The Basics of Using Trust Funds to Protect and Preserve Wealth
A trust fund is a type of legal arrangement in which a trustee holds title to property, such as stocks, bonds, or real estate, and administers it for the benefit of another person or institution, known as the beneficiary, according to the terms of the trust instrument.
I have long been a proponent of using trust funds as a way to build wealth for future generations but many new investors tend to shy away from concepts they think are only for the rich.
Although trusts have an association with blue blood families and powerful moguls, trust funds can make a lot of sense even if you are a widowed grandmother who just wants to leave $30,000 to a grandchild to help him complete his or her education.
In this introductory article, my goal is to break down the basics of trust funds for you so that, five minutes from now, you can answer these three questions:
- What is a trust fund?
- How is a trust fund structured?
- Why would I, or other investors, consider using a trust fund?
What Is a Trust Fund?
A trust fund is a special type of legal entity that holds property for the benefit of another person, group, or organization. There are many different types of trust funds and many different trust fund provisions that change how they work. Generally speaking, all trust funds have three important parties:
- The Grantor: This is the person who establishes the trust fund, donates the property (such as cash, stocks, bonds, real estate, mutual funds, art, a private business, or anything else of value) to the fund, and who decides the terms upon which it must be managed.
- The Beneficiary: This is the person for whom the trust fund was established. It is intended that the assets in the trust, though not belonging to the beneficiary, will be managed in a way that will benefit him or her, as per the specifics laid out by the grantor when the trust fund was created.
- The Trustee: The trustee, which can be a single individual, an institution (such as a bank trust department that appoints one of its staff to the responsibility), or multiple trusted advisors, is responsible for overseeing that the trust fund maintains its duties as laid out in the trust documents and applicable law. The trustee is often paid a small management fee. Some trusts give responsibility for managing the trust assets to the trustee, while others require the trustee to select qualified investment advisors to handle the money.
How Is a Trust Fund Structured?
Trust funds are a fictional entity given life by the state legislature of the state in which the trust was formed. Certain states have advantages over others depending on what it is the grantor is attempting to accomplish, which is why it is so important to work with a qualified attorney when drafting your trust fund documents. Some states permit so-called perpetual trusts, which can last forever, while others will forbid such entities for fear of creating another landed gentry class that results in future generations inheriting large amounts of wealth that the beneficiaries did not earn. One of the most popular provisions inserted into trust funds is the so-called “spendthrift” clause. What this means in plain English is that the beneficiary cannot pledge the assets of the trusts, or dip into them, to satisfy his debts. This can make it impossible for profligates to find themselves destitute after they incur large gambling debts, for example. Why? The casinos probably won’t be able to touch the principal. It is a way for concerned parents to make sure their irresponsible children don’t end up homeless or broke, regardless of how terrible their life decisions are.
Why Would I, or Other Investors, Consider Using a Trust Fund?
In addition to the creditor protections that can be enjoyed, there are several reasons trust funds are so popular:
- If you don’t trust your family members to follow the letter of your intentions following your passing, a trust fund with an independent third-party trustee can often alleviate your fears. For example, if you want to make sure your son and daughter from a first marriage inherit a lake cabin that must be shared among them, you could use a trust fund to do it.
- There are some significant tax advantages that can be achieved when using trust funds. For example, setting up a so-called Charitable Annuity Trust or Charitable Remainder Trust can make it possible to shield thousands, or even millions, of dollars from taxes, while benefiting your favorite charity.
- Trust funds can be used in a way that maximizing estate tax bypasses so you can get more cash to more generations further down the family tree.
- Grandparents often set up trust funds for their grandchildren, designed to pay educational expenses and then distribute any additional principal following graduation as start-up money to establishing a life.
- Trust funds can protect assets that you cherish, such as a family business, from your beneficiaries. Imagine you own an ice cream factory and feel tremendous loyalty towards your employees. You want the business to continue being successful, and run by the people who work in it, but you want the profits to go to your son, who has an addiction problem. By using a trust fund, and letting the trustee be responsible for overseeing management, you could achieve this. Your son would still get the financial benefits of the business but he would have no say in running it.
- There are some interesting ways to transfer large sums of money by using a trust fund, including establishing a small trust that buys a life insurance policy on the grantor. When the grantor passes away, the insurance proceeds are distributed to the trust, funding it. That money is then used to acquire investments that generate dividends, interest, and rents for the beneficiary to enjoy.
Please keep in mind that, while I hope it has been helpful, this is a brief overview of trust funds. To learn more, you may want to read The Complete Book of Trusts, which provides a great overview of 60 different types of trust funds and the reasons each is used. Please note that whether or not a trust fund is appropriate for your situation will depend on your unique circumstances, what you want to accomplish, and even the laws of your particular state. It is of the utmost importance that you discuss your needs with a qualified trust attorney, your accountant, and your registered investment advisory firm.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
Article by: Joshua Kennon