How Trusts Work

Common Trust Terms

There are several important terms and definitions you should know if you're thinking about setting up a trust.
There are several important terms and definitions you should know if you're thinking about setting up a trust.

To really understand how trusts work, it helps to know a few terms.

A grantor is the person or family that sets up and funds the trust. The grantor may also be called a settlor or donor, but whatever term you choose, this is basically the money source.

The beneficiary is the person, or persons, who will get assets or property from the trust. The trustafarians we mentioned earlier? Those would be the beneficiaries.

The trustee is the third party, either a person or organization, that manages the trust according to the grantor's instructions. The grantor may be the trustee when the trust is first set up and then name a successor trustee for the life of the trust. The grantor may also be a beneficiary of a trust at the beginning. These are called grantor trusts. Until the grantor is no longer able to make decisions, the trust can exist for his or her benefit.

Whether an individual or a trust company, the trustee is a fiduciary, meaning the trustee should manage the assets according to the instructions in the trust.

The trust instrument is the written document that spells out the terms of the trust.

Revocable trusts are those that can be changed or revoked by the grantor after it is set up. That means the grantor retains control of the assets. In a revocable trust, any income generated is taxable to the grantor, who pays taxes on distributions and any capital gains.

Irrevocable trusts generally can't be changed once they are set up. The grantor loses control of the assets to receive full tax benefits. Trusts may start out as revocable and become irrevocable upon the death of the grantor.

The distinction between revocable and irrevocable is important. Typically, there are no tax or asset protection benefits to a trust that you can still control, or a revocable trust. You can end and liquidate a revocable trust to pay a creditor, for example. An irrevocable trust, on the other hand, can't be stopped or changed once it's funded. This lack of control makes it easier to prove it's out of your estate should a creditor come knocking.