Here's how a trust fund works to shelter your assets, distribute income, and manage taxes during and after your lifetime

Oliver Rossi/Digital Vision/GettyEvery type of trust fund works a little differently.

Setting up a trust gives you control over your money after your death, and sometimes even during your lifetime.

More specifically, trust funds can serve various purposes, from sheltering assets from estate taxes to paying yourself or your heirs an annual income to giving to charity. You can be as specific and conditional as you like when it comes to when, how, and to whom your assets are distributed, and some trusts are more flexible than others.

Because there are so many different types of trusts, there isn’t one single operational structure. Here are the basics.

How does a trust fund work?

A trust is a legal entity that can hold almost any asset, including real estate, bank accounts, investment accounts, business interests, and life insurance policies. You typically need to consult an estate planning attorney to set up a trust fund, although you may want to meet with a certified financial planner first to discuss which type of trust is best for your situation.

The type of trust and the trust documents themselves stipulate exactly how and to whom your assets will be distributed, whether that’s in the form of annual income paid to yourself or your beneficiaries, money or property to be transferred to your heirs, or gifts to charity at your death.

Trusts can shelter assets from going through probate, or the legal process that happens after a person’s death in which the courts handle the payment of debts and taxes, and distribute remaining property according to the will or state law.

Every trust has a grantor, beneficiary, and trustee

Three parties are involved in the operation of every trust: a grantor, who opens and funds the trust; a beneficiary, who is the person, people, or charity receiving the assets; and a trustee – the person, group of advisers, or organisation that has a fiduciary responsibility to manage the trust now and after the grantor’s death.

In some cases, there will also be a remainderman. This person or organisation (often a charity) is different from the beneficiary and inherits the remainder of the trust assets at the grantor’s death.

A trust will be revocable or irrevocable

Broadly, a trust must either be revocable (also known as a living trust) or irrevocable. This refers to the grantor’s ability to make changes to the trust after it is set up and funded. A revocable trust can be altered throughout the grantor’s life, while an irrevocable trust cannot. Once the grantor dies, a revocable trust becomes irrevocable.

In some revocable trusts, a single person can act as the grantor, beneficiary, and trustee during their lifetime. This means they fund the trust, earn income, and manage the assets. In an irrevocable trust, the grantor can also be an income beneficiary during their lifetime.

Who pays the income taxes?

If a trust pays out a portion of its assets as income, or holds assets that appreciate or generate interest income such as real estate or stocks, then the person receiving the money must pay income taxes. In a revocable trust, this is typically the grantor.

When an irrevocable trust distributes income to a beneficiary, they are responsible for paying taxes. If the income beneficiary is a charity, the trust will receive an income tax deduction. If the trust generates income that remains inside, it is taxed at the trust rates.

Who pays the estate taxes?

In a revocable trust, the grantor still owns all their assets. When they die, the assets are considered part of their estate (although the trust itself is now irrevocable) and may be subject to estate taxes. Since the person is deceased, the trustee acts as their stand-in and pays the taxes using money from the trust.

Irrevocable trusts cannot be changed and therefore exist to remove assets from a person’s gross estate before their death. In most cases, the trust is not responsible for estate taxes upon the grantor’s death, although there are at least two notable exceptions, 2503(b) and 2503(c) trusts, which are created for the benefit of minors.

How long does a trust fund last?

A trust fund can end when all the assets are paid out to the beneficiary. Oftentimes, however, assets continue to generate income. Rules vary by state for how long a trust fund can remain open, but many impose the “rule against perpetuities,” which says that a trust must expire no more than 21 years after the death of a potential beneficiary. Some states allow dynasty trusts, which can last for many years and are a tool for avoiding estate and generational wealth taxes.

Need help making a plan for your money? SmartAsset’s free tool can help find a financial planner near you »

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