A trust is a legal entity created to benefit a specific party. People use trusts for many purposes, such as managing family assets, supporting charitable goals, and reducing certain taxes. Brokerage accounts opened for trusts are considered fiduciary accounts.
Numerous parties with different responsibilities can be involved in a trust.
The grantor is the person who creates and funds the trust. The grantor uses legal services to create a trust agreement, which is the document that establishes the trust. Some grantors hire attorneys, while others use digital services like LegalZoom. Either way, the trust agreement lays out the trust’s objectives, how it will be managed, and who the beneficiaries are. Trusts can serve many goals, such as funding a child’s college education or caring for an elderly parent.
The grantor names trustees in the trust agreement. Trustees manage the trust as fiduciaries and must follow the grantor’s instructions. When a trust account is opened at a brokerage firm, trustees have the authority to trade and transact in the account.
The trust is managed for the sole benefit of its beneficiaries, which may be a person or an organization (for example, a charity). Beneficiaries don’t have direct control over the trust because trustees manage it. Even so, trustees must act for the benefit of the trust and its beneficiaries.
It’s possible for one person to serve in all three roles. One individual could be the grantor, trustee, and beneficiary at the same time.
Trust accounts are fiduciary accounts, but they aren’t subject to the same suitability standards as typical fiduciary accounts. Many fiduciary accounts are managed conservatively (for example, a court-appointed guardian managing the assets of an incapacitated person). With a trust, the grantor can authorize a more aggressive investment approach in the trust agreement.
Trust accounts can also be opened as margin accounts (accounts that allow borrowing) as long as the trust agreement specifically permits it. When a brokerage firm receives a trust account application, it requests the trust agreement to confirm whether margin is allowed.
When creating a trust, the grantor must decide whether it will be revocable or irrevocable. Each choice has trade-offs.
Revocable trusts, also called living trusts or inter vivos trusts, can be amended during the grantor’s lifetime* if needed. The grantor can change the trust agreement’s terms, including the trust’s objectives, trustees, beneficiaries, or even whether the trust continues to exist (it can be terminated). The main advantage of a revocable trust is flexibility.
*Revocable trusts become irrevocable upon the death of the grantor. The trust agreement provisions may not be changed once the grantor passes away.
Another benefit of a living trust is avoiding probate. As discussed in the previous chapter, assets left to a person’s estate go through probate, which can be time-consuming and expensive. Almost all trusts (except testamentary trusts, discussed below) include instructions for distributing trust assets when the grantor dies.
A drawback of revocable trusts is that they don’t avoid certain taxes:
Estate taxes can be substantial when they apply, which is an important consideration for clients using revocable trusts.
Irrevocable trusts require the grantor to give up control of the trust assets, and the grantor can’t serve as trustee (grantors can serve as trustees on revocable trusts). The trust agreement generally can’t be changed, so the lack of flexibility is a key drawback.
The main benefit of an irrevocable trust is tax-related:
As a result, irrevocable trusts can avoid significant estate taxes* when the grantor dies.
*Although estate taxes are not a concern for irrevocable trusts, contributions made to these trusts upon creation are subject to gift taxes.
A trust can also be classified by how it handles income distributions to beneficiaries.
Simple trusts must distribute investment income* to beneficiaries each year. They also may not distribute principal (basis). In fact, distributing principal terminates the trust. Simple trusts have certain tax benefits, but you likely won’t be tested on the details.
*Income distributed by a trust to its beneficiaries is referred to as distributed net income (DNI).
Complex trusts are trusts that don’t meet the requirements of simple trusts. In particular, they may accumulate investment income rather than distributing it annually.
A testamentary trust is created through a person’s will. As covered in the previous chapter, many people use a last will and testament to direct how their assets will be distributed at death. With help from a legal resource (such as an estate attorney), a testamentary trust is written into the will and becomes effective when the person dies. Assets identified in the will are then transferred into the trust.
Because wills are part of estate settlement, a testamentary trust is generally the only type of trust that goes through probate. Assets held in testamentary trusts are also subject to estate taxes.
A joint trust is a living trust created by two people, usually married spouses. Joint trusts matter in estate planning because ownership structure affects what happens at death. There are several types of joint trusts:
Tenants in Common (TIC): A TIC structure can allow each spouse to own a defined percentage of the assets. At death, that portion does not automatically pass to the survivor, it passes according to the deceased’s will or trust.
Joint Tenants with Right of Survivorship (JTWROS): The ownership is equal and undivided. When one joint owner dies, their interest automatically passes to the other surviving joint owner, avoiding probate.
Joint Beneficial Ownership (JBO): This refers more broadly to multiple parties sharing the benefits of trust assets, regardless of legal title. It applies to how income, control, and access are shared. It is used for both trust and non-trust arrangements.
Sign up for free to take 10 quiz questions on this topic