How Does a Bare Trust Work?
Parents and grandparents looking for a way to pass assets to their beneficiaries should consider a bare trust, also known as a naked trust or simple trust. It is one of the simplest forms of a trust but can still be an effective way to accomplish the goal of handing off assets to the next generation. Although this kind of trust is not available in the U.S., Americans can set one up outside the country for the benefit of a child or grandchild. If you need help sorting through the estate planning options, try out SmartAsset’s free financial advisor matching tool to get the specialized help you might need.
What Is a Bare Trust?
A trustee can place assets into a bare trust for the use of a beneficiary. Once set up, a bare trust’s beneficiary has an absolute right to the assets, principal and income produced by its assets. However, the assets will remain in the trustee’s name. Trustees of a bare trust are expected to manage the assets with the intent of maximizing profit. If the beneficiary is of age, the trustee is expected to follow the beneficiary’s directions, assuming the instructions are legal.
Although the trustee can be involved in managing the assets, the trustee doesn’t have control over the distribution of capital or income. Instead, the beneficiary determines the particulars of the distribution of the income or capital.
Typically, the beneficiary won’t have the ability to make decisions about the distribution of capital or income until they are at least 18 years old. However, the trustee can choose the age at which this control is conferred to the beneficiary. With that, the age at which a beneficiary can access the capital or income held in a bare trust may vary.
Bare trusts can have more than one beneficiary. But that’s only the case if each beneficiary is entitled to a set share of the assets. After the initial setup, a trustee cannot change the determined share amounts or reclaim the assets for their personal use.
In many cases, bare trusts are used as a way for grandparents or parents to fund educational costs. This is because trustees can reasonably estimate the costs ahead of time. Even with rising education costs, trustees can limit the funds placed into the trust. With that, the beneficiary will only have access to a smaller lump sum instead of an extreme amount of money.
Tax Implications of a Bare Trust
How Does a Bare Trust Work?
While you cannot set up a bare trust in the United States, an American could set up a bare trust in Canada or in the U.K as a non-resident trust. However, that choice would come with plenty of tax consequences. On the U.K. side, non-resident trustees are subject to unique tax requirements based on the assets in the trust and the citizenship status of the trustee and the beneficiaries. But in general, non-resident trustees should expect to pay dividend taxes of their basic rate on income in a trust produced by a U.K. asset. If the income is produced through foreign assets, a non-resident shouldn’t have to pay U.K. taxes.
Additionally, non-resident trustees would face U.S. tax consequences. As the owner of the trust, you would be taxed by the IRS on income produced from a foreign trust.
With these complications, it seems more likely that U.K. residents would use a bare trust. When a U.K. trustee places the initial assets into a bare trust, it may qualify as an exempt transfer. If exempt, the beneficiary will not have to pay an inheritance tax if you survive for at least seven years after the transfer.
Once the U.K. beneficiary withdraws income or assets from the trust, they pay taxes at their regular income tax rate. Additionally, the assets within the trust may be subject to capital gains tax.
Pros and Cons of a Bare Trust
As with every estate planning option, a bare trust has some advantages and disadvantages to consider. Here’s a closer look at both sides.
Let’s start with the benefits of a bare trust:
Straightforward. The setup and administration of this type of trust are relatively streamlined, which makes for easier management.
Potentially lower tax burden on beneficiaries. If the trustee survives for at least seven years after opening the trust, the beneficiary may be able to avoid inheritance taxes.
Now for the drawbacks of a bare trust:
No changes. After the you set up the bare trust, you can’t make any changes.
No recourse. The trustee relinquishes control to the beneficiary when they come of age. If the trustee disagrees with the way the beneficiary uses the assets, there is nothing they can do.
How Does a Bare Trust Work?
A bare trust offers an efficient tax option for trustees to pass on assets to the next generation. But the lack of control over the distribution and use of the funds might not sit well with many. If you don’t feel comfortable handing over the keys to the kingdom, that’s understandable. Consider a different type of trust with more discretion given to the trustee might be a better option.
Tips on Estate Planning
Before moving forward with a bare trust, make sure to understand all of your trust options.
Estate planning isn’t always easy. Consider working with a financial advisor to create the best plan for your unique situation. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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