How To Set Up a Trust Fund If You're Not Rich

If you've heard of trust funds but don't know what they are or how they work, you're not alone. Many people know just one key fact about trust funds: they're set up by the ultra-wealthy as a way to protect passing on significant sums of money to family, friends or entities (charities, for example) after they pass away.

Only part of the conventional wisdom is true though. Trust funds are designed to allow a person's money to continue to be useful well after they pass away, but trusts aren't useful only for ultra high-net-worth individuals. Middle-class people can use trust funds as well, and setting one up isn't entirely out of financial reach.

To understand how a trust fund operates, let's look at an example. You've worked hard all of your life and have built up a comfortable savings cushion. You know that sometime in the future you're going to pass away, and you want your hard-earned savings to go to the people you love, or the charities or causes that you believe in.

Now, what about loved ones who are not as financially savvy as you? You could be concerned about leaving them a lump-sum gift because they might use it irresponsibly. Furthermore, you may even like to see your money carry over for generations to come. If this is how you feel, then you should set up a living irrevocable trust fund. This type of trust can be set up to begin dispersing funds when certain conditions are met. There is no stipulation that you cannot be alive when that happens.

You can place cash, stock, real estate or other valuable assets in your trust. You meet with an attorney and decide on the beneficiaries and set stipulations. Maybe you say that the beneficiaries receive a monthly payment, can only use the funds for education expenses, expenses due to an injury or disability, or the purchase of a home. It's your money, so you get to decide.

Although the trust is irrevocable, the money is not the property of the person receiving it. Because of this, a child applying for financial aid would not have to claim these funds as assets. As a result, there will be no impact on eligibility for needs-based financial aid. The trustor can also establish trusts for future generations of children, making the trust a lasting legacy for an indefinite number of generations.

Because it's irrevocable, you don't have the option of later dissolving the trust fund. Once you place assets in the trust, they are no longer yours. They are under the care of a trustee. A trustee is a bank, attorney or other entity set up for this purpose.

Since the assets are no longer yours, you don't have to pay income tax on any money made from the assets. Also, with proper planning, the assets can be exempt from estate and gift taxes. These tax exemptions are a primary reason that some people set up an irrevocable trust. If you, the trustor (the person setting up the trust) is in a higher income tax bracket, setting up the irrevocable trust allows you to remove these assets from your net worth and move into a lower tax bracket.

There are some downsides to setting up a trust. The biggest downside is attorney fees. Think of a trust as a human in the eyes of tax law. This new person has to pay taxes and the mechanics of the trust have to be written with an extraordinary amount of detail. In order to make it as tax-efficient as possible, it has to be crafted by somebody who has a lot of specialized legal and financial knowledge. Trust attorneys are expensive. A traditional irrevocable trust will likely cost a minimum of a few thousand dollars and could cost much more.

If you don't want to set up a trust fund, there are other options, but none of these leave you, the trustor, with as much control over your assets as a trust.

Will: Writing a will costs much less money, but your property is subject to more taxes and the terms can easily be contested in a process called probate. Additionally, you won't have as much control over how your assets are used. If the will is contested, attorney's fees could eat up a large portion of the money that you wanted to see used in a way that would benefit others.

UGMA/UTMA Custodial Accounts: Similar to a 529 college-savings plan, these types of accounts are designed to place money in custodial accounts that allow a person to use the funds for education-related expenses. You could use an account like this to gift a certain amount up to the maximum gift tax or fund maximum to reduce your tax liability while setting aside funds that can only be used for education-related expenses.

The disadvantages to UGMA/UTMA Custodial Accounts and 529 plans is that the beneficiary may be attending college, but using these funds for other expenses outside of your control. Furthermore, the amount of money in the minor's custodial account is considered an asset, and that may make him or her ineligible to receive needs-based financial aid.

For those who don't have a high net-worth but wish to leave money to children or grandchildren and control how that money is used, a trust may be right for you; it's not just available to high-net-worth individuals, and it offers a way for trustors to protect their assets long after they pass on.