Home Financial Terms Starting with L Living Trust vs. Testamentary Trust

Living Trust vs. Testamentary Trust

Explore the key differences between living trusts and testamentary trusts in this insightful article.

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Understanding the difference between a Living Trust and a Testamentary Trust is crucial when planning for the future, especially in terms of financial and retirement planning. These two types of trusts serve different purposes and have unique characteristics, which can significantly impact the way your assets are managed and distributed after your death.

Financial advisors often recommend one type of trust over the other depending on the specific needs and circumstances of their clients. Therefore, having a clear understanding of these two types of trusts can help you make informed decisions about your estate planning.

What is a Trust?

A trust is a legal arrangement that allows a third party, known as a trustee, to hold and manage assets on behalf of the trust’s beneficiaries. The person who creates the trust is known as the settlor, grantor, or trustor. Trusts are used for a variety of purposes, including to avoid probate, protect assets, provide for minors or disabled family members, and reduce estate taxes.

There are many types of trusts, but they can generally be divided into two categories: living trusts and testamentary trusts. These two types of trusts differ primarily in terms of when they are created and how they are funded and managed.

Living Trusts

A living trust, also known as an inter vivos trust, is a trust that is created and takes effect during the lifetime of the grantor. The grantor typically serves as the initial trustee and maintains control over the trust assets during their lifetime. Upon the grantor’s death, a successor trustee takes over the management and distribution of the trust assets according to the terms of the trust agreement.

Living trusts can be either revocable or irrevocable. A revocable living trust allows the grantor to change or terminate the trust at any time during their lifetime. An irrevocable living trust, on the other hand, cannot be changed or terminated without the consent of the beneficiaries.

Testamentary Trusts

A testamentary trust, also known as a will trust, is a trust that is created by a will and takes effect upon the death of the testator (the person who made the will). Unlike a living trust, a testamentary trust does not exist during the lifetime of the testator and cannot be used to manage assets or avoid probate during the testator’s lifetime.

Testamentary trusts are always irrevocable because they cannot be changed or terminated once the testator dies. They are often used to provide for minor children or other dependents who may not be able to manage their inheritance responsibly.

Key Differences Between Living Trusts and Testamentary Trusts

While both living trusts and testamentary trusts are tools for managing and distributing assets, they have several key differences that can impact their suitability for different situations.

The following sections will delve into these differences in more detail, covering aspects such as creation and funding, control and management, probate avoidance, privacy, and tax implications.

Creation and Funding

A living trust is created and funded during the lifetime of the grantor. This means that the grantor transfers ownership of their assets to the trust while they are still alive. In contrast, a testamentary trust is created by a will and is funded with assets from the testator’s estate after their death.

The timing of the creation and funding of these trusts can have significant implications. For example, a living trust can be used to manage the grantor’s assets if they become incapacitated, while a testamentary trust cannot. On the other hand, creating and funding a living trust can require more effort and cost upfront than creating a testamentary trust.

Control and Management

In a living trust, the grantor typically retains control over the trust assets during their lifetime, either by serving as the trustee or by retaining the power to change or terminate the trust. This allows the grantor to continue using and benefiting from the trust assets as if they still owned them outright.

In contrast, a testamentary trust is controlled and managed by a trustee appointed by the testator in their will. The testator has no control over the trust assets during their lifetime because the trust does not exist until after their death.

Probate Avoidance

One of the main advantages of a living trust is that it can avoid probate. Probate is the legal process of validating a will and distributing the deceased’s assets under court supervision. It can be time-consuming, expensive, and public. Because a living trust is funded during the grantor’s lifetime, the trust assets do not need to go through probate upon the grantor’s death.

In contrast, assets that fund a testamentary trust must go through probate because they are part of the testator’s probate estate. This means that the beneficiaries of a testamentary trust may have to wait longer to receive their inheritance and that the value of the inheritance may be reduced by probate costs.

Privacy

Another advantage of a living trust is that it can provide privacy. Unlike a will, which becomes a public record when it is probated, a trust agreement is a private document that is not filed with the court. This means that the terms of a living trust, including the identity of the beneficiaries and the nature and value of the trust assets, can be kept private.

In contrast, a testamentary trust is created by a will, which becomes a public record when it is probated. This means that the terms of a testamentary trust, including the identity of the beneficiaries and the nature and value of the trust assets, are made public.

Tax Implications

Both living trusts and testamentary trusts can have tax implications, but these can vary depending on the specific circumstances. For example, the assets of a revocable living trust are included in the grantor’s taxable estate for estate tax purposes, while the assets of an irrevocable living trust are not. Testamentary trusts can also have estate tax implications, but these are generally less favorable than those of living trusts.

Income tax treatment can also vary. For example, a revocable living trust is typically treated as a grantor trust for income tax purposes, which means that the grantor is taxed on the trust’s income. In contrast, a testamentary trust is a separate tax entity that is responsible for paying income taxes on its income.

Choosing Between a Living Trust and a Testamentary Trust

The choice between a living trust and a testamentary trust depends on a variety of factors, including your goals, circumstances, and preferences. Both types of trusts have their advantages and disadvantages, and what works best for one person may not work best for another.

It’s important to discuss your options with a qualified financial advisor or estate planning attorney who can help you understand the implications of each type of trust and guide you in making the best decision for your situation.

Considerations for Choosing a Living Trust

If you value privacy, want to avoid probate, or need a mechanism to manage your assets in case of incapacity, a living trust may be a good choice for you. A living trust can also provide more flexibility and control during your lifetime, as you can change or terminate a revocable living trust at any time.

However, creating and funding a living trust can require more effort and cost upfront than creating a testamentary trust. If you have a small estate or if your main concern is providing for minor children or other dependents after your death, a testamentary trust may be sufficient.

Considerations for Choosing a Testamentary Trust

If you have a small estate, want to provide for minor children or other dependents after your death, or do not mind the probate process, a testamentary trust may be a good choice for you. A testamentary trust can also be easier and less costly to set up than a living trust, as it is created by your will and does not require transferring assets during your lifetime.

However, a testamentary trust does not provide the same level of control, flexibility, and privacy as a living trust. It cannot be used to manage your assets in case of incapacity, and it does not avoid probate. If these factors are important to you, a living trust may be a better choice.

Conclusion

Both living trusts and testamentary trusts are valuable estate planning tools that can help you manage and distribute your assets according to your wishes. The best choice depends on your individual circumstances and goals. By understanding the differences between these two types of trusts, you can make an informed decision that best serves your needs and those of your beneficiaries.

Remember, estate planning is not a one-size-fits-all process. It’s important to seek professional advice and to review and update your estate plan regularly to ensure that it continues to meet your needs and objectives.

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