Technically speaking, a trust is an account where you appoint another party to handle assets under a fiduciary responsibility understood by all stakeholders.
But, really, in plain English, what the heck is a trust account?
Breaking down a trust account
The basic idea of a trust account is to designate another party to hold on to your assets, and possibly manage them, too.
There are several types of trust accounts designed for a variety of different financial planning purposes. Their primary use is to save money for a long period of time.
Trust accounts can be useful for estate planning because funds are delivered to a beneficiary quickly. The accounts also provide tax advantages and more privacy in asset dealings.
One of the most common examples of a trust account is an escrow account. An escrow account is set up at a bank or another financial institution that can legally perform certain duties on behalf of the account owner.
What’s the difference between a trust account and a custodial account?
Custodial accounts and trust accounts are similar. Both account types have similar structures, including the ability for the account holder to authorize a separate party to handle the assets. However, custodial accounts have a specific purpose, which is narrower in scope than a trust account.
Custodial accounts can be thought of as a type of trust account, and are used to save money for children, their beneficiaries. These accounts are set up under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). Custodial accounts allow minors under—generally defined as someone under the age of 18—to own an account without the burden of handling the assets. The responsibility of managing the account falls to the custodian. Custodians are usually the parents or appointed guardians.
Custodial accounts can help teach young people investing and money management basics, by allowing custodians to show them what goes into investing.
Individual retirement accounts, or IRAs, can also function as custodial accounts. Custodians, in those scenarios, are banks or financial entities responsible for handling the assets in your retirement fund.
What is a trust account?: Use cases
Aside from custodial accounts, there are many other types of trust accounts.
While custodial accounts are designed to save money for children, other trust accounts are designed to save money for family members in the event of the account holder’s death, or even for charities if the account creator wishes.
It’s likely that you can set up a trust that fits with your own particular plan. Trust accounts can be set up in a variety of ways to meet specific account requirements on how and when to use the assets.
Trust account advantages
Trusts allow for a significant degree of control over assets since you can specify the terms of the trust. Terms can include how to use and distribute the assets at an appointed time.
Trust accounts can also protect wealth—they lock assets into place for a specific purpose or beneficiary. Most trust accounts can even prevent creditors from touching the assets.
Trusts are also set up to protect your privacy. They can avoid probate, which is a process involving a court and a judge, that makes the use of your assets a matter of public record.
Trust account disadvantages
Setting up a trust account can be a costly and complex process.
Many trust accounts are also inflexible once they have been set up. For example, assets can’t be withdrawn or used for purposes that differ from the terms of the trust. For some accounts, the assets in the account may no longer even belong to you; They become the property of the beneficiaries of the account.
Custodial account advantages
Custodial accounts are generally flexible. The money does not just need to be spent specifically on educational endeavors, for example. The child can also use the money for purposes including travel or medical expenses once they reach adulthood and the money belongs to them.
Custodial account disadvantages
One of the key disadvantages of a custodial account, however, is that it can impact financial aid eligibility when it comes time to apply to college. Custodial accounts are assets in a child’s name, which can put a family in a higher income bracket.
Another disadvantage is that tax breaks are limited for custodial accounts. Contributions under $1,050 go untaxed, while anything more than that can be taxed at different rates depending on where you live.
The investments choices in custodial accounts are also limited. The account is restricted to mutual funds and similar investment types offered by regulated investment companies.