How to Set Up a Trust Fund

There are many ways to set up a trust depending on what you want to achieve. You may see trust funds as a tool of the ultra-wealthy, but they can be useful to anyone who wants to protect their assets for the future needs of the people or causes that are important to them.

People entering second marriages may set up trust funds to protect property for the children of their first marriages. People who want to contribute to the causes of their choice can set up trusts to manage the money for the long term.

But trust funds are most commonly set up to cover the future educational costs of children and grandchildren. They certainly are useful for the purpose, but there may be easier and less expensive ways to set aside money for them.

Structure and Operation

Regardless of their size and purpose, all trusts have the same basic structure and terminology.   The terms “trust” and “trust fund” are often used interchangeably but they have slightly different legal meanings.

• A trust is a legal arrangement evidenced in a written agreement transferring property from a grantor to a trustee for specified purposes. The trustee has the fiduciary responsibility to manage the property in accordance with the directions in the agreement and the best interests of the trust’s beneficiaries.
• A trust fund is the property transferred by the grantor to the trustee, known as the "corpus" of the trust. Though the word fund suggests financial assets, almost any type of property—including real estate, art, patents, or copyrights—can comprise all or part of a trust fund.  

Revocable Grantor Trusts: Ownership Retained

In some circumstances, the grantor is the trustee and retains ownership and control of the assets. This is sometimes used to avoid the cost, time, and potential publicity associated with the probate of an estate.

A grantor may create a revocable trust by limiting the term that the trust remains in effect or retaining the right to end the arrangement.

Grantor trusts serve a variety of purposes but do not offer tax savings. The grantor continues to be liable for any taxes due on trust income, and the assets may be available to the grantor’s creditors.

Employers create grantor trusts to identify and segregate assets to back future liabilities for employee retirement benefits.

Some public officials transfer stock shares and other investments to blind trusts to be managed by a hird party without the officials’ knowledge during their tenure in office to avoid potential conflicts of interest. 

Irrevocable Trusts

When the grantor permanently transfers ownership and control of property to a third-party trustee, the trust is irrevocable. The grantor no longer owns the transferred assets and is not responsible for any taxes due, and the trust assets cannot be claimed by the grantor’s creditors.

These trusts—which are often designed to provide financially for children and grandchildren or to serve as college funds—have tax- and estate-planning benefits for the grantor.  

Trusts for Individuals

Irrevocable trusts are often used to hold assets for the benefit of family members. The trust itself can be named the beneficiary of life insurance policies and individual retirement accounts (IRAs), though doing so subjects the funds to estate taxes and IRS regulations on retirement withdrawals.

When constructed correctly, trust arrangements can provide tax- and estate-planning advantages. Grandparents often appoint a parent as trustee for their children. 

Depending on the terms of the arrangement, beneficiaries may receive income or assets from the trust fund during the lifetime or after the grantor's death. For example, the trustee of a college trust fund may be directed to use trust income to pay tuition expenses directly to the school and to pay or reimburse the beneficiary for college living expenses.

Distributions also might be scheduled at a specific age or event. Use of the trust distributions may be limited to specific purposes such as medical expenses or a down payment for a home or left to the beneficiaries’ choice.

How Are Trusts Managed?

The trustees of a trust may be individuals or the trust departments of banks and other financial institutions. Typically, their responsibilities include the collection of income, disposition and replacement of assets, and distributions to beneficiaries. Distributions may be required on a prescribed schedule or for specific purposes.  

Trustees are compensated for their work unless the fees are waived, as sometimes occurs with family member trustees. The management of trust assets includes record-keeping and reporting as well as legal and tax compliance. 

Creating and documenting a trust with a limited amount of financial assets and simple, clear directives usually entails legal fees of a few thousand dollars and low annual expenses. Expenses increase with the value of the trust fund and the complexity of its terms.

Expenses of Managing a Trust Fund

In addition to trustee fees, trusts may incur expenses for financial and investment advisors, attorneys, accountants, property managers, and brokers. Financial institution trust departments generally charge annual fees of 1% to 2% of the value of trust assets, with the rate declining as the values managed increase.

Some large investment firms—especially those that offer mutual funds for retirement and other personal accounts—offer standardized, relatively low-cost trust services.

Individuals who use online services for banking and investment accounts can establish trust fund accounts directly online. However, a substantial trust, particularly one with varied assets, may incur significant costs. It’s important to consider alternative arrangements that might cost less.

Estate Planning and Trusts for Children

Trusts can help parents and grandparents plan for their offspring’s financial needs while complementing their own tax and estate planning. However, it's worth investigating whether there are simpler and less expensive alternatives.

Parents whose total estate values exceed the estate tax threshold of $12.92 million for 2023 may want to consider removing assets from their estates by transferring their ownership to trusts.

The gift tax exemption is set at $17,000 for 2023. That means each parent and grandparent can make a gift of up to this limit annually per recipient without incurring a gift tax.

If the value of a gift exceeds that amount, the excess is taxable, but the tax isn’t due until the total of “excess” gifts exceeds the estate tax threshold. Only then are the excess gifts added back to the value of the remaining estate and taxed.  

Affluent families may take advantage of trusts to limit the value of their estates, reducing their tax rate to the rate imposed on their children’s income. Any appreciation in the transferred asset ultimately belongs to the beneficiaries. For example, the trust would pay capital gains tax on the sale of any stock shares held in the trust.

Also, if assets paying dividends or interest are transferred to an irrevocable trust, the grantor will not owe tax on the income. Instead, the trust must pay tax, at rates from 10% to 37% as of 2023, on annual income that is not distributed during the year.

Annual income distributed to a grantor’s child can be taxed under the "kiddie tax" at rates lower than the grantor’s higher rates.

Alternatives to Trusts for Education

Financing a child’s education may be the most common reason that families create trusts. However, for families who are not ultra-rich, there are alternative vehicles that can be more efficient.

The most common alternatives to college trust funds are direct payments to the college on behalf of a grandchild, contributions to a Section 529 plan, or setting up either a Uniform Gifts to Minors Act (UGMA) account or a Uniform Transfer to Minors Act (UTMA) account. 

Section 529 plans and UGMA and UTMA accounts can be set up through banks and financial institutions making them less costly to set up and manage than trusts.

Research the fees charged by 529 plan sponsors before choosing one. Some investment firms sponsor plans that have no upfront or management fees. Other brokers and advisors charge relatively high fees that lower the plans’ returns.

Another option is a Coverdell Education Savings Account (ESA). These can be established for children under the age of 18 for elementary, secondary, and postsecondary educational expenses.

Unlike the other two options, there are income limitations: A contributor to a Coverdell ESA must have a modified adjusted gross income (MAGI) of less than $220,000 for a joint return and $110,000 for a single return.

Section 529 Plans

Section 529 plans are established by states or their agencies and enable a contributor to prepay—or contribute to an account to prepay—a beneficiary’s qualified educational expenses.

Contributions are not tax-deductible but earnings and distributions for qualified expenses are tax-free. Funds may be used to pay tuition and necessary expenses for both postsecondary and K-12 schools.

Funds can also be used to repay student loans up to a lifetime limit of $10,000. In the case of K-12 education, an annual limit of $10,000 of expenses may be paid with funds from the Section 529 plan. The beneficiary can generally exclude the earnings and distributions from taxable income.

Most 529 plans offer investment options that are limited and conservative. Before investing in a 529 plan, fees charged by plan sponsors should be compared. They differ widely.

Parents and grandparents establishing Section 529 funds can maintain control over the accounts and distributions, and even change the beneficiary. Contributions to a Section 529 plan can be front-loaded. Five years of annual gifts of up to the 2022 gift-tax limit of $16,000 would equal $80,000, while five years of annual gifts up to the 2023 gift-tax limit of $17,000 would equal $85,000.

Because contributions can be substantial, especially if front-loading is chosen, establishing these accounts for young children can result in significant tax-free savings for college.

In some cases, these plans—or the distributions from them—will harm a student’s ability to obtain need-based financial aid.

UGMA and UTMA Custodial Accounts

Custodial accounts can be established for underage beneficiaries under the Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA).

Both entail irrevocable transfers of assets to accounts for minors. Transfers are nontaxable to the beneficiary up to the annual gift tax limit. The assets must be transferred from the custodial account to the beneficiary upon attaining an age set by state law, generally 18 or 21 years.

Although not limited to educational financing, these vehicles are often used as a simplified form of college trust fund.

Earnings on these accounts up to the child’s annual taxable income ceiling are taxable at the beneficiary’s tax rate, which is generally lower than parents’, grandparents’, or other contributors’ tax rates. Income above the ceiling is taxed at the parents’ rate.

UGMA accounts are limited to money and financial securities, while UTMA accounts can hold tangible and even risky assets such as art and real estate. As savings vehicles, these accounts can provide funds to beneficiaries for any purpose, not just educational expenses. 

Coverdell Education Savings Accounts (ESAs)

Coverdell ESAs can be established for children under age 18 for qualified elementary, secondary, and postsecondary educational expenses. Contributions must be made in cash and are not tax-deductible.

The maximum total of contributions for a beneficiary cannot exceed $2,000 per year. Earnings are not taxed; distributions also are tax-free provided they are used for qualified educational expenses.

A contributor to a Coverdell ESA must have a modified adjusted gross income of less than $220,000 for a joint return and $110,000 for a single return.

Other Trusts

Federal and state laws expressly recognize and provide benefits for trusts that help individuals with disabilities. In particular, special needs trusts and ABLE program accounts enjoy legal recognition.

Special Needs Trusts

A special needs trust provides financial assistance to an individual with disabilities while maintaining that person’s eligibility for government benefits based on need, such as Medicaid and Supplemental Security Income. These trusts must be operated for the sole benefit of the beneficiary, who must be under the age of 65 when the trust is created. It pays for costs that are not covered by Medicare or Medicaid.

If the trust is established with assets owned by the individual with disabilities, it generally must be irrevocable and must provide that Medicaid will be reimbursed upon the beneficiary’s death or the trust’s termination.

Specialized professional advice is important in the creation and operation of these arrangements because state laws impose varied and complex requirements.

ABLE Programs

The tax code provides benefits for people with disabilities or blindness through tax benefits for state-sponsored savings programs established under the Achieving a Better Life Experience Act of 2014 (ABLE).

Contributions to ABLE accounts must be in cash and are not tax-deductible. Earnings and distributions for qualified disability expenses are tax-free and the accounts do not count against eligibility for other federal assistance programs.

The Bottom Line

Trusts are useful arrangements for designating assets for specific purposes. Differences in legal structure and terms significantly affect a trust's tax impact, asset protection, and benefits. 

In some cases, alternative vehicles can be more efficient and less costly. Careful evaluation is critical, and professional advice is advisable.