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What Is a Trust Fund – How It Works, Types & How to Set One Up

When most people hear “trust fund,” they think of wealthy people living in fancy estates using them to pass immense amounts of wealth to their heirs. But that isn’t always the case.

A trust fund is simply a legal entity that holds assets of value like property or stocks and bonds on someone else’s behalf (in trust). They’re useful for numerous reasons, including estate planning, protecting assets, avoiding complications during probate, and minimizing taxes.

Trust funds are helpful for estates of varying sizes. But before you set one up, it’s best to understand what it is and what it can and can’t do.

What Is a Trust Fund?

A trust fund is a legal entity that can hold valuable assets on behalf of an individual person, group, or organization. There are many different types of trust fund, each designed to achieve a different goal.

Trusts give the person establishing them more control over their estate than a will does. They can also provide legal protections or tax benefits that reduce the taxes the person establishing the trust or its beneficiaries may owe.

How a Trust Fund Works

Establishing a trust fund requires three parties:

  1. The Grantor. The person who establishes the trust and places assets into that trust is the grantor. They determine the beneficiaries and any rules or stipulations they wish to put in place, such as only allowing the beneficiary to use the money to pay for college.
  2. The Beneficiary. The person, people, or organization that benefits from the trust is the beneficiary. They don’t own the assets but will benefit from them, often by receiving access at some point or getting monetary distributions from the trust.
  3. The Trustee. The person or organization responsible for managing the trust and its assets is the trustee. They must act as a fiduciary for the beneficiary and follow the rules or stipulations laid out in the trust documents.

To establish a trust, the grantor typically works with a lawyer to draw up a document outlining the terms of the trust, the beneficiaries, the trustee, and the details of how the trust will work. 

For example, a grandparent might establish a trust for their grandchildren, name their children as trustees, and stipulate that they must use the money for their grandchildren’s college education.

One perk for beneficiaries is that they do not pay taxes on their distributions. Instead, the IRS taxes the trust directly.

Trusts are a popular estate planning tool because they’re more binding than something like a will. In the example, the grandchildren must use the trust fund to pay for college costs. If the grandparent instead distributed that money in a will simply noting they want it to go toward college costs, the grandchildren don’t have the same legal obligations to use it for that. 

Types of Trust Funds

One of the benefits of trusts is their flexibility. You can establish one for almost any purpose. And there are many types of trust funds available to suit various needs. 

Living Trusts

Living trusts are trusts that you create while you’re alive. The benefit of a revocable trust is that they let the assets in the trust avoid probate, the process by which the executor of the estate determines how to distribute the property left behind. Probate can be a lengthy process, which living trusts let families avoid.

They come in two primary forms: revocable and irrevocable.

A revocable trust gives the grantor more power over the trust’s assets. The grantor can amend the trust documents at any time after creating a revocable trust, changing the terms of the trust, or naming different beneficiaries. 

Once the grantor dies, a revocable trust becomes an irrevocable trust and cannot be altered.

In contrast, irrevocable trusts are more permanent. Once the grantor establishes an irrevocable trust, they cannot make changes to it or name different beneficiaries without the consent of the current beneficiaries.

An irrevocable trust has additional tax benefits for the grantor. Because they can’t make changes or remove assets after forming the trust, any assets placed in the trust are no longer the grantor’s property.

That means the grantor can take advantage of the annual gift tax exclusion by making gifts to an irrevocable trust.

Testamentary Trust

You can also create a testamentary trust through your last will and testament. Essentially, it instructs the executor to create the trust after your death.

While that means testamentary trusts don’t provide all the benefits of avoiding probate you could get from a living trust, they still carry other benefits. For example, it allows the decedent to establish another kind of trust, like an educational trust, for an heir. It also lets them place more restrictions on how their heirs use the money left behind.

Educational Trust

An educational trust simply specifies the beneficiary must use the assets for educational purposes. It can be revocable or irrevocable.

Depending on the grantor’s wishes, the trust can specify where the beneficiary has to study, what subjects they need to study, how frequently it will make distributions, and what types of expenses it will cover.

For example, it could state that it will only cover the beneficiary’s tuition costs or make a lump-sum distribution each year the beneficiary is in school and leave it to the beneficiary to decide how best to spend the money for education.

Of course, these restrictions could have consequences. If the beneficiary doesn’t go to college or leaves money in the trust once they leave school, you need a plan for what to do with it.

Special Needs Trust

A special needs trust is a trust designed to help care for someone who is disabled or otherwise requires accommodations without disqualifying them from receiving government assistance.

Many government assistance programs require aid recipients to have a limited income or limited assets. If their income rises or they receive a large gift, it can stop them from receiving essential government aid.

A special needs trust can hold assets on behalf of someone receiving government care and ensure the trustee uses those assets to help the beneficiary.

The rules for these trusts can vary from state to state, but they must typically be irrevocable and give the trustee significant control over how to use or distribute the assets.

Charitable Remainder Trust

Charitable remainder trusts allow the grantor to benefit from charitable contribution tax deductions while still receiving income from their assets. In exchange, the funds remaining in the trust go to a charity once the grantor dies.

For example, Brianna could establish a charitable trust and name a local museum as the charity of her choice. If she places $100,000 in the trust, the trust might give her (or another named beneficiary) an annual payment of $5,000 each year until she dies.

When Brianna establishes the trust, she receives a tax benefit for making a charitable contribution to the museum. However, she does have to pay taxes on the distributions she receives.

Once Brianna dies, whatever money she left in the trust goes to the museum.

Charitable remainder trusts can be highly complex when it comes to taxes, so it’s essential to work with a tax professional when considering whether one is right for you.

Common Collective Trust Fund

A common collective trust fund is a trust fund managed by a bank or trust company. It combines assets for multiple investors, often pooling assets from things like profit-sharing, pension, and employee stock bonus plans. 

These funds are very similar to mutual funds and are commonly held in employer retirement plans.

Perpetual Trust Fund (Dynasty Trust)

A perpetual trust fund, also called a dynasty trust, is a trust that aims to pass wealth to future generations while avoiding taxes like the estate tax, gift tax, or generation-skipping transfer tax. A properly designed dynasty trust can last for many generations, creating a family dynasty of wealth.

These trusts usually include clauses to change their beneficiaries over time. For example, it might start benefiting the grantor’s children, then change to benefit the grantor’s grandchildren once they reach a certain age or all of the grantor’s children die.

Because the goal of dynasty trusts is to last for a long time or even forever, the grantors of these trusts typically name a financial institution or bank the trustee.

Assets in the trust aren’t the property of any of the beneficiaries, so they can avoid taxes like capital gains and estate taxes. However, they do have to pay income tax on distributions.

Spendthrift Trust

A spendthrift trust is one designed to protect the beneficiary from creditors and their own poor financial habits. These trusts typically give the trustee more control over the assets in the fund.

The effect is that the beneficiary can’t sell the trust’s assets or access significant amounts at once to squander. But neither can creditors if the beneficiary racks up considerable debt.

Social Security Trust Fund

The Social Security Trust Fund is the trust fund the Social Security Administration uses to hold all the assets used to pay benefits like Social Security and disability. It’s not a trust you can create, but almost every American pays into it and hopes to benefit from it someday, so it’s important to know how it works.

The trust fund owns interest-bearing government securities, such as bonds, and gets its funds from payroll tax deductions paid by both employees and employers.

When the benefits paid out by Social Security exceed the income received from payroll taxes, money from the trust fund pays those benefits. When payroll taxes exceed benefits paid, the additional revenue goes into the trust.

As of the Social Security Administration’s 2021 report, the Social Security Trust fund held $2.908 trillion in assets.

Advantages & Disadvantages of Trust Funds

Trusts have many tax benefits and can give the person establishing the trust more control over how the beneficiary ultimately uses their money. However, they’re not perfect for every situation.

Advantages of Trust Funds

Trusts can give their grantors control over their hard-earned money in life and in death, ensuring more of it goes to their beneficiaries than the government. A trust’s many benefits include: 

  1. Grantor Control. The person establishing the trust can set rules for how beneficiaries should use the funds in the trust, and the beneficiary must follow those wishes, even after the grantor dies.
  2. Tax Incentives. Various types of trusts can help the grantor and beneficiary avoid or reduce taxes like capital gains and estate taxes.
  3. Probate Avoidance. When someone dies, their estate goes through probate, a legal process by which the state or executor distributes assets, whether or not they have a last will and testament. Assets in a trust can skip this process, meaning loved ones can access the assets sooner. It also reduces the chance of the grantor’s wishes being ignored.
  4. Privacy. The probate process is public, which means the estate and wishes of someone who dies become public record. Trusts offer a more private option.

Disadvantages of Trust Funds

Though there are advantages to trusts, they aren’t right for everyone. Carefully consider these disadvantages before setting one up.

  1. Limited Benefit for Small Estates. One of the reasons to establish a trust is to avoid taxes. But smaller estates are unlikely to face taxes, anyway. For 2022, the estate tax exclusion is $12.6 million federally, though some states have lower limits. For example, Massachusetts and Oregon have the lowest exclusions as of this writing, taxing estates that exceed $1 million.
  2. Cost. Setting up a trust means working with expensive professionals like lawyers and tax professionals. The cost may exceed the benefit for some.
  3. Finding a Trustee. Establishing a trust means finding a trustee to manage it. You either have to ask a friend or relative to take on this task, which might be a large one depending on the trust’s assets, or pay a professional to handle the work.
  4. Loss of Control. While trusts give the grantor more control in some ways, setting up an irrevocable trust means losing control in others. Once you establish an irrevocable trust, you can’t make changes, which means losing some level of control over your assets.

How to Set Up a Trust Fund

Setting up a trust fund is a multistep process. If you’re looking to create a simple trust, you could finish in a few weeks. If you want to construct a more complicated one with many restrictions and beneficiaries and a large number of assets, you should expect a monthslong process. But the steps you take are the same either way.

1. Figure Out the Goals of Your Trust

The first step to set up a trust fund is to figure out your goals for establishing the trust.

Do you want to use the trust to have more control over how your beneficiaries use your assets after your death? Is avoiding taxes your primary goal? Do you want a way to donate money to charity but retain a stream of income for retirement? 

You can use a trust to accomplish each of these goals, but each requires a different type of trust.

2. Find a Trust Professional

Once you know your goals, you’re ready to sit down with a professional. Most major financial institutions offer fee-based trust services if you have sufficient assets with them. For example, Fidelity manages trusts of $1 million or more. Fees start at 0.45% of the invested assets, but the percentage decreases as you add funds. You can work with the professional to hammer out details.

3. Choose a Trustee

You also have to determine who the trustee and the beneficiary will be. For some types of trusts, such as a dynasty trust, you need a professional trustee, like a bank or financial institution. Other trusts, like educational trusts or spendthrift trusts, more naturally lend themselves to having a family member serve as trustee.

4. Make the Trust Official

Once you’ve worked out the details, your estate planning attorney, the trustee, and any financial advisors will help draft the trust documents. You just have to sign on the dotted line to make it official. 

5. Fund the Trust

Once you’ve signed the paperwork, you’re ready to start funding the trust. You can put pretty much any asset of value into the trust, including cash, real estate, and stocks.

6. Register the Trust

You must register your trust with the IRS so it can get a taxpayer identification number and file tax returns. If you’re working closely with a financial institution to manage the trust, your trustee can help. Otherwise, the tax professional, lawyer, or brokerage company holding the trust’s assets can help register it.

Trust Fund FAQs

Trusts are complicated, and there are many ways to set them up. But first, it’s essential to understand how they work and how you can use them to accomplish your financial goals.

What’s the Difference Between a Trust & a Trust Fund?

People often use the terms trust and trust fund interchangeably, but they’re slightly different things.

A trust fund is the legal entity that contains assets or property for the benefit of someone else. A trust is a legal document outlining the rules of who the trust fund benefits and how the beneficiary can use assets in a trust fund.

How Is a Trust Fund Handled in Probate?

One of the most popular reasons to set up a trust is to avoid the probate process, which can be lengthy and prevent your loved ones from accessing the money you leave behind when you die.

Any assets in a trust avoid probate court and can skip the normal legal process.

Who Should I Make My Trustee?

Naming your trustee can be difficult because you’re trusting that person with managing your assets and following the wishes you outlined in the trust. 

Some types of trusts naturally lend themselves to making a family member the trustee. For example, if you establish a trust to benefit your grandchild, it makes sense to name their parents (your own child) as the trustee.

Longer-term trusts may require a financial institution or a long-lasting entity to serve as the trustee. But that can mean paying management fees.

How Does a Trust Fund Affect Estate Taxes?

You can use a trust fund to reduce or avoid estate taxes to some degree. The IRS considers money placed in an irrevocable trust a gift in the year you place it in the trust.

Each year, taxpayers may make gifts up to a certain amount ($16,000 in 2022) without it counting against their lifetime gift limit. That means the grantor of a trust can add $16,000 to the fund each year and pay no taxes on that amount, reducing their potential estate tax liability.

What Is a Trust Fund Baby?

A trust fund baby is a pejorative term used to describe a young person whose parents or family established a trust fund for them. This trust provides them with a sufficient income to live comfortably without having to work or find significantly gainful employment.

The common image of a trust fund baby is that of a privileged young adult coasting their way through life with little to no responsibilities.

These situations certainly exist, but the term doesn’t accurately describe most people benefiting from trust funds. Trust funds are simply a legal tool people can use to protect their assets and ensure their beneficiaries follow their wishes. 

Many middle-class families use trust funds for reasons as simple as avoiding probate or keeping assets safe from creditors, not to let their children live a life of luxury without having to work.

Final Word

Trust funds are a powerful legal tool you can use for reasons ranging from estate planning and tax avoidance to caring for a loved one. Though they may have a negative reputation as a toll available only to the wealthy, many groups can benefit from using them.

If you’re thinking about setting up a trust fund, it’s also a good opportunity to think about taking inventory of your finances and ensuring everything is in order. You might also consider talking to an estate planning attorney to draft a will if you don’t already have one. Being prepared only benefits your family in the long run.

TJ is a Boston-based writer who focuses on credit cards, credit, and bank accounts. When he's not writing about all things personal finance, he enjoys cooking, esports, soccer, hockey, and games of the video and board varieties.