Testamentary and Inter Vivos Trusts

Notary public wax seal
•••

djedzura/iStock/Getty Images Plus 

Trust funds have long been used to pass on wealth between family members. They range in use (i.e., from leaving behind assets to certain people to ensuring a child has a steady flow of money). In the world of trust funds, there are two broad categories: testamentary trust funds and living trusts (the latter is also known as inter vivos trust funds). Testamentary trust funds are formed after the death of the grantor while living trusts are formed while the grantor is still alive.

Testamentary Trust Funds

A testamentary trust fund comes into existence upon the death of the grantor, the person establishing the trust fund, as prescribed in his or her will. One downside of this approach is that the assets used to fund the trust are almost certainly going to go through the probate process. This could lead to outcomes the grantor never desired.

For example, imagine a married couple with an estate of $2,000,000. They pass away and their will calls for all of their assets to be placed into a trust fund, at which point the cash will be invested in blue-chip stocks. When their two young children turn 18 years old, they will receive 4% distributions from the trust, split evenly between them.

When they turn 30 years old, the entire trust terminates and the money is distributed between the two beneficiaries equally. The bank that handled the family's financial affairs acts as an institutional trustee, investing the money and making sure that compliance with the trust terms and relevant state laws are met.

This is a testamentary trust fund since it did not exist until the parents died.

Inter Vivos Trust Funds

Inter vivos trust funds (also known as living trust funds) are created while the grantor is alive. For an inter vivos trust fund, the grantor can serve as both the trustee and beneficiary. This reduces available asset protections and takes away most immediate tax benefits, but it can protect the elderly from abusive family or friends. When a grantor dies, the entire portion of the estate that was within the trust fund should sidestep probate and immediately begin benefiting the contingent beneficiaries, which are named ahead of time. This can be anyone, including your children, nieces, nephews, a life-long friend, or a charity.

Imagine that the same married couple in the example above decides to establish two trust funds for their children. They name themselves as trustees and gift $100,000 into each fund. The two children will not receive any distributions until they turn 18 years old when the fund will begin to pay 3% of its net worth each year to help with living expenses.

From time to time, the couple can make additional gifts to the trust fund balances. They can contribute cash or, in some cases, include other assets such as real estate investments. Families that own businesses may consider contributing the equity of their companies.

This an inter vivos trust, since it was formed during the grantor's lifetime. There was no death necessary to trigger the creation of the trust itself.

Revocable vs. Irrevocable Trust Funds

If a trust is revocable, the grantor can make changes to it during his or her lifetime. In other words, the trust fund can be undone. The most popular form of such a trust is known as a revocable living trust, which offers a way to reduce estate taxes.

If a trust is irrevocable, the grantor cannot take the money or assets back once the trust fund is established. There are no "do-overs," so you need to make sure it is structured correctly. All else being equal, irrevocable trust funds provide the most asset protection against creditors and adverse judgments because the property truly does not belong to either the grantor or the beneficiary.

Which Trust Fund Is Right for Your Situation?

Trust fund law is one of those areas where there is no substitute for qualified legal advice from highly respected, competent attorneys specializing in the field. The laws in every state are different, as are the terms of every trust fund.

You should be as thorough as possible when planning a trust. If it is not done properly from the start, the lawyers may end up getting it after you are gone when your family is fighting over the assets.