Saving for College in Trust Accounts: Types of Trusts and How They Work

Investigating Inter Vivos Trusts

If you're so fortunate as to remember some of the Latin you learned in school, you know that "inter vivos" refers to a period during life. In the case of these trusts, it's during your life. Inter vivos trusts are created by you (the grantor) during your lifetime, to hold assets for another person. These trusts can be revocable (you can change your mind at any time and do away with it, taking back all the assets that you've placed in it) or irrevocable.

Living And Other Grantor-type Trusts

A so-called living trust is probably the most talked-about trust variety in the media these days. Everyone and his brother is touting these trusts as a way to avoid probate and even estate taxes, and they're generally being sold as the greatest thing since sliced bread. In reality, a living trust is an entity that you set up, fund, and then retain total control over. You have the right to revoke the trust at any time as long as you're still alive — once you die, all bets are off. All trusts become irrevocable at the death of the grantor. Because you retain control over the assets, you're taxed on any income earned by this trust just as if you never put it into the trust.

As a college savings vehicle, a living trust really doesn't make much sense. Here are a few reasons why:

• When the financial aid folks come around counting your assets, whatever is in this trust is counted as your asset and a maximum of 5.64 percent of the value will be included in the federal formula for the expected family contribution.You haven't successfully removed it from the mix.
• Even if you make a distribution to your child to pay for his college expenses, you still have to pay the annual income tax bill on the income you've earned in the current year (just like you've been paying every year since you set up the trust).
• If you're the type of parent that wants your child to really understand how much this education is costing, and you hand your child a check and tell him to use it to pay his expenses (fortunately for you, he's a good kid and does what he's told), you've just made a gift to him that may have gift tax consequences.

Irrevocable Inter Vivos Trusts

Although many financial planners use the term inter vivos trust interchangeably with living trust or grantor trust, you can create an inter vivos trust that is irrevocable. And it's with irrevocable trusts that you begin to see some benefits of using trusts to save for future events.

With an inter vivos irrevocable trust, any assets that you put into the trust represent a gift to the person for whose benefit you've created the trust, even though that person may not receive any benefit from the money either now, or ever. And here begins the tricky legal waltz you'll dance, because, in order to receive annual exclusion treatment for the gifts you're making, you have to make a completed gift of a present interest.

A completed gift of a present interest contains two essential aspects: First, it consists of property over which you've given up all dominion and control, and second, the person to whom you've given the property must receive immediate benefit from that property (a present interest). Because, in the case of a trust, you're not actually putting the money into the beneficiary's hands, most contributions to ordinary irrevocable inter vivos trusts don't qualify as annual exclusion gifts and become subject to gift tax (and Generation-Skipping Transfer Tax for gifts to grandchildren) rules and regulations. Even though your control over the gift is severed, your beneficiary doesn't receive any current benefit from it.

Although making taxable gifts into an inter vivos trust isn't necessarily a bad tax move, if you're in the position to be able to gift money away, you really want to be able to benefit from the annual gift exclusion. Three types of trusts allow you to take advantage of this particular tax break.

Crummey Trusts

The name of this particular type of trust isn't a reflection on whether it's a good trust or a bad trust. It's actually named after the poor soul who invented it who was blessed with an awkward last name.

Crummey trusts are irrevocable and must contain so-called Crummey powers, or specific instructions regarding what must happen every time you make a contribution to the trust. And what must happen, in order for the gift to be deemed completed and a present interest, is that your trustee must notify all the beneficiaries that a gift has been made. The trust must then give them the opportunity to withdraw the value of the gift (within a specific period of time, usually 30 or 45 days from the date the gift is made) from the trust and take the cash or other property. The beneficiary's ability to cash out the gift to the trust is what makes it a gift of a present interest and therefore eligible for annual exclusion treatment.

Here's how it works. Aunt Jane decides to set up a Crummey trust for her nieces and nephew (she has three), and names her sister as trustee. Each year, Aunt Jane makes a gift of $39,000 (3 x $13,000 — the current annual exclusion gift per child) into the trust. After her sister receives the check, she sends letters (certified mail and with return receipts, so she can prove to the Internal Revenue Service (IRS) that the notices went out should they decide to ask) to each of the children (or their parents, in the case of minor children), notifying them that a gift has been made into the trust and that they each have the right to withdraw $13,000 within the next 45 days.

Not surprisingly, no one decides to withdraw their share of the money, and their right to ask for the money expires with all the money still sitting in the trustee's possession. Now the trustee is free to invest the money, and Aunt Jane is perfectly within her rights to show she made three annual exclusion gifts on her gift tax return. Meanwhile, the money remains invested in the trust, growing until that time when the beneficiaries need distributions to pay for college expenses (or to buy that first house, pay for a wedding, or whatever other good reason the beneficiary needs the money for).

Even though Crummey trusts are irrevocable, remember that it's very easy to inadvertently turn them into grantor-type trusts (where the grantor pays all the tax each and every year). To avoid this treatment, don't make yourself or your spouse a beneficiary of the trust, and don't name yourself or your spouse as trustee of the trust, because the IRS views a husband and wife as essentially the same person (in case you wondered). To have this trust treated as its own entity, you really need to keep all the roles very distinct.

Section 2053(c) And 2053(b) Trusts For Minors

The only way a minor child can own securities outright is through a Uniform Gift to Minors Act (UGMA) account. One of the great drawbacks of this account, however, is that, at age 18 (or 21, depending on the state), the no-longer minor child now controls the account and everything in it to use as he or she determines.

To give parents and grandparents more control over the situation, you may also create trusts under Internal Revenue Code Section 2053(c) or (b), which allows you to save for that child until he or she reaches the age of 21. Unlike the Crummey trust, this trust doesn't require that you maintain the rather elaborate fiction of providing an opportunity for that child to take money out every time you put money in.

Instead, Section 2053(c) and (b) trusts to minors allow the grantor to create the premise of making annual exclusion gifts in the following ways:

• Section 2053 (c) requires that the trust (all contributions plus all accumulated income) become completely payable to the beneficiary on his or her 21st birthday.
• Section 2053 (b) requires that all income earned (but none of the contributions received from the grantor) is paid to the minor child every year that the trust is in effect.

You may wonder where the benefit lies in creating trusts of this type when you can achieve much the same result by using a UGMA/UTMA account. Well, when drafting the trust instrument, you can include language in it that allows you to change the trust to a Crummey trust when the beneficiary reaches age 21. Because staying away from grantor-trust rules when dealing with a minor child is especially difficult, formulating the trust as a Section 2053(c) or (b) trust during your child's minority and then changing it over after he or she becomes an adult allow you to neatly sidestep some unfavorable tax treatments.

Tackling Testamentary Trusts

As the name suggests, these trusts are created under, and through, your last will and testament. Because these trusts are governed by terms contained in your last will, and because your last will doesn't become truly effective until you die, a testamentary trust comes into being and is administered after your death. Beyond that, it functions in all ways exactly the same as an irrevocable inter vivos trust does. You may include the same provisions in your testamentary trust as you might in any other, especially regarding how, when, and to whom distributions are made.

For obvious reasons, funding a testamentary trust has no gift tax consequences; however, you may have estate tax consequences. To ensure that all your desires for your children and/or grandchildren are carried out after your death, make sure that a competent trust and estate attorney draws up your last will.

If your priority during life is being sure you have adequate resources for your own needs, and you haven't made lifetime gifts of significant pieces of wealth to your family, a testamentary trust may be the ticket. Rather than making specific bequests of money to your children, grandchildren, or other relatives, the terms of the trust govern how your money will be used, preventing your descendents from frittering away their legacies. Because you define what that money may be used for (education is always a nice choice) before you die, you ensure that your money is actually used for those purposes.