What Are the Different Types of Trusts? Explained and Compared
Trusts are versatile financial instruments with many uses and benefits. However, there are several different types of trusts in existence, each with their own unique characteristics, and therefore different uses and relative strengths and weaknesses.
Before deciding to form a trust, it is important to have a thorough understanding of how trusts are classified and the various types which exist. This will help you to make an informed choice on the right type of trust for you, and understand its various terms and features.
We will start with a general explanation of what a trust is. We will then look at the main trust categories before going over the various types of trusts which exist within these categories. Finally, we will discuss how to decide which trust is the best type for you.
Table of Contents:
- What Is A Trust?
- What Are The Main Trust Categories?
- Living Trust Vs Testamentary Trust
- Revocable Vs Irrevocable Trust
- The Different Types Of Trusts
- Asset Protection Trust
- Spendthrift Trust
- Qualified Terminable Interest Property Trust (QTIP Trust)
- Charitable Trust
- Life Insurance Trust
- Which Type Of Trust Should You Choose?
What is a Trust?
A trust is a legal agreement between three parties: the grantor/settlor, the trustee, and the beneficiary/beneficiaries. The grantor transfers assets into the trust’s possession, which are overseen by the trustee (who acts as a neutral third party in the best interest of the trust). The beneficiary is the party who ultimately receives the benefits of the assets in one form or another. The way in which the benefits are distributed will depend primarily on the terms of the trust. Some types of trusts allow the grantor to also be the sole beneficiary, meaning there are really only two parties involved in the trust agreement.
Trusts are most commonly used either as estate planning tools for transferring assets to heirs in an efficient manner, or as asset protection vehicles to protect one’s own wealth from lawsuits and other risks. There are also various other purposes for forming a trust, such as to optimise taxes, increase financial privacy, access better investment opportunities, diversify one’s asset portfolio, and so forth.
What are the Main Trust Categories?
Trusts can broadly be categorised in two ways. The first is to classify the trust according to whether it is a living trust or a testamentary trust. The second is to classify it as revocable or irrevocable. It is important to note that any trust type can be categorised along both of these lines. In other words, it will be either a living trust or a testamentary trust, and it will be either revocable or irrevocable. For example, an asset protection trust is both a living trust and an irrevocable trust because:
- It is created while the grantor is alive (living trust) and,
- The terms cannot be changed after inception (irrevocable trust).
We provide a more detailed explanation and comparison of these categories below:
Living Trust vs Testamentary Trust
All trusts are set up by the grantor/settlor, and will either be a living trust or a testamentary trust.
A living trust (aka inter vivos trust) is created while you are alive. Most trusts are living trusts, and they have a variety of purposes, including:
- Efficient transfer of your estate to your beneficiaries thanks to the avoidance of probate procedures. This can save time and legal costs, as well as reduce estate taxes.
- Asset protection, as in the case of specialised irrevocable asset protection trusts.
A testamentary trust is a trust that is set up after you die according to your last will and testament. Testamentary trusts are interesting in that the terms can be changed at any time during your lifetime (as they depend on your final will), yet once established after your death, they generally take the form of an irrevocable trust. So, in a practical sense, they are as flexible as revocable living trusts for you, the grantor. This is because you can alter the terms at any time before the trust’s inception, which only happens after your death. However, the terms become fixed once you pass away, which protects the trust from any malicious tampering after that time.
Revocable vs Irrevocable Trust
The difference between a revocable and an irrevocable trust is easy to understand by the names. To put it simply:
A revocable trust is a trust that allows you to alter or terminate (revoke) the trust after it has been created. In other words, you remain in full control of the assets in the trust, and are even legally still seen as the owner of the assets during your lifetime. With a revocable trust, you are allowed to name yourself as the primary trustee and appoint a successor trustee to take over in the event that you die or become incapacitated.
The advantages of a revocable trust include:
- Flexibility, because the terms of the trust can be altered at any stage, and you can add or remove assets from the trust as you please.
- Optimises the transfer of your estate to beneficiaries by circumventing costly and lengthy probate procedures.
- Can provide greater overall tax efficiency depending on tax laws and conventions in the jurisdiction in which you and the trust are based.
An irrevocable trust is one that cannot be changed or modified in any way after it has been established. It is a completely separate legal entity from the grantor, and once you have transferred your assets into the trust, you are no longer the legal owner of those assets. Unlike a revocable trust, the grantor of the trust is not allowed to name themselves as the trustee, and must instead choose a third party to act as the official trustee of the trust.
An irrevocable trust clearly provides less flexibility than a revocable trust, so you might be wondering why it is ever worthwhile opting to establish an irrevocable trust?
The main benefit of an irrevocable trust is that it offers a much greater level of protection to the assets that you transfer into the trust. This is because you are no longer the legal owner of the assets, which makes it difficult for a creditor or plaintiff to lay claim to the assets in relation to a personal obligation you have. The irrevocable trust effectively creates a shield for the assets, and the price for this shield is a certain amount of loss of control.
There are well-crafted irrevocable trusts such as the asset protection trust (APT), which allow the grantor to simultaneously be the sole beneficiary and therefore retain practical control and benefits related to the assets, while remaining legally separated.
Along with strong asset protection, other benefits of an irrevocable trust include:
- Reduction in taxes (specifically estate and gift tax) by removing the assets from your personal estate.
- Increased financial privacy by removing your personal name from the ownership of the assets. This is enhanced with offshore irrevocable trusts.
- Allows you to tailor the way in which your assets are handled after death, without the risk of the terms of the trust being manipulated by malicious parties.
- Removes the risk of rash decisions or those made out of mental impairment that could negatively alter the trust terms (i.e., a way to protect you from your future self or from being manipulated by others).
The Different Types of Trusts
There are a wide range of specific types of trusts that fall within the categories mentioned above. It is important to note that these types of trusts are not separate from the primary classifications previously mentioned. We can in fact think of them as the sub-categories that come after the main classifications.
Testamentary trusts and living trusts are often also referred to as individual types of trusts on their own (without any specific sub-categorisation). As we have discussed the features of these two types of trusts above, we won’t go over them again here. We will instead look at the more specialised types of trusts, all of which are classified as either revocable or irrevocable.
Some of the most well-known special types of trusts are:
Asset Protection Trust
An asset protection trust (APT) is a special type of irrevocable trust that allows you to be both the grantor of the trust and the sole beneficiary at the same time. You only need appoint a trusted third-party trustee to oversee the assets in the trust. The trustee acts as per your wishes except if the assets are under direct threat of seizure (e.g., if there is a court case against you), in which case they can exercise their power as trustee to protect the assets in the trust.
An APT is one of the most effective and widely used asset protection tools available. It provides a strong layer of protection by removing legal ownership and having irrevocable terms, while allowing you to retain control and benefits of the assets for all practical intents and purposes. APTs have been used with success to protect assets from creditors, legal disputes, and other judgements against the grantor’s estate.
A spendthrift trust allows you to tailor the terms of the trust to specify exactly when and how the assets are distributed to the beneficiaries, as opposed to them simply receiving a lump sum upon your death. This is particularly useful for transferring an estate to your children where you believe they may not be mature enough to manage the funds properly. You can specify that they receive the benefits in instalments over time, or that they only get allocated regular income from the assets.
Qualified Terminable Interest Property Trust (QTIP Trust)
A QTIP trust allows you to allocate the assets in the trust or income from those assets to different beneficiaries at various times. One example would be to allocate a fixed monthly income from the trust to your spouse while they are alive, and then the remaining assets to your children after your spouse dies. This can stop your spouse from receiving the total capital value of the trust assets and ensures that your children will finally receive the benefits of the estate, while still providing for your spouse with the regular income payments.
A charitable trust distributes assets to a charity or non-profit organisation of your choice upon death. There are different types of charitable trusts, but they are most commonly living and revocable in nature. They allow the charity to receive a greater share of assets as they reduce or completely avoid estate and gift taxes.
Charitable trust terms can also be added to a standard living trust so that your heirs receive a fixed portion of the estate, and the charity receives the remainder. This is known as a ‘charitable remainder trust’.
Life Insurance Trust
A life insurance trust is a type of irrevocable trust with the function of holding the proceeds of your life insurance policy when it is paid out. This allows the insurance pay-outs to be invested as they are received. It also means that the trustee can distribute the pay-outs to your beneficiaries without them incurring any estate taxes.
Other Trust Types
The above list is by no means exhaustive, but covers some of the most frequently used and popular trusts. Other types of trusts worth mentioning for you to do your own additional research on include:
- Joint trust
- Totten trust
- Constructive trust
- Special needs trust
- By-pass trust
- Generation-skipping trust
- Credit shelter trust
- Blind trust
- AB trust
Which Type of Trust Should You Choose?
It should be clear by now that there is no one-size-fits-all solution when it comes to establishing a trust. Each type of trust has its own unique set of features which makes it useful in certain circumstances and useless in others. It is exactly this wide versatility of trusts that have made them such popular and effective financial tools.
In order to determine which type of trust you should choose; you must first have a clear understanding of your own situation and what your objectives are for opening a trust. You should then consult directly with an asset protection attorney or other trust fund expert to help you decide which type of trust is best for you. They will also be able to guide on where and how to establish the trust in the most effective and affordable way. Doing your own prior research and having a basic understanding of the different types of trusts available and how they operate will definitely smoothen the process and help ensure that you get exactly what you are looking for.
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