Trust accounts

In short

A friend of mine once asked me where her late uncle's house should go, and the answer turned out to be sitting in a folder he had signed years before. If you are holding a trust account, or thinking about one, you are holding a container with a set of rules written by a person. The grantor, who is the person who creates the trust, puts assets inside. The trustee manages them. The beneficiary receives the benefit. Read the trust document first, since it controls almost everything. Ask whether the trust is revocable, meaning the grantor can change it, or irrevocable, meaning the grantor mostly cannot. Check who pays the tax on the income. Ask what the trustee charges. Then write down who is named and in what order.

The whole of it

What it is

I once watched an old farmer hand his neighbor a ring of keys and say, "These are for the barn, but the barn is still the boys' someday." That is a trust in a sentence. It is a legal arrangement where one person holds property for the benefit of another, under written instructions. The account is the container. The trust document is the rulebook.

You have probably heard the word used for several different things, so let me sort it out gently. A revocable living trust is one the grantor can change or cancel while alive. An irrevocable trust is one the grantor generally gives up control over once it is signed. A testamentary trust is one that springs to life only after a person dies, through a will. A special needs trust helps a person with a disability while protecting certain benefits. Each one holds accounts, such as a bank account, a brokerage account, or a house. They differ in who has control and who pays the tax.

None of this is exotic. Plenty of ordinary families use trusts. They are tools, and like any tool, they work well when the person using them knows what they are for.

How it works

A friend of mine, a retired schoolteacher, set up a trust so her house could pass to her daughter without a long court process. Here is the plain machinery behind that. The grantor signs the trust document. The grantor then retitles assets so the trust owns them, which is called funding the trust. An unfunded trust is an empty box. This is the most common slip, and it is an easy one to make.

The trustee is the person or company who runs the trust. A trustee has a duty to follow the document and act in the beneficiaries' interest. The trustee pays bills, keeps records, and makes the payouts the document allows. The beneficiary is the person who receives the benefit, sometimes income now, sometimes the principal later.

Tax is where trusts get interesting. A revocable trust is usually treated as the grantor's own money for income tax, so the grantor keeps reporting it as before. An irrevocable trust can be its own taxpayer. The IRS says that trusts file Form 1041, U.S. Income Tax Return for Estates and Trusts. The IRS also notes that trust income is taxed at compressed rates, which means the higher brackets start at a much lower income than for a single person. Income the trust passes out to a beneficiary is generally taxed to that beneficiary instead, and the trust reports it on Schedule K-1.

Money in a trust account also has to be managed. The trustee can often hold cash, stocks, funds, and real estate. A bank or brokerage will want a copy of the trust, or a certification of trust, and the trust's own tax ID number when one is needed.

The numbers, and where to find yours

I like to tell people to start with the paper, not the website. The numbers that matter live in a few places. The trust document names the trustee, the beneficiaries, and any payout rules. The account statement shows the balance and the fees. The tax forms show the income.

A few figures change by year, so I will not guess at them. The income level where trust tax rates reach the top bracket is set each year. It is the current figure, which the official source publishes each year, and the top rate is the current figure, which the official source publishes each year. You can find both in the IRS instructions for Form 1041. The annual gift tax exclusion, which matters if the grantor is adding money to a trust for others, is the current figure, which the official source publishes each year. The federal estate tax exemption is the current figure, which the official source publishes each year. Each is published by the IRS, and the site fills in the verified figure with its source and date.

Trustee fees are not set by law. They come from the trust document, a fee schedule, or a state rule about what is reasonable. Ask for the schedule in writing. Also ask what the trustee bills for tax work, legal help, and investment advice, because those can be separate.

A worked example

Let me tell you about a woman named Marcy Doyle. Marcy is 68 and has a revocable living trust. It holds a brokerage account worth $400,000. Her daughter Elise is the successor trustee, which means she takes over when Marcy dies or cannot manage things.

While Marcy lives, the trust is treated as hers for income tax. Say the account earns $12,000 in interest and dividends in a year. Marcy reports that $12,000 on her own return. No separate trust return is needed. Simple enough.

Now picture Marcy passing away. The trust becomes irrevocable. Say it keeps earning, and this year it earns $12,000 again. The document tells Elise to pay $9,000 out to Elise's brother Paul, and the trust keeps $3,000. The trust passes $9,000 to Paul. Paul gets a K-1 and reports $9,000 on his own return. The trust reports the remaining $3,000 on Form 1041.

Now the fee. Suppose a corporate trustee charges 1 percent a year on the $400,000 balance. That is $400,000 times 0.01, which is $4,000 a year. Marcy chose Elise instead, who charges nothing. That choice saves $4,000 a year. Over five years it saves $20,000, before any growth. Elise is still paid back for real expenses, like the $350 it costs to have the return prepared. Her out of pocket cost is that $350, not a percentage of the pile.

Where it goes wrong

I have seen good folks stumble over small things, and nobody ought to feel foolish about it. The first trouble is the empty box. The trust is signed, but the house and the accounts were never retitled. The assets then pass through probate, the court process, as if the trust did not exist. Check the titles.

The second trouble is a stale document. A grantor divorces, a child dies, or a new grandchild arrives, and the trust still names the old plan. Review it after big life changes. Third, the trustee is a poor fit. A trustee must keep records, treat beneficiaries fairly, and file the tax return. A kind relative can still be overwhelmed. Naming a backup trustee helps.

Fourth, the tax surprise. Because trust brackets are compressed, income that stays inside an irrevocable trust can be taxed at high rates fast. The IRS publishes the rates each year in the Form 1041 instructions. Paying income out to a beneficiary can change the picture, though the document must allow it. Last, some people think a revocable trust shields money from creditors or from estate tax. It generally does not, since the grantor still controls it. Rules on this vary by state, so read your own state's law or ask a lawyer licensed there.

Questions to answer before you leave this page

Do you know whether your trust is revocable or irrevocable, and where the signed copy is kept? Have the house, the bank accounts, and the brokerage accounts actually been retitled in the trust's name? Who is the trustee today, who steps in next, and have they agreed to serve? What does the trustee charge, and is that fee in writing? Who pays the income tax on what the trust earns, and which forms get filed? Have the beneficiaries and their order been checked since the last birth, death, or divorce? And if you had to hand this folder to someone you love tomorrow, would they know where to start?