A trust is a legal type of ownership in which property is held by a fiduciary, called a trustee, for the benefit of someone else, called a beneficiary. The trustee runs things; the beneficiary gets things from the trust. The person who gives the money to the trust is called a grantor or settler.
Piggybank on It
Instead of using a trust to gift property to kids, you can use a custodial account. The key difference is that kids are entitled to all the funds from a custodial account at 18 (or 21, depending on state law), as explained in Giving Significant Money to Your Kids. In contrast, trusts can restrict when and how much is given out.
It used to be that only the Rockefellers set up trust funds for their children and grandchildren. Today, with ordinary people becoming millionaires through the increased property value of their homes and stock market-driven accumulations in their company retirement plans, trust funds are becoming more commonplace. Parents and grandparents in this category are undertaking estate planning to preserve their wealth and minimize death taxes. This means good news to the younger generations.
Trusts are set up to provide certain benefits for all concerned:
- Protection of assets for the beneficiary. The property in the trust is managed by a trustee. Usually, this is someone who's good at handling money. It can even be a parent (although this may not be a good idea tax-wise) or a trust company. Having a trustee in charge means that the beneficiary can't squander the property; it's protected for his benefit.
- Tax savings for the person setting up the trust. There are income, estate, and gift tax advantages to using a trust.
Grandparents who are wealthy may be especially interested in making gifts in trust to their grandchildren. Grandparents can do this while they're alive or can leave money in trust when they die. Grandparents whose own children are wealthy in their own right might not want to complicate the estate plans of their kids, so they leave money to the grandkids.
Types of Trusts for Kids
When you make gifts to a child in trust, you want to do it in such a way that your gifts qualify for the annual gift tax exclusion. This isn't automatic because your kid can't touch the money until she's an adult. Under the gift tax law, this is viewed as a gift of future interest, which doesn't automatically qualify for the annual gift tax exclusion. But the law allows two types of trusts for minors to qualify for this exclusion. Both types get their names from the provision in the Internal Revenue Code that creates them.
Financial Building Blocks
Gifts from grandparents to grandchildren may fall victim to a special transfer tax because the gifts skip a generation (that of the parents). However, each grandparent has a $1 million exemption (that's indexed annually for inflation) that can be used to make gifts to grandchildren without the generation-skipping transfer tax. This tax is complex, and wealthy people should talk to their tax advisers before making any large gifts.
- Section 2503(b) trust. In this type of trust, income must be distributed at least annually to your child while he's a minor. It doesn't actually have to be put in his hands; it can go into a custodial account if the child is too young to handle things or if the funds are too great. Alternatively, he must be given the right to withdraw an amount at least equal to the annual gift tax exclusion. Of course, because he's still a minor, it's you, his parent, who decides whether to exercise this right.
- Section 2503 trust. This type of trust must allow trust income and principal to be used for the child until she's 21. At that age, all the money still in the trust must be paid to the child. At that time, the child is allowed to decide whether to extend the trust.
A Kid's Rights in the Trust
Once you put money in a child's name, it's his. You can't get it back, even if you need it. (Of course, the same is true of any gift you make.) As beneficiary of the trust, your child is entitled to whatever income and principal from the trust that the trust document says he's entitled to. Usually, this is only the income while he's a minor.
When do you tell a child about being a beneficiary of a trust? There's no magic age because it depends on your circumstances. Does he need to know? What would happen if he knew? As a general rule, it's always a good idea to give as much information about financial matters as your child can handle. There's no point in telling a 10-year-old that there's a million dollars sitting in trust that Grandma funded for him. But as a child gets older, this can ease concerns about being able to pay for college or do other things—plus, you can start to prepare him to handle his money.
When the trust ends and whatever remains in it is distributed to the child, he's usually entitled to an accounting from the trustee. This means that the trustee must show how the money has been spent over the years. If the trustee has acted in violation of the terms of the trust or state law, then your child has a lawsuit for damages against the trustee.