When Does It Make Sense to Set Up a Trust Fund for Your Kids?

Written by: John Landers

Trust funds aren’t only for ultra-rich but middle class families can also set up trusts. Many parents and grandparents have made trusts a key component of their estate planning strategy. They choose trust as a way to preserve their wealth and minimize or eliminate estate taxes. The main benefits of setting up a trust are: 1) Asset protection for beneficiary and 2) tax savings.

Asset protection means that property put into the trust is managed by a trustee. The trustee may be a trust company or individual skilled at managing money. The trustee ensures the child doesn’t’ squander the funds and protect the money for the person’s benefit. The person setting up the trust fund—the grantor— benefits from tax can realize advantages, such as estate, and gift tax advantages from trusts.

Exactly when it makes sense to set up a trust fund for your kids depends on what you are trying to achieve with the trust.

Make sure basic finances are in order

For parents, the most common reason for setting up a trust fund for children is to ensure they are provided for should you and your spouse die before they reach adulthood.  Some parents set up trusts for a special needs child.

Before you set up trusts for your children, make sure that you have other component of your financial house in order. Financial planning expert Susan Orman recommends that you have an eight-month emergency savings fund in place as a top priority. Next, Orman advises people to pay off credit card debt.

If you intend to remain in your home when you retire, she believes it best to pay down your mortgage or invest money into a retirement account before setting up trust for your kids.

Trusts for the benefit of children

When you make a gift to a child in trust, the tax code categorizes it as a gift of “future interest.” This means the child cannot touch the money until he or she becomes an adult. IRS code do allow you to set up two types of trusts that qualify for the for the annual gift tax exclusion.

  1. Section 2503 trust– The money in this type of trust—income and principal—must be used to the benefit of the child until he’s age 21. At the age of 21, all the money in the trust must be paid directly to the child. Simultaneously, the child must decide whether to extend the trust.
    1. Section 2503(b) trust –Tax codes require the income to be distributed to the child at least annually while the person is still a minor. The rule does not require the trustee to put the money directly in the child’s hands. If the funds are sizable or the child is too young, the funds can go into a custodial account. The child must be”given” the right to withdraw money up to the annual gift tax exclusion. A parent can decide whether to exercise this right

Some parents use Section 2503 trust funds to finance their child college education.

Kid’s Rights in the Trust
When you put the money into the trust, it becomes the legal property of the child. Your child is the beneficiary of the trust and is entitled to receive any income and principal from the trust as outlined in the trust agreement. In most trust documents, the child can only receive the income if still a minor.

When the trust ends, the balance in the trust must be distributed to the child.  The trustee must also provide an accounting of how the money was spent.

Regulations for trusts vary from state to state . Seek advice and guidance from an attorney in your home state who specializes in trust funds and estate planning issues to find out what trust or other options make sense for your circumstances.


When Does It Make Sense to Set Up a Trust Fund...

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