Should Your Children be Trust Fund Kids?
What do you picture when you hear the term “trust fund kid?” For many, the phrase conjures up images of wealthy, over-privileged teenagers driving fancy cars, attending expensive private schools, and spending summers basking on yachts in the Mediterranean.
But these days, that’s a stereotype with little basis in fact. “Trust funds aren't just for the uber-wealthy anymore—more people than ever are faced with making crucial financial decisions for their heirs,” says Hillary Hoffower, Senior Reporter on millennial wealth for Business Insider. “Middle-class citizens can set up trust funds too.”
In reality, trust funds can be powerful estate planning tools for families from all sorts of socioeconomic backgrounds. But before you can decide if a trust fund is right for your children or grandchildren, it’s important to understand what a trust fund is, how it works, and the possible advantages and disadvantages that may arise for you and your heirs.
What Is a Trust Fund?
Financial education website The Balance defines a trust fund as “a special type of legal entity that holds property for the benefit of another person, group, or organization.”
In layman’s terms, a trust fund is a flexible account that offers a number of important advantages for families looking to manage their assets wisely. Depending on the type of trust you establish, you can use it for a variety of purposes, including (but not limited to):
- Reducing estate or gift taxes
- Distributing assets to heirs while minimizing the hassles of probate court
- Providing charitable gifts
- Ensuring the financial well-being of family members with special needs
- Protecting assets from lawsuits and creditors
Trust funds are also a popular choice for families who want to ensure their children and grandchildren under the age of 18 will be beneficiaries of their estate, but also want to be able to set specific rules that control how the assets will be distributed and used.
How Does a Trust Fund Work?
Trusts typically involve three parties or entities: the grantor, who sets up the fund; the beneficiary, who the fund is established for; and the trustee, who oversees the fund. Trusts can hold anything of value, including money, real estate, stocks—even art and antiques.
How a particular trust fund works depends on the type of trust that is established and the rules that the grantor creates. When setting up a trust, It is the grantor’s responsibility to determine how the assets will be managed and what requirements must be met in order to trigger distributions to the beneficiaries. The grantor is also responsible for choosing a trustee to manage the fund.
Although there are many different types of trusts, the two main types are revocable trusts and irrevocable trusts.
A revocable trust, also known as a living trust, is one that’s created during the grantor’s lifetime that can be modified or revoked at any time. Although revocable trusts are helpful in terms of avoiding probate (i.e., the process of establishing a will), they do not protect assets from potential creditors or lawsuits (such as in the event of a bankruptcy).
Conversely, an irrevocable trust is one that, once created, can’t ever be modified or revoked—not even by the grantor. Once an irrevocable trust is established, the grantor no longer owns or controls the assets.
The main advantage of an irrevocable trust is that the assets are legally off-limits to creditors. That means the beneficiaries are guaranteed access to the funds no matter what financial problems may befall the family.
What Are the Advantages of Setting Up a Trust for Your Child?
A well-planned, well-managed trust can give your child or heir a solid head start on adulthood. It can also provide them with guaranteed financial security later in life, or ensure your assets are distributed only to certain family members in the unlikely event of your child’s untimely death. Again, it is entirely up to you, the trustmaker.
For example, you can choose to set up a trust fund to pay for your child’s college education, with the stipulation that they can access the remainder of the funds only after they graduate. Or, you may decide to set up the trust in such a way that the assets are disbursed to your adult child only at certain ages, e.g., 25, 35, and 45.
You might also choose to hinge the gifts on certain events, tagging some for college, some for a wedding, or a portion toward the purchase of a first home. You can make these events discretionary—your child will still receive regular increments of money, but the trustee can distribute more for specially-tagged needs.
When it comes to setting aside assets for minors, trusts also have a major advantage that many other types of accounts do not: beneficiaries cannot access the funds until the age of 18. Until that time, the assets should be managed by a reliable trustee.
What Are the Disadvantages?
One possible disadvantage involves taxation. Although it’s true that trust funds are often set up in part to shield assets from being taxes, trust fund distributions can be a problem. To avoid having beneficiaries pay heavy taxes on distributions, the trust needs to be very carefully structured. Trust taxation is very complicated, so it’s always essential to consult a tax professional—preferably one who specializes in trusts—when creating one for your heirs.
Another possible disadvantage is setting up a trust fund for a child who is not prepared to handle the responsibility. The last thing you want is to inadvertently set up a trust that your heirs will squander it as soon as they come of age. The best way to avoid this is to structure the trust in such a way that the money is distributed over time or for a specific purpose, instead of in one lump sum.
One way to accomplish this is via what’s called a “spendthrift trust.” With a spendthrift trust, money is distributed to the beneficiary over time, under the supervision of an independent trustee. “Under this type of arrangement, generally, the trustee or trustees are given broad discretionary powers to provide beneficiaries with funds—income and/or principal—to maintain their lifestyle, without allowing them direct access to the principal,” says certified public accountant Rob Clarfeld, writing for Forbes. “For example, Mom and Dad can establish a trust for the benefit of a child who spends injudiciously and shows signs of being financially irresponsible.”
Another possible disadvantage has to do with financial aid for your child’s college education. If your child fills out the FAFSA (Free Application for Federal Student Aid), they’ll be required to report their trust fund, which can significantly reduce the amount of money they receive.
The Bottom Line
There’s no question that trust funds are complicated financial instruments. There are a number of variables to consider, and poor planning can lead to unintentionally poor outcomes. However, with proper planning, careful analysis of your family’s unique needs, and the help of an estate planning professional, a trust could be the perfect way to ensure your offspring benefit from your hard-earned money—without spending all that money at once.