What is a Trust Fund and How Does it Work?

Posted Dec 17, 2022

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The phrase "trust fund" invokes a vision of wealth, privilege, and even tax avoidance. However, there are many types of trusts, and they have varied purposes. Indeed, many intend to support the perpetuation of wealth and seek to manage taxes for both the grantor and the beneficiary. The grantor is the individual who establishes the trust, the trustee is the neutral third party responsible for managing and distributing the assets according to the grantor’s instructions, and the beneficiary is the recipient. In some cases, the trustee may also be a beneficiary.

Trust funds come in varieties.

Taxpayers may establish a trust to avoid probate. Revocable trusts are similar to wills because they arrange for the distribution of assets and because the trustor can revoke the trust or change the will as long as they are alive and capable. Because the trust is revocable, its assets remain the trustor's property and are subject to their tax rate. However, the trustee manages a revocable trust to benefit the beneficiary or beneficiaries. Since the trust directs the future distribution of assets, it can help avoid probate, but it doesn't confer any advantages for income taxes, estate taxes (if applicable), or capital gains.

While trusts have an advantage regarding avoiding probate, wills can be more helpful in expressing the deceased’s wishes regarding funeral plans and other issues like guardianship. If the writer of a will becomes incapacitated, the will can't be legally changed. Similarly, the incapacitation of a trustor will move a revocable trust into an irrevocable status.

Irrevocable trusts transfer assets to the beneficiaries (though managed by the trustee) while the grantor remains alive and can’t be altered or terminated without the consent of those beneficiaries. The primary motivation for establishing an irrevocable trust is that it can be an effective tax strategy if the grantor has a higher bracket than the beneficiaries.

When do beneficiaries receive distributions from trust funds?

The function of a trust fund is determined by the trustee—the individual who establishes it. The trustor can create the fund using specific instructions, including to whom to distribute the assets and when. For example, a trust fund might be structured so that the trustee tends to the assets until a beneficiary reaches a particular age or accomplishes a specific goal. The beneficiary might be eligible to gain access when they turn 25 or graduate from college or anything else the trustor requires. It’s up to the trustee to follow the trustor’s instructions.

What are the advantages of each type?

A revocable trust has the benefit of remaining under the trustor’s control. If the trustor changes their mind about the designation of beneficiaries, they can alter the trust accordingly. As mentioned, the trust also avoids the potentially lengthy probate process. However, a revocable trust does not provide protection from tax obligations or creditors as an irrevocable one does.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. 

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

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