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Understanding Trust Accounts and Their Basic Purpose

A trust account is a legal arrangement where one person or organization holds money or property on behalf of another person. The person who creates the trust is called the grantor or settlor. The person or entity who manages the trust is called the trustee. The person who benefits from the trust is called the beneficiary. This three-part structure has been used for centuries in legal systems around the world.

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Trust accounts serve many different purposes in financial and legal planning. Some people create trusts to manage money for children until they reach adulthood. Others use trusts to avoid probate, which is the court process that happens after someone dies. Some individuals create trusts for tax planning purposes. Business owners sometimes use trusts as part of their succession planning. People with significant assets may use trusts to keep their financial matters private, since trusts do not become public record like wills do.

The trustee has a legal responsibility called a fiduciary duty. This means the trustee must act in the best interest of the beneficiary, not in their own interest. The trustee must follow the instructions written in the trust document. Trustees must keep detailed records of all money coming in and going out of the trust. They must file tax returns for the trust if required. Trustees can face legal consequences if they mishandle trust funds or fail to follow the trust terms.

Trust accounts can hold different types of assets. Common assets in trusts include real estate, bank accounts, investment accounts, life insurance policies, and business interests. Some trusts hold only money, while others hold a mix of different assets. The type of assets in a trust affects how the trustee manages it and what taxes may apply.

Practical takeaway: Learning about trust basics helps you understand why trusts exist and what role each person plays in a trust arrangement. This foundation makes it easier to understand more complex trust topics and whether a trust might be useful in your situation.

Different Types of Trusts and How They Work

Several main categories of trusts exist, each designed for different situations and goals. A revocable trust, sometimes called a living trust, can be changed or canceled by the person who created it while they are alive. A revocable trust becomes irrevocable when the grantor dies, meaning it cannot be changed after that point. Many people use revocable trusts as part of their estate planning because they offer flexibility during life and can help avoid probate after death.

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An irrevocable trust cannot be changed or canceled once it is created, except in rare circumstances. People create irrevocable trusts for specific purposes like protecting assets from creditors, reducing estate taxes, or qualifying for government programs that look at assets. Once you transfer money or property into an irrevocable trust, you no longer own those assets legally, even though they may benefit you. This permanent nature makes irrevocable trusts a serious decision that requires careful thought.

A testamentary trust is created through a will and only comes into existence after the person dies. This type of trust does not exist during the grantor's lifetime. Testamentary trusts can be useful if you want certain conditions attached to how your property is distributed. For example, you might want money held in trust for a young child until they reach age 21, rather than giving them the money immediately. However, testamentary trusts go through probate because they are created by will.

Charitable trusts are designed to benefit charitable organizations. A charitable remainder trust pays income to the grantor or other beneficiaries for a period of time, then transfers the remaining assets to a charity. This type of trust can offer tax benefits to donors while still providing income. A charitable lead trust works in the opposite way, giving income to a charity first, then transferring remaining assets to family members or other beneficiaries.

Special needs trusts are created for people with disabilities. This type of trust can hold money without disqualifying the person from government benefits like Supplemental Security Income or Medicaid. A special needs trust gives a trustee the ability to spend money on things that improve the beneficiary's quality of life while protecting their benefit eligibility. Special needs trusts require careful drafting to comply with government program rules.

Practical takeaway: Trusts come in many forms, each designed for different family situations and financial goals. Understanding the differences between these types helps explain why one trust might make sense for one person but not another. If you think a trust might fit your situation, this information provides a starting point for conversations with a legal professional.

Trust Accounts and Tax Considerations

Trusts have tax implications that differ from individual tax situations. When a trust earns income from interest, dividends, or capital gains, the trust may owe federal income taxes on that income. Some trusts must file a Form 1041, which is the income tax return for trusts and estates. The requirements for filing depend on how much income the trust earned and what type of trust it is. Trusts that distribute all their income to beneficiaries may not owe taxes themselves, because the beneficiaries report the income on their own tax returns instead.

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Income that a trust distributes to beneficiaries flows through to those beneficiaries for tax purposes. If a trust earns $5,000 and distributes all of it to a beneficiary, that beneficiary reports the $5,000 on their own tax return, not the trust. However, if the trust keeps some income and only distributes part of it, the situation becomes more complex. The trust pays taxes on the income it keeps, and the beneficiaries pay taxes on the income they receive.

Estate taxes may apply to very large trusts. The federal government charges an estate tax on estates above a certain value. As of recent years, this threshold is quite high, around $12 million per person, but this amount changes based on tax law changes. Some states also charge their own estate taxes at lower thresholds. Irrevocable trusts can sometimes reduce estate taxes because assets in an irrevocable trust are no longer part of your estate for tax purposes. This is one reason people with substantial wealth use irrevocable trusts.

Capital gains taxes apply when a trust sells assets that have increased in value. If a trust owns stock that was purchased for $10,000 and sells it for $15,000, the $5,000 gain is subject to capital gains tax. The tax rate depends on how long the trust held the asset and what type of beneficiary receives the gain. Long-term capital gains, from assets held more than one year, usually have lower tax rates than short-term gains.

The "step-up in basis" is an important concept in trust taxation. When someone dies, the assets in their estate generally receive a new tax value equal to what they were worth on the date of death. This means if someone bought stock for $10,000 and it was worth $50,000 when they died, the heirs would receive the stock with a basis of $50,000. If they later sold it for $50,000, they would owe no capital gains tax. This step-up applies differently depending on whether assets are in a trust or held individually.

Practical takeaway: Trust accounts have their own tax rules that are different from individual taxation. The tax situation depends on the type of trust, what income it earns, and how it distributes money to beneficiaries. Working with a tax professional or accountant who understands trust taxation helps ensure compliance with tax laws and may identify ways to reduce tax burden.

Setting Up a Trust Account: Steps and Requirements

Creating a trust involves several clear steps. First, you need to decide what type of trust meets your needs. This decision depends on your family situation, your assets, your goals, and your timeline. Someone who wants to avoid probate and maintain privacy might lean toward a revocable living trust. Someone concerned about creditor protection might consider an irrevocable trust. Someone with a child with special needs might create a special needs trust. Taking time to think about your actual situation helps clarify which type of trust makes sense.

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Next, you typically work with an attorney who practices estate planning or trust law. The attorney will ask questions about your family, your assets, your wishes, and your concerns. They will explain the legal implications of different choices. They will draft a trust document that outlines all the terms of your trust. This document should be specific and clear, because it becomes the instruction manual for how your trustee manages the trust. The cost of having an attorney draft a trust varies widely depending on complexity and location, but typically ranges from a few hundred dollars to several thousand dollars.

After the trust document is created, you must fund the trust by transferring assets into it. For real