To determine whether or not you should use trusts, you need to understand what they are. A trust is a paper entity created to express a fiduciary relationship: every trust has a trustee, who holds property for one or more beneficiaries. The trustee assumes the responsibility of managing trust assets prudently, often in return for a management fee. Most banks, for example, have trust departments, which manage money held in trust for beneficiaries.
To help you understand trusts, you might want to first slice them into two categories: living and dead. That is, some trusts are created by living people. Others trusts originate at the creator’s death–they’re usually called "testamentary" trusts because they may be created in a decedent’s "last will and testament".
Then, you can dice trusts into two different types of categories: revocable and irrevocable. As the name suggests, a revocable trust can be changed or revoked altogether. In the latter case, the creator gets his assets back and the trust ceases to exist.
An irrevocable trust, on the other hand, is a permanent and thus far more serious matter. Once assets are transferred to an irrevocable trust, they generally can’t be reclaimed. Terms of an irrevocable trust usually can’t be altered, although there are some exceptions.
A living trust can be revocable or irrevocable. A testamentary trust is always irrevocable–dead people can’t change their minds. Revocable trusts either terminate or become irrevocable after the creator’s death.
These two types of trusts offer different benefits. With revocable trusts, you retain control of trust assets and you don’t have to pay gift taxes on transfers. On the other hand, revocable trusts provide no tax benefits and little protection against creditors.
Irrevocable trusts, on the other hand, offer tax savings and solid creditor protection. On the downside, you must relinquish control of the trust assets and you may incur gift taxes on transfers to irrevocable trusts.
Because they can’t be annulled, irrevocable trusts are considered separate entities. Assets transferred to an irrevocable trust are out of your taxable estate. Similarly, income earned by an irrevocable trust generally is taxed to the beneficiary, if distributed, or to the trust itself if not distributed. In some cases, this may reduce income tax.
If you create an irrevocable trust during your lifetime, the assets in such a trust will enjoy all the benefits of a revocable trust: probate avoidance, continuity in case of incapacity, and privacy. However, there will be additional advantages as well.
Assets you transfer to an irrevocable trust are gone forever. (Or maybe they aren’t, as you’ll see). Thus, they’re considered beyond the reach of your creditors. The tax code, moreover, states that assets not available to your creditors are out of your taxable estate, too.
In addition, assets transferred to an irrevocable trust are beyond the reach of trust beneficiaries. That is, it’s up to the trustee to make decisions on distributions. If the trustee doesn’t distribute assets to beneficiaries, the assets can’t be stolen or squandered.