What Is a Trust Fund?

The Basics of Using Trust Funds to Protect and Preserve Wealth

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Trust funds are a great way to build wealth for future generations, but many new investors tend to shy away from them because they think they are only for the rich. Although trusts are usually associated with blue blood families and powerful moguls, trust funds can make a lot of sense even if you are, for example, a widowed grandmother who just wants to leave $30,000 to a grandchild to help them complete their education. 

What Is a Trust Fund?

A trust fund is a special type of legal entity that holds property for the benefit of another person, group, or organization. There are many different types of trust funds. There are also many different types of trust fund provisions that define how they work.

Generally speaking, there are three parties involved in all trust funds:

How a Trust Fund Works
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  • The Grantor: This is the person who establishes the trust fund, donates the property (such as cash, stocks, bonds, real estate, mutual funds, art, a private business, or anything else of value) to the fund, and decides the terms upon which it must be managed.
  • The Beneficiary: This is the person for whom the trust fund was established. It is intended that the assets in the trust, though not belonging to the beneficiary, will be managed in a way that will benefit them, as per the specific instructions and rules laid out by the grantor when the trust fund was created.
  • The Trustee: The trustee, which can be a single individual, an institution (such as a bank trust department that appoints one of its staff), or multiple trusted advisers, is responsible for making sure the trust fund maintains its duties as laid out in the trust documents and pursuant to applicable law. The trustee is often paid a small management fee. Some trusts give responsibility for managing the trust assets to the trustee, while others require the trustee to select qualified investment advisers to handle the money.

How Is a Trust Fund Structured?

Trust funds are fictional entities that are given life by the state legislature of the state in which the funds are formed. Certain states may offer more advantages than others depending on what the grantor is attempting to accomplish. It is, therefore, important to work with a qualified attorney when drafting your trust fund documents. 

Some states permit so-called perpetual trusts, which can last forever, while others forbid such entities for fear of creating another landed gentry class that results in future generations inheriting large amounts of wealth that the beneficiaries did not earn.

One of the most popular provisions inserted into trust funds is the so-called "spendthrift" clause. Pursuant to this clause, the beneficiary cannot pledge the assets of the trust, or dip into them, to satisfy their debts. This can make it impossible for profligates to find themselves destitute after they incur large debts.

As an example, let's say that the beneficiary made a large bet at the roulette table, lost, and was not able to repay the debt. The casino probably would not be able to touch the trust fund's principal when it goes to collect the money owed to them. The "spendthrift" clause is a way for concerned parents to make sure their irresponsible children do not end up homeless or broke, regardless of how terrible their life decisions may be.

Why Consider Using a Trust Fund?

In addition to creditor protections, there are several reasons trust funds are so popular:

  • Intentions: If you do not trust your family members to follow the letter of your intentions following your passing, a trust fund with an independent third-party trustee can often alleviate your fears. For example, if you want to make sure your children from a first marriage inherit a lake cabin that must be shared among them, you could use a trust fund to do it.
  • Tax benefits: Trust funds can be used in a way that maximizes estate tax bypasses so you can get more cash to more generations further down the family tree.
  • Grandchildren: Grandparents often set up trust funds for their grandchildren that are designed to pay educational expenses. When the grandchildren graduate, any additional principal remaining is distributed as start-up money, which they can use to establish their post-college life.
  • Protection: Trust funds can protect cherished assets from your beneficiaries—such as a family business. Imagine you own an ice cream factory and feel tremendous loyalty toward your employees. You want the business to continue being successful and run by the people who work in it, but you want the profits to go to your son, who has an addiction problem. By using a trust fund, and letting the trustee be responsible for overseeing management, you can achieve this. Your son would still get the financial benefits of the business, but he would have no say in running it.
  • Ongoing transfers: There are some interesting ways to transfer large sums of money by using a trust fund, including establishing a small trust that buys a life insurance policy on the grantor. When the grantor passes away, the insurance proceeds are distributed to the trust. That money is then used to acquire investments that generate dividends, interest, and rents for the beneficiary to enjoy.

Whether a trust fund is appropriate for your situation will depend on your unique circumstances, what you want to accomplish, and even the laws of your particular state. It is of the utmost importance that you discuss your needs with a qualified trust attorney, your accountant, and your registered investment advisory firm.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.