A trust can be a useful estate planning tool, in addition to a will. You can use a trust to remove assets from probate, potentially minimize estate and gift taxes and ensure that assets are managed on behalf of beneficiaries according to your wishes. There are different types of trusts you can establish and some are more specialized than others. Knowing how these broad categories of trusts compare can help with choosing the right option. When it comes to estate planning, including whether to create a trust, a financial advisor can help you make the most informed decision possible.
What Is a Trust?
A trust is a type of legal entity that can be created in accordance with your state laws to manage your assets. The person who creates a trust is called a grantor and they have the right to transfer assets into the trust. They can also choose one or more trustees to oversee the trust and manage the assets within it.
The trusteeâs job is to manage assets according to the grantorâs specifications on behalf of one or more trust beneficiaries. For example, you might set up a trust to hold assets that you want to be distributed among your three children when you pass away. Or you might choose your favorite charitable organization to be a beneficiary of your trust.
There are many different kinds of trusts and they can be categorized in different ways. For instance, a revocable trust can be changed during the grantorâs lifetime. If you have this type of trust and you want to add assets to it or change the beneficiaries, you can do so while youâre still living. An irrevocable trust, on the other hand, involves a permanent transfer of assets.
Trusts can also be categorized as grantor or non-grantor. In a grantor trust, the trust creator retains certain powers over the trust, including rights to the trustâs assets and income. Trust assets may be included in the trust creatorâs estate when they pass away. With a non-grantor trust the trust creator has no interest or control over trust assets. Trust assets are generally excluded from the trust creatorâs estate at their death.
Benefits of Trusts in Estate Planning
Trusts can be used inside an estate plan to perform a number of functions. For example, you might create a trust to:
- Pass on specific assets to your chosen beneficiaries
- Ensure that certain assets arenât subject to the probate process
- Manage estate and gift tax liability
- Protect assets from creditors
- Ensure that a special needs beneficiary is cared for when youâre gone
- Receive the proceeds of a life insurance policy when you pass away
Some of these scenarios may call for a simple trust, while others may require a more specialized trust. One thing thatâs important to keep in mind is how each one is treated for tax purposes when creating a simple vs. complex trust.
Simple Trust, Explained
A simple trust is a type of non-grantor trust. To be classified as a simple trust, it must meet certain criteria set by the IRS. Specifically, a simple trust:
- Must distribute income earned on trust assets to beneficiaries annually
- Make no principal distributions
- Make no distributions to charity
With this type of trust, the trust income is considered taxable to the beneficiaries. Thatâs true even if they donât withdraw income from the trust. The trust reports income to the IRS annually and itâs allowed to take a deduction for any amounts distributed to beneficiaries. The trust itself is required to pay capital gains tax on earnings.
Complex Trust, Explained
A complex trust also has certain criteria it must meet. In order for a trust to be complex, it must do one of the following each year:
- Refrain from distributing all of its income to trust beneficiaries
- Distribute some or all of the principal assets in the trust to beneficiaries
- Make distributions to charitable organizations
Any trust that doesnât meet the guidelines to qualify as a simple trust is considered to be a complex trust. Complex trusts can take deductions when computing taxable income for the year. This deduction is equal to the amount of any income the trust is required to distribute for the year.
There are also some other rules to keep in mind with complex trusts. First, no principal can be distributed unless all income has been distributed for the year first. Ordinary income takes first place in the distribution line ahead of dividends and dividends have to be distributed ahead of capital gains. Once those conditions are met, then the principal can be distributed. And all distributions have to be equitable for all trust beneficiaries who are receiving them.
Simple vs. Complex Trust: Which Is Better?
When it comes to simple and complex trusts, one isnât necessarily better than the other. The type of trust that ultimately works best for you can hinge on what you need the trust to do for you.
A simple trust offers the advantage of being fairly straightforward when it comes to how assets and income can be distributed and how those distributions are taxed. A complex trust, on the other hand, could offer more flexibility in terms of estate planning if you have a sizable estate or numerous beneficiaries.
When comparing trust options, consider whether you want to retain control or an interest in the assets that are transferred to it. If you choose a simple or complex trust, youâre choosing a non-grantor trust which means youâll no longer have an interest in the trust assets. Talking to an estate planning attorney or trust professional can help you decide which type of trust may work best for your financial situation.
The Bottom Line
The main difference between a simple vs. complex trust lies in how income and assets are distributed and how those distributions are taxed. Whether it makes sense to establish a simple vs. complex trust can depend on the size of your estate, the nature of the assets you want to include and your wishes for managing those assets. Itâs important to understand the tax rules before creating either type of trust as well as how a trust fits into your larger estate plan.
Tips for Estate Planning
- Consider talking to a financial advisor about whether it makes sense to use a trust to plan ahead for the distribution of assets or to manage estate and gift taxes. If you donât have a financial advisor yet, finding one doesnât have to be complicated. SmartAssetâs financial advisor matching tool can help you connect with a financial advisor in your local area. It takes just a few minutes to get your personalized recommendations online. If youâre ready, get started now.
- While trusts can offer numerous benefits, creating one doesnât necessarily mean you donât also need a last will and testament. You can use a will to distribute assets that you donât want to include in a trust. Or you could create a pour-over will to transfer assets into a trust.
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