Testamentary Trust vs Living Trust
An estate constitutes the total financial value of a person’s belongings at the time of their death – including their real estate, personal property, investments, financial instruments, and sentimental possessions. When you die, all of these things must go on to be distributed among the living. The probate process is meant to help facilitate this distribution, both with and without the help of documents like a last will.
However, there are ways to manage and distribute your belongings outside of probate. Trusts are one of the most common tools for doing so. The main reason to use a trust to bypass probate is for flexibility. The probate process is rigid and lengthy. Every step requires a court’s approval, and the bigger the estate, the longer it takes.
Trusts can help estates slim down before their big date in court, but they also offer other benefits such as potentially reducing an estate’s tax liability, managing wealth for a financially illiterate beneficiary, turning a financial legacy into a moral one through continuous contributions to charities, research projects, and humanitarian efforts, or growing a family’s fortune over multiple generations.
However, not all trusts are created equal. Unlike the general template of the last will and testament, different types of trusts are built for radically different purposes. Understanding how trusts work can give you a greater insight into the complexities and possibilities of estate planning.
What is a Legal Trust?
A trust is best defined as an agreement between three parties: the trustor, the trustee, and the beneficiary. These three parties do not need to be three separate entities – even a single person can set up, manage, and absolve a trust entirely for themselves if they so choose.
However, in the context of an estate plan, most trust are designed by the trustor (the person commissioning and funding the trust), to be managed by a trustee (someone put in charge of maintaining the trust’s contents later on), and to be distributed eventually to multiple beneficiaries.
A trust’s functions and scope are outlined in the trust document – but the trust itself is more than a piece of paper. Unlike a will or an advance directive, a trust is a separate legal entity, one that can hold onto property, albeit “in trust” (for someone else).
People sometimes compare trusts and wills, but they are two very different things. A trust is almost always used in tandem with a will, because while the trust can be used to manage or separate assets from the larger estate, the will is what ultimately determines how an estate is distributed in probate.
A trust’s flexibility helps explain why it is a multipurpose tool. You can use a trust to isolate an asset from your own risk and liability – allowing you to preserve it, despite bankruptcy proceedings or angry creditors. You can use a trust to create a fund for a loved one who might be sick, or unable to manage their finances alone. You can even assign a financial trustee with a fiduciary duty to do what is in the beneficiary’s best interest. You can use trusts to combine your and your spouse’s individual tax exemptions, to avoid a hefty estate tax on the combined wealth one of you will leave behind at their end of life.
The exact kind of trust you want to create will depend on:
- The assets the trust should hold.
- How long the trust should exist.
- When the trust should start existing.
- The kind of asset protections the trust should enable.
- Whether you’re okay with creating an irrevocable trust.
- Whether you prefer to be able to revoke and control your trust.
- The ages and financial competencies of your beneficiaries.
- Your state’s limit for a small estate affidavit, or expedited probate process.
- And more.
Trusts are either testamentary or living, and either revocable or irrevocable. All testamentary trusts are irrevocable.
What is a Testamentary Trust?
A testamentary trust is one that is only called into existence upon your death. Many testamentary trusts are written to be executed upon the reading of the last will. Like any other trust, testamentary trusts involve three parties – the trustor, who created the trust and left instructions as to how it should be funded; the trustee, who will manage the trust once it is called into life; and the beneficiaries, for whom the trust is designed.
A distinct disadvantage of a testamentary trust is that it cannot avoid probate. These trusts are usually written to be triggered upon the reading of the will, which requires probate to begin. Furthermore, they are irrevocable because they only go into effect upon the trustor’s death. Lastly, testamentary trusts offer none of the benefits to the trustor that a living trust might have offered.
On the other hand, there are advantages as well. Testamentary trusts can be a simple way to assign a financial guardian for a minor beneficiary’s inheritance.
If one of your beneficiaries is under the age of majority, you can utilize a testamentary trust as a failsafe to ensure that, if you pass away sooner than expected, their wealth will be managed for them until they are ready to manage it themselves. Unlike other arrangements, a testamentary trust can also be written to manage wealth for a beneficiary until other requirements are met – such as becoming 21 or finishing school.
Furthermore, testamentary trusts do not employ the services of a trustee until after the trustor is dead. This means the trustor would not have to pay the trustee to manage their trust while they are still alive.
What is a Living Trust?
As the name implies, a living trust is defined by the fact that it can be called into life immediately after signing and notarizing the trust agreement. When a living trust is created, it can be funded by the trustor and managed by the trustee right away.
Living trusts can be used for more than just estate planning. Some politicians and non-profit organizers utilize blind trusts to place their investments and financial holdings in the managing hands of an impartial and independent trustee. The trustee has a fiduciary duty to the trustor but cannot tell them how or where they have invested their money, to avoid conflicts of interest.
Most importantly, a living trust bypasses probate entirely. Anything funded into a living trust is no longer part of the trustor’s probatable estate. This is doubly true for irrevocable trusts, which create an additional degree of separation.
However, living trusts also come with their own disadvantages. The biggest one is cost. A living trust requires compensation for every month or year that the trustee manages it. When the trustor themselves acts as trustee to their trust (until a successor trustee is called upon), that cost can be minimized, but it sacrifices some of the trust’s utility as a vehicle to avoid liability.
Are Living Trusts Preferred?
The more complex an estate plan, the more that plan might benefit from a flexible trust. Testamentary trusts can be a useful tool to protect a child’s inheritance until they are ready for it, but most use cases for trusts in and outside of estate planning involve living trusts.
If you wish to create a trust of your own, it is important not to work alone. Trust agreements can be complex and require specific legal language to operate properly. Work with an experienced estate planning professional for the best possible results.