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

By — John Wiley & Sons, Inc.
Updated on Jul 26, 2010

No two trusts are alike in every respect. Different grantors, beneficiaries, and fiduciaries make sure this is the case. Individual provisions make the variations even more pronounced. And that doesn't even begin to touch the wide variety of types of trusts that are available: living trusts, grantor-type trusts, irrevocable inter vivos trusts, testamentary trusts, and so on. The list is lengthy, and each serves a particular purpose. Still, some basic types of trusts may be particularly appropriate for you when saving for your children's college education.

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.

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