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April 07, 2014

How does a living trust work?

Establishing the trust

Typically, an individual creates and funds the trust, and names himself or herself as both the trustee and sole beneficiary for his or her lifetime (if married, both spouses are typically named beneficiaries). The grantor also names a successor trustee or co-trustee, as well as the beneficiaries who will receive any assets that remain in the trust at the grantor's death. Often, a spouse or child is named as the successor or co-trustee and is also named as an ultimate beneficiary.

Caution: In some states, a co-trustee is required.

The grantor continues to manage trust assets during his or her life. Any income earned or expenses incurred by the trust flow through to the grantor on the grantor's individual income tax return. A separate return for the trust is not necessary.

In the event the grantor becomes incapacitated (e.g., from illness or injury), the successor trustee or co-trustee can immediately step in to take over the management of the trust on the grantor's behalf, avoiding the need for the grantor's spouse or other family members to petition the court to appoint a guardian.

Tip: If special knowledge or skill is required to manage property in the trust, the successor or co-trustee should be qualified.

At the grantor's death, assets remaining in the trust pass directly to the beneficiaries, bypassing the probate process. This can save time and money, and can minimize some of the burden of settling the grantor's estate.

Funding the trust

To ensure that the trust fulfills its objectives, the trust must be funded after it is created. Funding the trust means transferring legal title from the grantor into the name of the trust. This may entail recording a new deed for real estate; re-titling cars and trucks; renaming checking, savings, and investment portfolio accounts; transferring life insurance policies, stocks, and bonds; executing new beneficiary designation forms; or executing assignments.

Although a revocable living trust can be funded with virtually any kind of property, including personal property, special consideration should be made before transferring certain types of property, including:

  • Incentive stock options
  • Section 1244 stock
  • Professional corporations
Tip: Transfers to the trust are not considered gifts, so the grantor doesn't need to file a gift tax return.

Some states will reassess the value of a home for property tax purposes when it is transferred to a trust. Some states will disallow income tax deductions related to the home if it is owned by a trust.

Some banks may impose a penalty when certificates of deposits (CDs) are transferred to a trust because they consider such transfers to be early withdrawals.

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