work?
Every trust fund has at least three important components:
● The grantor - The individual who initiated the creation of the trust and contributed assets to it.
● The beneficiary - The person or organization who will benefit from the assets held by the trust fund.
● The trustee - The person or organization that will manage the trust and oversee the distribution of its assets to the beneficiaries.
Note that in each case, there can be more than one grantor, beneficiary, and trustee.
Trust funds begin with their creation by the grantor. A well-written trust will describe its purpose and provide instructions for how the trust should operate. The grantor will also name the beneficiaries of the trust and appoint their trustees.
After a trust is written, it can then be funded with assets from the grantor. These can be any type of property such as savings, investments, a home, business ownership, etc. Depending on the type of trust, the grantor may or may not have access to these funds after they enter into the trust.
Types of Trusts
Although there are dozens of different types of trusts, it helps to categorize them into two major categories:
● Living trust vs Testamentary trust
● Revocable trust vs Irrevocable trust
Here are the differences:
● Living trust - A trust you create while you're still alive. They are also referred to as inter vivos trusts.
● Testamentary trust - A trust that is created after your death (generally according to your will).
● Revocable trust - A trust that can be changed or “revoked” by the grantor after its creation.
● Irrevocable trust - A trust that cannot be changed once it has been created. Assets that are moved into an irrevocable trust fund are effectively "gifted" away, and the grantor no longer has any rights to them.
These terms can be combined to create specific types of trusts. For instance, you may wish to create a living revocable trust or a living irrevocable trust.
What Are Trust Funds Used For?
Trust funds can be utilized for a variety of purposes. The following are a few of the most commonly used applications.
Estate Planning
Trust funds are primarily a tool for estate planning. This is because they provide far more legal protection for your beneficiaries than a last will and testament.
Unlike a will, trusts don’t have to pass through probate (i.e. the court process used to validate a will). Having the ability to sidestep the probate process is a very important advantage. It accomplishes two critical goals:
1. It protects your assets from potentially being seized by creditors during the probate process.
2. It allows your assets to be distributed to your beneficiaries without challenge from anyone else.
Generally in estate planning, the grantor will be an individual or couple who wishes to leave an inheritance to their adult children and/or grandchildren. They will begin by having a revocable living trust drawn up and making it the secondary beneficiary to the majority of their assets. This gives them the ability to retain ownership and usage of those assets throughout their lifetime.
Upon death, the revocable trust then becomes irrevocable. At this point, all of the assets that named the trust fund as the beneficiary will pass to it. Again, this keeps them out of probate and shields them from creditors. The trustees that were appointed can then begin making distributions according to the guidelines that were written into the trust.
Take notice that, unlike a will, trust fund assets do not have to be dispersed immediately. The trust could state that only a certain amount of proceeds should be sent to the beneficiaries each month or year until the beneficiaries reach a certain age. This is an important provision that grantors often purposely include to ensure that the beneficiaries don’t foolishly spend their entire inheritance all at once (especially if they are young).
Asset Protection
Trust funds can also be used while you’re living to provide legal protection for your property. This is generally in the form of an irrevocable living trust.
Again, it's worth repeating that once you move assets into an irrevocable trust, they no longer belong to you. They will be under the control of your appointed trustees who are obligated to carry out the goals of the trust at their discretion.
The reason some people choose to proceed with the creation of an irrevocable trust fund is that they want this legal separation. For example, consider a scenario where an individual with a high net worth is being sued by someone interested in gaining access to their wealth. If they have only a revocable living trust, then a judge could order them to transfer the assets to the plaintiff. However, if they have moved assets into an irrevocable trust fund, then they have no control over them, and those assets are therefore shielded.
This is common among households with second marriages. One of the spouses may have adult children from the first marriage they want to leave an inheritance to if tragedy were to occur. Usually, all of the assets will simply pass on to the new spouse leaving the children with nothing. Therefore, they can guarantee to leave some money to their children by setting up an irrevocable trust fund in advance and assigning them as beneficiaries.
Another way irrevocable living trust funds often get utilized is when applying for the U.S. government assistance program Medicaid. Elderly individuals who are unable to pay for the full cost of a nursing home will require the assistance of Medicaid. However, the rules of Medicaid are that this individual must first “spend down” their savings before they can qualify. This creates a problem where the elderly individual has virtually no assets left to leave to their loved ones.
Therefore, many people choose to implement a strategy where they begin transferring a portion of their assets into an irrevocable living trust several years before they believe they will need Medicaid. Since the assets will technically no longer legally belong to them, they are protected from the Medicaid spend-down rules, and this leaves them with something to bequeath to their heirs.
Non-Profit Organizations
One more place where trust funds get used often is within non-profit organizations. Since a typical company will have owners, this means that those individuals will have access to the company’s earnings and can do with them as they please. This would not be a desirable corporate structure for an organization such as a charity.
Therefore, the creators of the organization can choose instead to set it up as a charitable trust. Trustees can then be appointed or elected to determine how the funds inside the trust should be best put to use. An example of such an organization would be St. Jude Children's Research Hospital located in Memphis, Tennessee.
How Do You Set Up a Trust Fund?
Before a trust fund can be created, the first step is to write the trust. Trusts should only be made under the guidance of a quantified and experienced attorney.
Although there are some online platforms that offer the service of trust creation, they should be considered with caution. Depending on the language used and where you live, the rules for certain trusts may be different. For this reason, you won’t want to risk leaving any legal gaps or loopholes that challengers can use against you.
Once a trust is initiated, the grantors can decide how to fund them. Again, a revocable living trust is funded after death by the grantor simply naming the trust as a beneficiary. With irrevocable trusts, a separate account should be set up and managed.
Who Can Set Up a Trust?
Although there is a common perception that trust funds are only used by the rich and wealthy, the truth is that anyone can initiate their creation. Middle-class and upper-middle-class citizens are frequently finding that trusts are very effective mediums for protecting and transferring assets. Anyone with a net worth that includes more than their primary residence (i.e., savings, retirement accounts, business interests) would be wise to consider consulting with a trust lawyer.
The Bottom Line
Trust funds are used to hold and distribute assets to beneficiaries - in some cases, long after they’ve passed away. They’re an important tool used primarily in estate planning, but can also be utilized in a variety of ways while the grantor is still living.
Trusts aren’t just for the wealthy. Anyone with property that they’d like to receive legal protection can have a trust created. However, this should only be done under the guidance and supervision of a qualified attorney so that the trust fund can be properly enforced.