Navigating the World of Trust Funds: Your Quick Guide

By Markets Fool.com

Many folks assume that trust funds are only for the rich, but in reality, people with all kinds of economic circumstances can benefit from them. A trust fund is a special legal arrangement that allows a benefactor to arrange for certain assets to go to someone else.

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There are various types of trust funds that can serve as useful estate-planning tools. You might consider a revocable or irrevocable trust, a credit shelter trust, a generation-skipping trust, or a qualified personal-residence trust. Let's explore these options to see which might be best for you.

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Revocable trusts

Also known as a revocable living trust, a revocable trust allows you to manage your trust during your lifetime. When you set up the trust, you can establish yourself as the trustee in charge of overseeing its assets. You can also move assets in and out of the trust as you see fit, or terminate the trust if your circumstances change.

Revocable trusts come with a fair amount of flexibility and can work well for average-income and wealthy folks alike. One major benefit they offer is the ability to bypass probate, the often-extensive (and expensive!) legal process by which a court decides how to distribute the assets of someone who has passed. If you're concerned about estate taxes, a revocable trust might also help you minimize the burden on your beneficiaries.

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Irrevocable trusts

An irrevocable trust is the opposite of a revocable trust -- it can't be altered or terminated without the consent of the trustee and the trust's beneficiary or beneficiaries. Once you transfer assets into an irrevocable trust, you no longer have any rights to them. The main benefit of an irrevocable trust is saving money on estate taxes.

Once you transfer assets into an irrevocable trust, they're no longer considered yours, so they're excluded from your estate's value for tax purposes. Along these lines, assets placed in an irrevocable trust can't be touched by creditors or anyone who initiates a lawsuit against you. Furthermore, if you hold assets that you believe will appreciate a great deal over time, you can transfer those assets into the trust to not only remove them from your taxable estate, but ensure that any future appreciation on those assets isn't subject to taxes.While an irrevocable trust involves a more serious long-term commitment than a revocable trust, it could be a good choice if you have a larger estate.

Among the different types of irrevocable trusts, irrevocable life insurance trusts are fairly popular. With this type of arrangement, you transfer your life insurance policy into the trust so that your death benefit isn't included in your estate. This move could save your beneficiaries a fair amount of money on taxes depending on the value of your death benefit.

Credit shelter trusts

A credit shelter trust can help wealthy married couples lower their estate taxes by maximizing federal and state exemptions. Currently, the first $5.45 million of an estate is exempt from federal taxes. If your estate exceeds this amount, then a credit shelter trust may be right for you.

If you set up a credit shelter trust, the assets in that trust will be transferred to your beneficiaries upon your death, but your spouse can maintain his or her rights to the assets contained in the trust for the rest of his or her life. At the same time, those assets won't be counted as part of your spouse's estate, which can help your family take advantage of available tax exemptions.

Though credit shelter trusts can be a useful tool for couples, thanks to a recent development known as the portability law, they're less useful now than they once were. In a nutshell, this law allows the first spouse who dies to transfer his or her unused estate tax exclusion amount to the surviving spouse, who can then apply it to his or her own estate. While portability was first approved as a temporary provision in 2011, it has since become a permanent part of the federal estate tax system.

Generation-skipping trusts

As the name implies, a generation-skipping trust is one that you establish for the benefit of your grandchildren, as opposed to your children. You might go this route if you don't want your children to get their hands on your assets, but in most cases, these trusts are used to avoid estate taxes more so than family drama.

If your children inherit your estate directly, and the value of your estate exceeds the current exemption limit, your children will be hit with hefty taxes on their inheritance. Then, when that estate is passed on to your children's children, they, too, will be taxed on whatever exceeds the limit. While generation-skipping trusts are still subject to taxes, they can be structured in a way to reduce estate taxes so that affluent families can preserve their wealth for future generations.

In fact, one big advantage of generation-skipping trusts is that they can help you avoid more than just regular old estate taxes. You see, those who gift assets to beneficiaries at a skipped generational level (such as a grandparent gifting assets to a grandchild directly) can get hit with what's known as a generation-skipping transfer tax. However, you can structure a generation-skipping trust to avoid this tax.

Qualified personal residence trusts

A qualified personal residence trust is a way to leave your home to your beneficiaries while reducing your estate taxes. Under this type of legal arrangement, you can transfer your property deed into the trust while retaining the right to live there for a certain period of time. Once that period ends, your beneficiaries can inherit your home, and they'll only need to pay taxes on the value of the home at the time of the deed transfer. Since property values can increase significantly over time, a qualified personal residence trust can be useful in locking in a lower value for gift tax purposes.Furthermore, you can claim a lower value of the gift for your beneficiaries based on their delay in actually receiving the property.However, if you die while living in your home, it will count as part of your estate and be taxed according to its value at the time.

Trust funds can be an integral part of your estate-planning strategy, and you don't have to be rich to set one up. You do, however, need to speak to a qualified attorney, and do your research to see which type of trust is the best one for you.

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