If you have acquired assets in your life, you surely want to have a plan in place for how those assets will be distributed. And the more you plan ahead, the less logistical stress your loved ones will experience.
Fortunately, there are well-established legal structures and protocols for transferring assets upon one’s death. This general process is called estate planning. Estate planning can include drafting a will, setting up a trust, or making other legal plans for how your assets will transfer upon your death.
The various terms involved in estate planning are often confused. For instance, what is the difference between a trust and an estate? This comprehensive guide will set the record straight and help define some of the most common terms and practices in the world of estate planning.
What Is an Estate?
An “estate” is simply everything that an individual or household owns. It includes all the person’s assets — real estate, investments, possessions, etc.
Technically speaking, the legal definition of “estate” refers to an individual’s net worth, which is calculated as their total assets minus their total liabilities (debts).
The term “estate” is typically used to refer to a person’s assets when they pass away. For example, upon one’s death, their estate may be divided between their children.
Most people can benefit from having an estate plan in place. This is often handled by drafting a will, which creates a one-time transfer of assets upon the individual’s death. Many families also choose to set up a trust, which provides more control over how and when their assets will be distributed.
Estate planning can be complex, however. It’s worthwhile to work with a professional — and to educate yourself on the various approaches to estate planning.
If you have children, you should, at a minimum, have a will drafted and appoint a guardian for your children should you pass away.
What is an estate plan?
An estate plan is a formal legal plan that establishes an individual’s wishes for how their assets will be distributed.
Estate planning allows a person to lay out clear instructions for how they want their estate distributed upon (or even before) their death. It documents legal heirs, like family members or close friends, as well as charitable causes that the individual wishes to support.
Estate planning is often conducted with the help of a lawyer or estate planning professional. Plans can include various legal forms and documents, such as a last will and testament or a trust.
The plan may also include legal documents that assign legal rights should the individual become incapacitated. These include power of attorney, which assigns a trusted individual the right to make legal decisions if the other person is unable to, as well as an advanced healthcare directive or living will, which outlines an individual’s wishes when it comes to their medical care.
Another main aspect of estate planning is planning for and minimizing estate tax. When an individual passes, the transfer of their assets to other people may be subject to an estate tax. Fortunately, there are generous tax exemptions, which means that many estates won’t owe any tax.
Even so, with estate planning, it is important to plan ahead for potential tax implications. Through optimal structuring, even very wealthy families can minimize the impact of estate tax.
What Is a Trust?
A trust is an agreement that allows a third party — known as a “trustee” — to hold assets on behalf of the intended beneficiaries. It is a common tool used in the estate planning process.
There are three parties involved in a trust:
- Trustor (or grantor) - This is the individual who owns the assets and sets up the trust.
- Trustee - This is the individual or company who is given the right to hold title to the property or assets on behalf of the beneficiaries.
- Beneficiaries - These are the recipients of the trustor’s assets, which may be their children, loved ones, and/or charities. A trust may have just one beneficiary or many.
Simply speaking, a trust allows an individual to transfer their assets to a third party before they pass away and to make known their wishes for how those assets will be distributed.
A trust is established while the trustor is alive. It provides legal protection for the trustor’s assets, ensuring that the assets will be distributed as they wish. Trusts also help to reduce paperwork, as they avoid the probate process.
Some types of trusts provide versatility in how assets will be distributed. For example, a trustor could choose to have certain assets distributed each year leading up to their death, a substantial sum distributed upon their death, and then smaller amounts distributed to their children each year for 10 years after their death.
This is one substantial difference between wills and trusts — wills are designed to transfer assets upon an individual’s death. Trusts can be much more flexible in how and when assets are disbursed.
This factor also makes trusts useful for individuals with young children. By setting up a trust, a person can ensure that their assets will be held responsibly by the trustee until their children reach a certain age and are deemed able to manage the assets themselves.
However, trusts do not establish guardianship rights. Parents of minor children must nominate guardians in their last will and testament. So, parents who choose to set up a trust must still take the required steps to draft a will.
Pros and cons of trusts
Trusts have advantages and disadvantages to consider.
- Allow you to avoid probate court
- Provide flexibility in how assets are distributed
- Enhance privacy over wills (wills are public record in some jurisdictions)
- Can be used for estate tax planning
- Provide legal protection for assets
- Can be pricey — legal setup costs can range from $1,000 to $5,000 or more
- Require substantial paperwork
- Depending on the structure, may not be easily revoked/reversed
- May require ongoing administrative work
The pros and cons of trusts depend on the type of trust, the size of the estate, and other factors. Because there are so many options and types of trust structures, it’s recommended to work with an estate planning professional.
Trusts vs. Wills
Trusts and wills are two common tools used in the estate planning process. They may be used separately or in combination — the best approach depends on the size of the estate and other factors.
All adults should have a will in place, particularly if they have children. Many estates can also benefit from a trust — although this depends on several factors.
The main difference between a will and a trust is that a will takes effect immediately upon the individual’s death. Trusts, on the other hand, can be active either before or after the death of the trustor.
Trusts are also more complex and generally have higher setup costs.
A last will and testament is a legal document that outlines how an individual wants their assets distributed and their affairs handled after their death. It appoints an executor, which is an individual tasked with overseeing the affairs of the deceased person.
Wills can assign beneficiaries (heirs), dictate funeral arrangements, assign a guardian for minor children, and more. Wills are the only common way to assign guardianship rights for minor children — so, even if you use a trust, you’ll also need to have a will in place if you have children.
Wills can also be used to direct an executor to set up a trust upon the individual’s death in order to safeguard he estate’s assets until the deceased’s children come of age.
Wills must be filed with a probate court and must meet all state legal requirements in order to be valid. They are usually drafted with the help of a lawyer or online service.
The instructions included in a will take effect when the individual passes away or becomes incapacitated.
Keep in mind that in many jurisdictions, the contents of a will are made public record. This can present some privacy concerns for some families. Another downside is that having a will does not necessarily avoid the need to go through probate court, which can be a time-consuming process.
On the other hand, wills are much cheaper to set up than trusts. For simple estates, they may be sufficient.
Trusts are discussed in great detail above. In comparing trusts to wills, there are a few things to keep in mind:
- Trusts can be used before and after death and can distribute assets in a specific structure over many years
- Trusts are more costly to set up (often $1,000 to $5,000 or more)
- Trusts often avoid the need to go through probate court, while wills often do not
- Trusts can help minimize estate taxes
- Trusts cannot establish guardianship rights (a will is required to assign guardianship)
Do I need a trust to avoid probate?
Probate court is a court system that deals with the assets and debts of deceased individuals. Many estates need to go through probate court, which can be a time-consuming process.
Having a living trust is a popular way to avoid probate court. A trust is set up prior to the individual’s death, and it allows the person’s assets to be quickly and efficiently distributed without the need for probate court.
In most cases, simply having a will is insufficient to avoid probate. While there are a few other ways to avoid probate court, setting up a trust is the most foolproof.
Estate Planning Tips
If you’re starting to make a plan for your family’s future, here are some things to keep in mind:
Use a professional
Estate planning can be a complex process, and it’s important to handle everything correctly. For this reason, working with a professional to help you draft your plans is recommended.
In most cases, this will be a lawyer who specializes in estate planning. You can search for legal services in your area that offer estate planning assistance.
Financial advisors may also be able to help with basic tasks. In most cases, though, you will need to work with a lawyer.
Consider lifetime gifting
One approach that some families use to minimize taxes is “lifetime gifting.”
Rather than distributing your entire estate upon your death, you can choose to slowly gift your assets to family members over a period of several years or even decades.
There are some tax perks to consider here:
- You can gift up to $16,000 per person per year without a gift tax (no reporting required)
- This can be doubled to $32,000 per person per year if you’re married and filing jointly
- In addition to this annual limit, you can gift up to $12.06 million per person without paying taxes due to the lifetime gift tax exemption
Estate tax planning is complex, so it’s wise to work with a CPA or financial planner to help you minimize your tax liability.
Consider investing on behalf of your loved ones
Another approach is to make investments in your family members’ names. This is a way to give a substantial amount of wealth and allow it to grow over a number of years.
For children, the best way to do this is to set up a custodial investment account. This account is set up in the child’s name, with the adult as the custodian. Funds can then be invested in stocks and other assets. Once the child reaches adulthood, they are given full access to the account.
EarlyBird offers a simple way to set up children’s investment accounts from home. No investing experience is required, and you can choose from a variety of prebuilt investment portfolios.
An estate is simply everything you own upon your death. The process of estate planning is often handled by drafting a last will and testament, a formal document that outlines where you want your assets to go when you pass away. With a will, your assets are transferred to your beneficiaries upon your death.
A trust is a legal entity that is set up during your lifetime. You can use a trust to establish your wishes as to how your assets will be distributed. And importantly, trusts can start transferring assets either during or after your life.
Want to proactively give money to the children in your life? Consider using EarlyBird.
EarlyBird makes it simple to set up custodial investment accounts on behalf of the children in your life. You can then invest money on their behalf — and the account will be transferred to them automatically when they reach legal adulthood.
This page contains general information and does not contain financial advice. All investments involve risk. Any hypothetical performance shown is for illustrative purposes only. Actual investment performance may be different for many reasons, including, but not limited to, market fluctuations, time horizon, taxes, and fees. Please consult a qualified financial advisor and/or tax professional for investment guidance.