How Does a Living Trust Work?

A living trust is an estate planning tool that can allow you to maintain control over your assets, specify how they should be distributed and even protect them from legal challenges or financial mismanagement. Unlike a will, which requires probate court proceedings, assets held in a living trust can be distributed efficiently and privately. Working with a financial advisor could help you determine how a living trust aligns with your estate planning goals.

What Is a Living Trust?

A living trust is a legal entity created to hold and manage assets during a person’s lifetime, with instructions for their distribution to beneficiaries upon death, thus avoiding delays and legal fees associated with court proceedings.

A grantor, also known as the trustor, is the person who establishes the trust and transfers assets into it. A trustee is the person responsible for managing these assets according to the grantor’s instructions. Often, the grantor serves as the trustee at the beginning, which allows them to maintain full control of the trust while they are alive. Then, upon the grantor’s passing or incapacitation, a successor trustee takes over to distribute assets held in the trust to designated beneficiaries. Depending on the arrangement there may be trustee fees involved in this transition.

Living trusts can include a wide range of assets, such as:

Real estate
Bank accounts
Investment portfolios
Personal property (e.g., jewelry, artwork)
Business interests
Life insurance policies

Steps to Set Up a Living Trust Work

Setting up a living trust involves choosing which assets to include, naming beneficiaries and appointing a trustee to oversee the trust. Here are six simple steps to help you get started:

Decide on the type of trust. Choose between a revocable vs irrevocable trust, depending on your needs. A revocable trust allows you to change terms during your lifetime, while an irrevocable trust generally cannot be altered, though it can provide tax benefits and shield assets from creditors.
Select a trustee. The grantor often serves as the first trustee, but you will need to name a successor trustee who will manage the trust after the grantor’s passing.
List the assets. Identify which assets will be placed into the trust. These can include real estate, bank accounts, investments and personal property.
Prepare the trust document. Draft a legally binding trust document outlining the terms, beneficiaries and asset distribution.
Transfer assets to the trust. You can transfer ownership of assets by updating property titles, financial accounts and other records to show the trust as the new owner.
Manage and update the trust. Don’t forget to review and modify the trust regularly so that it reflects life changes like marriage, divorce, births or financial updates.

Types of Living Trusts

A woman comparing different types of trusts.

There are different types of trusts serving specific purposes that depend on financial and estate planning needs. Here are four common ones to consider.

Revocable Living Trust

A revocable living trust allows the grantor to retain control over their assets and make changes at any time. This type of trust is commonly used to bypass probate while maintaining flexibility. However, it does not provide asset protection from creditors or reduce estate taxes.

Irrevocable Living Trust

Unlike a revocable trust, an irrevocable living trust cannot be modified once established. Since the assets are no longer in the grantor’s control, they may receive tax advantages and protection from creditors. This type of trust is often used for wealth preservation and Medicaid planning.

Testamentary Trust

A testamentary trust is created through a will and only takes effect upon the grantor’s death. While it does not avoid probate, it allows for structured distribution of assets, such as setting aside funds for minors or dependents.

Special Needs Trust

A special needs trust is designed for individuals with disabilities, ensuring they receive financial support without jeopardizing their eligibility for government benefits like Medicaid or Supplemental Security Income (SSI).

Tax Implications

Living trusts generally do not provide direct tax benefits, but they can still impact estate and income taxes.

Revocable living trusts: Since the grantor retains control, the IRS considers the trust assets as part of their taxable estate. Income generated by the trust is taxed at the grantor’s individual tax rate.
Irrevocable living trusts: Assets transferred to an irrevocable trust are no longer considered part of the grantor’s estate, potentially reducing estate taxes. However, the trust itself may be subject to income tax on any earnings.
Gift tax considerations: Transferring assets into an irrevocable trust may trigger federal gift tax rules, depending on the value of the assets.

A tax advisor can help assess the tax implications and determine the most tax-efficient trust strategy based on your estate size and financial goals.

Benefits of Living Trusts

There are several advantages to establishing a living trust. Here are four common ones to keep in mind:

Avoiding probate. Assets in a trust bypass probate, allowing beneficiaries to receive their inheritance faster and without court fees.
Privacy protection. Unlike wills, which become public record, living trusts remain private.
Incapacity planning. If the grantor becomes incapacitated, the successor trustee can manage assets without requiring a court-appointed guardian.
Control over asset distribution. Grantors can specify how and when assets are distributed, such as providing for minor children over time.

Bottom Line

A woman making changes to her estate plan.

A living trust is an estate planning tool that allows the grantor to manage and distribute assets. Additionally, it can bypass probate, maintain privacy and provide clear inheritance instructions. It also offers potential tax benefits and can protect assets from creditors. However, the setup process requires careful planning and legal considerations.

Estate Planning Tips

If you’re considering a living trust, working with a financial advisor can help you determine which type of trust you should create. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
While handling your own estate planning might seem cost-effective, it’s important to be aware of potential pitfalls associated with DIY approaches. Without professional guidance, you risk creating invalid or inadequate documents, which can lead to significant legal issues and expenses for your heirs.