How To Set Up a Trust Fund

Many people view trust funds as tools to protect the wealth of the very rich or to provide their heirs, sometimes derided as “trust fund babies,” with independent incomes freeing them from the need to earn a living.  However, trust funds vary in complexity and purpose—preserving assets designated for charities, retirement funds, public works, and more.

Trust funds may be used by individuals, even some of modest means, who wish to set aside assets for specific purposes. For example, affluent, but not necessarily ultra-rich, parents and `grandparents create college trust funds to pay for children’s post-secondary education. To avoid potential family conflicts, widowed and divorced couples entering second marriages may use trust funds to hold property for children of their first marriages. 

Structure and Operation

Regardless of their size and purpose, all trusts have the same basic structure and terminology.   The terms “trust” and “trust fund” often are used interchangeably. Although closely related, they have different technical meanings.

The term “trust” refers to the legal arrangement evidenced in a written agreement transferring property from a “grantor” to a “trustee” for specified purposes. The trustee has the fiduciary responsibility to hold and manage the property in accordance with the directions in the agreement and in the best interests of the trust’s beneficiaries.

A “trust fund” refers to the property transferred by the grantor to the trustee, the “corpus” of the trust.  While the word “fund” suggests a trust is comprised of financial assets, almost any type of property—including real estate, art, patents, or copyrights—can comprise all or part of a trust fund.  

Revocable Grantor Trusts: Ownership Retained

In some circumstances, grantors designate themselves as the trustee and retain ownership and control of trust assets. Such a grantor trust may be used to avoid the cost, time, and potential publicity associated with probate of an estate.  In addition, a grantor may create a “revocable trust,” by limiting the term that the trust remains in effect or retaining the right to end the arrangement. Grantor trusts serve a variety of purposes but do not offer tax savings.

In the case of a trust that is revocable by the grantor, the grantor continues to be liable for any taxes due on trust income and the assets may be available to the grantor’s creditors. Employers create grantor trusts to identify and segregate assets to back future liabilities for employee
retirement benefits. Some public officials transfer stockholdings and other investments to “blind trusts” to be managed by a third party without the officials’ knowledge during their tenure in office, in order to avoid potential conflicts of interest. 

Irrevocable Trusts

When the grantor permanently transfers ownership and control of property pursuant to a trust agreement to a third-party trustee, the trust is irrevocable. The grantor of an irrevocable trust no longer owns the transferred assets, is not responsible for taxes due on the income from or the disposition of the assets, and the trust assets cannot be claimed by the grantor’s creditors. These trusts—which are widely designed as college trust funds and to provide financially for children and grandchildren—also allow grantors tax- and estate-planning benefits.  

Trusts for Individuals

Frequently irrevocable trusts are used to hold assets for the benefit of family members, usually children or grandchildren. These arrangements also can provide tax- and estate-planning advantages.  Grandparents often appoint a parent as trustee of a trust for grandchildren.  As a trustee, a parent must comply with the trust’s directives. A trust may grant the trustee limited discretion with respect to some actions, provided the actions are in the beneficiaries’ best interest and not for the trustee’s benefit.

Depending on the terms of the arrangement, beneficiaries may receive income and/or assets from the trust fund during the lifetime or after the death of the grantor. For example, the trustee of a college trust fund may be directed to use trust income to pay tuition expenses directly to the school and to pay or reimburse the beneficiary for college living expenses.  Distributions also might be scheduled upon attainment of a specified age or a particular event. Beneficiaries’ use of the
trust distributions may be limited to specific purposes, e.g., medical expenses or a down payment for a home, or left to the beneficiaries’ choice.

How Are Trusts Managed?

Trusts are managed by their trustees, who may be individuals or trust departments of banks and other financial institutions. Trustees are obliged to carry out the grantors’ directives set forth in the trust agreement. Typically, their responsibilities include the collection of income, disposition and replacement of assets, and distributions to beneficiaries. Distributions may be required on a prescribed schedule, e.g., monthly, annually, or for specific purposes, e.g., tuition and educational expenses.  

Trustees are compensated for their work, unless—as sometimes occurs with family member trustees—the fees are waived. The management of trust assets includes record-keeping and reporting, and legal and tax compliance.  Creating and documenting a trust with a limited amount of financial assets and simple, clear directives usually entails legal fees of a few thousand dollars and low annual expenses. Expenses increase, and could become very significant, the greater the value and variety of trust fund assets and the complexity of a trust’s terms.

In addition to trustee fees, trusts may incur expenses for financial and investment advisors, attorneys, accountants, property managers, brokers, and other necessary professionals for the trust. Financial institutions’ trust departments generally charge annual fees of 1% to 2% of the value of trust assets, with the rate declining as values increase. Some large investment firms—especially those that offer mutual funds for retirement and other personal accounts—offer standardized, relatively low-cost trust services.

With some firms, individuals who use online services for banking and investment accounts may establish trust fund accounts directly online. However, a substantial trust, particularly one with varied assets, likely will incur significant costs from its formation through its operation and ultimate termination. Thus, when deciding whether to establish a trust, it’s important to consider its costs in relation to the anticipated benefits and the availability of alternative arrangements that might cost less.

Estate Planning and Trusts for Children

Trusts can help parents and grandparents plan for their offspring’s financial needs and, at the same time, complement their own tax and estate planning. For many families—not just the wealthiest—trusts can be effective tools. However, those considering creating trusts should investigate whether there are simpler and less expensive alternatives for their purposes.

Parents whose total estate values exceed—or seem likely to appreciate to—values that eventually exceed the estate tax threshold, set at $11,700,000 per individual estate for 2021 ($12.06 million in 2022), can remove assets from their estates by transferring ownership to trusts.  With the gift tax exemption set at $15,000 ($16,000 for 2022), each parent and grandparent can make a gift of up to the exemption limit annually per recipient without incurring gift tax. If the value of a gift exceeds that amount, the excess is taxable, but the tax isn’t due until the total of “excess” gifts exceeds the estate tax threshold. Only then are the excess gifts added back to the value of the remaining estate and taxed.  

Affluent families with “spare” assets may take advantage of trusts to limit the value of their estates and to reduce a high rate of tax on their annual taxable income to the rate imposed on their children’s income, which is generally lower.  Any appreciation in the transferred asset ultimately belongs to the beneficiaries.

For example, assume an investor bought 100 shares of Apple stock in 1980 at its IPO price of $22 per share, a total price of $2,200 and immediately transferred the shares to a trust for a newborn child. If the trust held onto the shares, through five stock splits, as of November 4, 2021, the trust for the now 41-year-old child would own 22,400 shares of Apple at a value of S150.96 per share, for a total value of $3,381,504. The trust would pay capital gains tax on the gains on its disposition of appreciated shares. However, if the trust distributes the appreciated stock to the beneficiary, there is no tax on the transfer; the beneficiary will be liable for any tax due when the stock is later sold.  The original $2,200 gift to the trust would have been below the 1980 gift tax exemption of $3,000 and would not count against the parent’s estate tax exemption.

Also, if assets paying dividends or interest are transferred to an irrevocable trust, the grantor will not owe tax on the income. Instead, the trust must pay tax, at rates from 10% to 37% on annual income for 2021 that is not distributed during the year.  Annual income distributed to a
grantor’s child  can be taxed under the “kiddie tax” at rates lower than the grantor’s presumably higher rates. Income is taxed at the minor child’s rate up to an annual ceiling—$2,200 in 2021 ($2,300 in 2022). Distributed trust Income above the ceiling, is taxed at the parents’ tax rate.

Alternatives to Trusts for Education

Trusts can help parents and grandparents plan for children’s future financial needs. While some trusts for children might be established principally to deal with tax and estate planning, financing a child’s education, especially college expenses, probably is the most frequent reason that families consider creating trusts. For many, trusts can be effective tools. However. for families who are not ultra-rich, there are alternative vehicles that can be more efficient than college trust funds. 

When planning to sets aside funds for future college costs, it is important to evaluate additional vehicles and strategies that may provide equal or greater tax benefits for parents or grandparents and to consider the potentially adverse impact of trusts and other resources on students’ eligibility for scholarships and loans.  

The most common alternatives to college trust funds are direct payments to the college on behalf of a grandchild, contributions to a section 529 plan, or setting up either a Uniform Gifts to Minors Act (UGMA) account or a Uniform Transfer to Minors Act (UTMA) account.  Section 529 plans and UGMA and UTMA accounts can be set up through banks and financial institutions and thus can be less costly and involve less personal administrative and management responsibility than independently established trusts.

Research the fees charged by different 529 plan sponsors before choosing one. Some investment firms sponsor plans that have no upfront or management fees; other brokers and advisors charge relatively high fees that lower the plans’ returns.

Another option is a Coverdell ESA. These can be established for children under age 18 for qualified elementary, secondary, and post-secondary educational expenses. Unlike the other two options, there are income limitations: A contributor to a Coverdell ESA must have a modified adjusted gross income, of less than $220,000 for a joint return and $110,000 for a single return.

Section 529 Plans

Section 529 plans are programs established by states or their agencies that enable a contributor to prepay—or contribute to an account to prepay—a beneficiary’s qualified educational expenses. Contributions are not tax deductible but earnings and distributions for qualified expenses are
tax-free.  Funds may be used to pay tuition and necessary expenses for both post-secondary and K-through-12 schools. Funds also can be used to repay student loans up to a lifetime limit of $10,000. In the case of K-12 education, an annual limit of $10,000 of expenses may be paid with funds from the section 529 plan. The beneficiary generally can exclude the earnings and distributions from taxable income.

Generally, these 529 plans offer investment options that are limited and conservative.  Before investing in a 529 plan, fees charged by different plan sponsors should be compared. Some investment firms sponsor plans that have no upfront or management fees; their earnings are based on the charges for the mutual fund investments that they offer and manage for the plans. However, some brokers and advisors charge relatively high fees that lower the plans’ returns.

Parents and grandparents establishing section 529 funds can maintain control over the accounts and distributions, and even change the beneficiary. Contributions to a section 529 plan can be front-loaded. Five years of annual gifts of up to $15,000 from one individual, a maximum of $75,000, can be contributed at one time without incurring a gift tax or reducing the contributor’s lifetime exclusion. (Starting in 2022, the gift-tax limit rises to $16,000, allowing contributions to max out at $80,000.) If both grandparents give, that five-year gift could rise to $150,000 ($160,000 in 2022),

Because contributions can be substantial, especially if front-loading is chosen, establishing these accounts for young children can result in significant tax-free savings for college.  However, in some cases, these plans—or the distributions from them—will negatively affect an otherwise qualifying student’s ability to obtain needs-based financial aid.

UGMA and UGTMA Custodial Accounts

Custodial accounts can be established for underage beneficiaries under the Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA). Both entail irrevocable transfers of assets to accounts for minors. Transfers are nontaxable to the beneficiary up to the annual gift tax limit. The assets must be transferred from the custodial account to the beneficiary upon an attaining age set by state law, generally 19 or 21 years.  Although not limited to educational financing, these vehicles often are used as a simplified form of college trust fund.

Earnings on these accounts up to the child’s annual taxable income ceiling, $2200 for 2021 ($2,300 for 2022), are taxable at the beneficiary’s tax rate, which is generally lower than parents’, grandparents’, or other contributors’ tax rates.  Income above the ceiling is taxed at the parents’ rate. UGMA accounts are limited to money and financial securities while UGTA accounts can hold tangible and even risky assets, such as art and real estate. As savings vehicles, these accounts can be used to provide funds to beneficiaries for any purpose, not just educational expenses.

Coverdell Education Savings Accounts (ESAs)

Coverdell ESAs can be established for children under age 18 for qualified elementary, secondary, and post-secondary educational expenses. Contributions must be made in cash and are not tax deductible. The maximum total of contributions for a beneficiary cannot exceed $2000 per year. Earnings are not taxed; distributions also are tax-free, provided they are used for qualified educational expenses. A contributor to a Coverdell ESA must have a modified adjusted gross income, i.e., generally adjusted gross income plus excludible non-U.S. earnings and housing allowances, of less than $220,000 for a joint return and $110,000 for a single return.

Other Trusts

Only imagination and law limit the uses of trusts. Federal and state laws expressly recognize and provide benefits for trusts that help individuals with disabilities. In particular, special needs trusts and ABLE program accounts enjoy legal recognition.

Special Needs Trusts

A special needs trust is a legal arrangement to provide financial assistance for an individual with disabilities while maintaining that person’s eligibility for government benefits that are based on needs, for example Medicaid and Supplemental Security Income. These trusts must be operated for the sole benefit of the beneficiary, who must be under the age of 65 when the trust is created. It pays for costs that are not covered by Medicare or Medicaid.

If the trust is established with assets owned by the individual with disabilities, it generally must be irrevocable and must provide that Medicaid will be reimbursed upon the beneficiary’s death or the trust’s termination. Specialized professional advice is important in the creation and operation of these arrangements because state laws impose varied, complex requirements.

ABLE Programs

The tax code also provides benefits for persons experiencing disabilities or blindness through tax benefits for state-sponsored savings programs established under the Achieving a Better Life Experience Act of 2014 (ABLE). Contributions to ABLE accounts must be in cash and are not tax deductible.  Earnings and distributions used for qualified disability expenses are tax-free and the accounts do not count against eligibility for other federal assistance programs.

The Bottom Line

Trusts can be extremely useful arrangements for designating assets for specific purposes. Differences in legal structure and terms significantly affect trusts’ tax impact, asset protection, and benefits.  In some cases, alternative vehicles that can be more efficient and less costly may be preferable.  Careful evaluation is critical and professional advice may be necessary. Moreover, because of a history of abuse of trust structures for tax evasion, the proper structuring and operation of trusts are essential. 

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