Preserving Generational Wealth: The Trust Fund

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In: Financial Literacy

Author: Mark Roychowdhury, Graphics: Ria Raniwala

The BRB Bottomline:

Seven in 10 families lose their wealth by the second generation. Nine in 10 lose their wealth by the third. The root causes? Poor financial decisions, economic downturn, excessive debt — the list goes on. How can this trend be reversed? Trust funds may just be the solution.

The Trust Fund

Overview

A trust fund is a legal document that allocates to a legal entity the responsibility of holding and maintaining assets for an individual. These assets cover a variety of classes, including cash and cash equivalents, fixed income securities, real assets, and equities. As such, examples of trust fund assets are very diverse, and often include bank accounts, bonds, real estate, vehicles, businesses, and stocks.

A trust fund is typically composed of three parties: the settlor, the trustee, and the beneficiary. The settlor — also known as the grantor — is the one who first creates the fund for the purpose of securing assets. The trustee — who can be either an individual or an agency — is the neutral entity responsible for managing the fund in a way that satisfies the settlor’s interests. The beneficiary — who can be one or multiple individuals — benefits from the assets within the fund. 

At its core, the trust fund is an estate planning tool, meaning its primary purpose lies in planning out how an individual’s assets will be handled after their death. Poor financial decisions are one of the leading causes of lost generational wealth, making trust funds an especially helpful tool for those looking to preserve their assets. When creating a trust fund, the settlor is able to place certain restrictions on how their beneficiaries will receive their assets. The control they provide and their wide range of uses make trust funds far more versatile than alternative estate planning tools.

Speaking of other estate planning options, how exactly does a trust fund differ from a will? Three main differences separate the two documents:

  1. A will is a legal document that explicitly details how the creator intends to distribute their assets after their death. A trust fund relies on a trustee who is given the task of distributing the creator’s assets in a way that suits their original interests and thus has more room for interpretation. 
  2. A will remains private throughout the duration of the creator’s life and only becomes active upon their death. A trust fund can be controlled throughout the creator’s life.
  3. A will requires probate — a lengthy court process undergone when a settlor passes away and assets must be transferred — while a trust fund does not. 
Speaking of other estate planning options, how exactly does a trust fund differ from a will? Three main differences separate the two documents:

1. A will is a legal document that explicitly details how the creator intends to distribute their assets after their death. A trust fund relies on a trustee who is given the task of distributing the creator’s assets in a way that suits their original interests and thus has more room for interpretation. 

2. A will remains private throughout the duration of the creator’s life and only becomes active upon their death. A trust fund can be controlled throughout the creator’s life.

3. A will requires probate — a lengthy court process undergone when a settlor passes away and assets must be transferred — while a trust fund does not.

Types of Trust Funds

There are over a dozen types of trust funds that settlors can open for various purposes. While each type of fund is unique and has its respective advantages and disadvantages, they can generally be categorized as either a revocable or irrevocable trust fund. 

The Revocable Trust Fund

A revocable trust fund, as the name suggests, allows a settlor the freedom to remove assets from the trust at any time and freely transfer them to any beneficiaries during their life. The settlor is also capable of terminating the trust and changing the restrictions imposed on the assets. In this sense, the settlor effectively acts as both the settlor and the trustee, as they have the power to manage the fund as they see fit. However, a trustee may still be hired to manage the trust’s assets and will be responsible for distributing those assets to the beneficiaries in the event that the settlor is physically unable to do so.

Besides the inherent flexibility that a revocable trust fund offers, another key benefit that its beneficiaries enjoy is the avoidance of probate. A probate, as mentioned above, is a court procedure initiated for the purpose of transferring an individual’s estate after they pass away. It is an extremely lengthy process that can take anywhere from nine months to upwards of a year and a half. Additionally, the process can cost a large amount of money, depending on the size of the creator’s assets and the state of residence. In California, for example, statutory probate fees on the first $1,000,000 worth of assets are listed as follows: 4% of the first $100,000, 3% of the next $100,000, and 2% of the next $800,000. Critically, only the assets placed in a trust fund can be distributed without probate; any assets that are left out will require some form of legal procedure to determine how they will be distributed. 

Drawbacks do exist for revocable trust funds as well, one of which is an increased vulnerability to creditors. Because a revocable trust fund can be controlled by its settlor, the settlor still maintains ownership of its assets. As such, if the settlor were to go into debt, their creditors would be able to sue them and take their assets, possibly out of the trust fund. For the same reason, revocable trust funds unfortunately do not offer any tax advantages for the settlor. All income that is generated from the settlor’s assets remain liable to taxation, with no exceptions. 

The Irrevocable Trust Fund

Contrary to the revocable trust fund, the irrevocable trust fund does not allow a settlor to remove or transfer any assets from the trust unless permission is obtained from all beneficiaries or specific court orders are given. Because the settlor is unable to freely access the fund, they are not considered to be the owner of the fund’s assets.

Irrevocable trusts offer quite a number of benefits for both settlors and their beneficiaries. The first benefit, like with a revocable trust fund, is the avoidance of probate. Irrevocable trust funds also exempt settlors from paying estate taxes upon their death, translating to more wealth for their families. Additionally, it is impossible for creditors to successfully sue and take assets from settlors who open irrevocable trust funds. This is due to the fact that the settlor can no longer control any of their assets under an irrevocable trust and thus has no ownership. Finally, irrevocable trust funds can significantly reduce income taxes for the settlor. Any amount of money that is made from assets within the trust will thereby be untaxed and eventually passed down to the beneficiaries.

The main disadvantage of opening an irrevocable trust fund is its clear inflexibility, which imposes restrictions upon the settlor. The added difficulty of freely removing, adding, or transferring assets may pose a significant risk to settlors. For instance, if a settlor were to experience financial hardship after opening a trust fund, they would not be able to access any of their assets unless all beneficiaries consent or legal action is undertaken.

The Versatility of Trust Funds

Trust Funds and the Wealthy

In the U.S., trust funds have long been associated with wealthy families and spoiled children, birthing derogatory terminologies such as “trust fund baby,” “trust bum,” and “trustafarian.” 

But why does such a stereotype exist? To answer this question, it is important to examine the facts.

The wealthy clearly utilize trust funds to a great extent. But that still doesn’t answer the question as to why they do so. The answer to that lies how estate taxes are structured in the United States. In the U.S., all citizens with a combined estate of over $12.06 million are subject to federal estate tax. Tax rates can range from 18% on the first $10,000 above the threshold to a staggering 40% for the first $1,000,000. Even for the top 1% of earners, these rates are not trivial. A reduction of personal assets of just 18% could have grave consequences for the longevity of an individual’s wealth. But through an irrevocable trust fund, estate taxes can be significantly decreased or even avoided entirely.

Another reason why trust funds tend to be popular among the wealthy is for their creditor protection. Wealthy individuals, contrary to popular belief, often borrow large amounts of money for a variety of purposes, including raising capital for business, increasing mortgage interest deductions, and improving credit. In fact, the top 1% of earners — consisting of just 1.3 million households in the U.S. — account for 4.6% of all debt. The creation of a trust fund guarantees that creditors are unable to easily repossess assets from the settlor in case of default on a loan, thus allowing the wealthy to effectively embark on risky ventures without undertaking the actual risk. Trust funds also provide individuals working in high-stakes environments who are thus particularly susceptible to litigation with a way to secure their assets from creditors. Surgeons, lawyers, and real estate agents — who make up quite a large portion of the top 1% — often use this tool to maintain their wealth.

But the average person is not among the top 1% of earners, does not have to deal with the estate tax, and is far less likely to be involved in litigation. Is it still beneficial for lower-income families to invest in a trust fund?

Trust Funds and the Not-So-Wealthy

In most cases, the answer is “yes.” Trust funds are highly versatile and can offer advantages to a wide range of families, regardless of familial or financial situation. Detailed in the list below are some of the most useful types of trust funds that individuals can benefit from.

  • Irrevocable Life Insurance Trust (ILIT): The ILIT allows settlors to reduce their income tax by treating their life insurance policy as an asset and placing it into a trust. Besides the standard benefits that come with an irrevocable trust — such as creditor protection — the ILIT can also be used to avoid federal gift tax on transfers of up to $16,000.
  • Spendthrift Trust: Poor financial decisions can drain a family of its generational wealth. The spendthrift trust serves to prevent that by limiting a beneficiary’s access to the trust’s assets. Instead of receiving assets as a lump sum after the settlor’s death, the beneficiaries receive funds incrementally at various stages of their lives. Exactly when and how often this depends on the trust’s terms, which the settlor delineates upon establishment. On top of limiting poor financial decisions, spendthrift trusts offer credit protection to both the settlor and beneficiaries. 
  • Marital Trust: A marital trust is an irrevocable trust fund that is established when both spouses are living and healthy. When one spouse passes away, their assets are transferred into the trust, and all income that is generated from those assets is given to the surviving spouse. The main advantage that a marital trust provides is the unlimited marital deduction, which allows spouses to transfer assets to one another without incurring taxation.   
  • Blind Trust: A blind trust gives a designated trustee full control over the assets and investments within the trust fund. The trustee is charged with not only managing the assets but ensuring that a steady stream of income is generated over time. Unlike a typical trust, blind trusts are created in such a way that neither the settlor nor beneficiaries are aware of the investment holdings within. This type of trust is typically created to avoid a conflict of interest between personal affairs and professional duties. For politicians and senior government officials, this trust can be especially helpful in maintaining an ethical boundary between personal life and work.

Conclusion

Building generational wealth starts with preserving it. All too often, people focus their efforts on increasing their current paycheck rather than protecting the assets they already have. Sure, earning money is important, but what good is that money if it is lost in a generation? Signing a will may guarantee that an individual’s assets are properly passed down, but it has no bearing on how that wealth will sustain itself in the future. A trust fund ensures that wealth will last for generations to come by providing individuals with the ability to control when and how their assets will be distributed.

Take-Home Points

  • A trust fund is a legal document that establishes a legal entity to hold and maintain assets for an individual.
  • A trust fund is typically composed of three parties: the settlor, the trustee, and the beneficiary. 
  • A revocable trust fund, as the name suggests, allows a settlor the freedom to remove assets from the trust at any time and freely transfer them to any beneficiaries during their life.
  • The irrevocable trust fund does not allow a settlor to remove or transfer any assets from the trust.
  • In the U.S., trust funds have long been associated with wealthy families and spoiled children.
  • Trust funds are highly versatile and can offer advantages to a wide range of families, regardless of familial or financial situation.

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