Nongrantor trusts can be a useful tool for estate planning purposes. However, it is important to understand how they work and what their advantages and disadvantages are before deciding whether or not to use one. In this blog, we’ll take a closer look at this type of trust so you can make an informed decision as to whether it’s the right choice for you and your family.
What is a Trust?
A trust is a legal entity that can be used by individuals or businesses to manage property or money. Generally speaking, it enables someone else (the trustee) to hold title or ownership on behalf of someone else (the beneficiary). The trustee is responsible via fiduciary relationship for managing the trust’s assets and carrying out the wishes of the grantor, who establishes the trust, upon the grantor’s death. The beneficiary has no control over the trust assets but may receive income from them if provided for in the trust agreement.
The Non-Grantor Trust
A non-grantor trust is a trust in which the settlor, or creator, does not retain any ownership rights over the trust property. Unlike a revocable trust, the settlor cannot revoke the trust or change the terms of the trust agreement. Non-grantor trusts are also sometimes referred to as “irrevocable trusts.”
There are several reasons why someone might choose to create a non-grantor trust. The most common reason is for estate planning purposes. By placing assets in an irrevocable trust, individuals can remove those assets from their taxable estate. This can be a valuable tool for reducing estate taxes. Non-grantor trusts can also be used for asset protection purposes. Because the settlor does not retain ownership rights over the trust property, creditors cannot go after those assets if the settlor is sued or incurs debts.
What are the Different Types of Non Grantor Trusts?
There are two main types of non-grantor trusts: testamentary and living (or revocable trust).
Testamentary trusts are created through your will and only exist after you die.
Living trusts, on the other hand, are created while you’re still alive.
Testamentary Trusts and Their Benefits
A testamentary trust is an irrevocable trust that’s created through your will. It doesn’t exist until after you die when it becomes responsible for managing and distributing your assets according to your wishes.
One of the main benefits of a testamentary trust is that it can help your loved ones avoid probate—a lengthy and expensive legal process required to transfer ownership of your assets after you die. If your estate is subject to probate, your loved ones may have to wait months or even years before they can access your assets. But if those assets are held in a testamentary trust, they can be distributed more quickly and easily.
Another benefit of a testamentary trust is it allows you to control how and when your beneficiaries will receive their inheritance. For example, if you have young children, you may want to put conditions on when they’ll receive their inheritance—such as when they turn 18 or 21. Or if you have an adult child with special needs, you may want to set up a “supplemental needs” trust, so their inheritance doesn’t disqualify them from receiving government benefits like Medicaid.
Living Trusts and Their Benefits
Unlike a testamentary trust, an irrevocable living trust is created while you’re still alive.
One of the main benefits of a living trust is it allows you to avoid probate—just like a testamentary trust does. Probate can be a lengthy and expensive legal process—but if your assets are held in a living trust, they can be distributed much more quickly and easily after your death since they won’t have to go through probate court first.
Furthermore, unlike a testamentary trust, a living trust takes effect as soon as it’s created. This means if something happens to you (like if you become incapacitated), your trustee will be able to step in and manage your affairs immediately without having to go through any legal hoops first.
Irrevocable Life Insurance Trust
Another type of non-grantor trust is an irrevocable life insurance trust (ILIT). As the name implies, an ILIT holds life insurance policies. The purpose of an ILIT is to keep the death benefit from those policies out of the settlor’s taxable estate.
Disadvantages of a Non-Grantor Trust
There are some drawbacks to non-grantor trusts as well. First, because the settlor has no control over the trust property, he or she cannot change its terms if circumstances change. For example, if the beneficiary dies before receiving all of the assets from the trust, the settlor cannot change the terms of the trust to give those assets to someone else. Second, non-grantor trusts can be more expensive to set up and maintain than other types of trusts because they require professional trustees.
Taxation of Grantor vs. Non-Grantor Trusts
Grantor trusts are generally subject to the settlor’s individual income tax rates. This means the trust’s income and gains—including capital gains, interest, dividends, etc.—are taxed at the settlor’s rate. On the other hand, non-grantor trusts are subject to their own set of tax rules.
In addition, non-grantor trusts are also subject to an additional 3.8% Medicare Surtax on all their net investment income above certain thresholds. Finally, some states may impose taxes on certain types of non-grantor trusts.
It’s important to consider these potential tax liabilities when deciding whether to set up a grantor or non-grantor trust. Depending on your situation, it may be more advantageous—from a tax perspective—to use one type of trust over the other.
There are many benefits to establishing a non-grantor trust—including avoiding the probate process, saving on taxes, and controlling how and when your beneficiaries receive their inheritance. If you’re thinking about setting up a trust, speak with an experienced attorney who can help ensure that it’s done correctly and meets all of your needs and objectives.
If you’re looking for additional trust resources, don’t forget to check out this Planning Made Simple article, Trust or Will: Which do I Need?