Trusts are fairly simple. Lawyers and estate planners make them seem more complicated than they are. That’s too bad, because nonlawyers  need to understand the different types of trusts and how a trust can ensure an estate plan is effective.

Trusts used to be for only the very wealthy or special situations. But now trusts are included in many estate plans, because they can help achieve so many goals. Almost everyone needs a working knowledge of trusts.

A trust is simply a contract between three parties. The parties can be groups, because more than one person can share any of the roles. Or one person can have more than one role, even serving as all three parties.

One party to the trust is the grantor or creator. Not surprisingly, this is the person who created the trust by signing the trust agreement and usually puts all the assets in the trust. Another party is the trustee. The trustee agrees to manage the assets according to the terms of the trust agreement and the law. Legally the trustee acts as owner of the assets, but the actions of the trustee are limited by the trust agreement and state law. In addition, the trust assets cannot be reached by personal creditors of the trustee.

The third party is the beneficiary. Beneficiaries have rights to receive income or principal or both according to the terms of the trust agreement, and the trust assets are managed for the benefit of the beneficiaries. Sometimes beneficiaries have other rights, such as the ability to change trustees or name who receives their interests after they pass away. Beneficiaries usually are named by the trustee when the trust is created, but there can be other ways a person becomes a beneficiary.

Either the beneficiaries or grantor normally can sue the trustee for violating the trust agreement or mismanaging the assets.

Trusts are very flexible. There are few limits to the terms that can be put in the trust agreement. To make their work easier, lawyers have shorthand names for trusts designed to achieve specific goals. The tax law also gives names to trusts with certain provisions. The flexibility and different names can make trusts seem confusing.

In general, it is easiest to think of trusts in four categories. In each category there are two possible labels. A trust can carry attributes from more than one category.

Living vs. post mortem. A living trust simply is a trust created during the grantor’s lifetime. A post mortem trust is one created in or as part of the will. A living trust often is given the Latin name inter vivos trust.

Keep in mind a trust can be created but not funded. For example, a grantor and trustee can sign the trust agreement. That creates the trust. But the trust has no effect and there is no business for it to do unless property is transferred to it. It is not unusual for grantors to create trusts then fail to transfer title to any assets to them. Also a trust can be created during life but funded only under the grantor’s will.

When most people hear the phrase “living trust” they actually are thinking of a revocable living trust, which is discussed in the next category.

Revocable vs. irrevocable. A living trust can be revocable or irrevocable. In a revocable trust, the grantor reserves the right to revoke the trust or change some of all of its terms. For example, the grantor might reserve only the right to change the beneficiaries but not the rest of the terms. An irrevocable trust is what the name says. Its terms cannot be changed by the grantor after the trust agreement is signed.

A very common trust is the revocable living trust. It is used to avoid probate in states with high probate costs or long probate procedures, especially California and Florida. It also is an aid in disability planning, because a substitute trustee takes over management of the assets when the initial trustee is disabled.

Under the revocable living trust the grantor transfers title to almost all his or her property to the trust, including homes, cars, checking accounts, investment accounts, and household furnishings. The grantor and grantor’s spouse usually are the initial trustees and beneficiaries. They generally treat the property as they did before the trust, except everything must be in the trust’s name, and they manage it as trustees instead of individuals. The trust agreement spells out who succeeds them as trustees and beneficiaries.

Property owned by a trust is transferred to the next generation under the terms of the trust agreement. A will has no effect, and property owned by a trust avoids the probate process. There is no public recording of the trust, and the trustees do not have to ask a court to transfer title to heirs. Instead, the trust agreement controls. That is why a revocable living trust is called a will substitute.

There are serious tax differences between revocable and irrevocable trusts, and tax consequences often dictate which is used. When a grantor creates a revocable trust, the grantor is treated as the owner of the property for tax purposes. The trust assets are included in the grantor’s taxable estate. Income and gains of the trust generally are taxed to the grantor as earned, whether or not money is paid from the trust to the grantor.

Irrevocable trusts can reduce income or estate taxes. When properly structured, trust property is not included in the grantor’s estate, and trust income and gains are taxed to either the trust or the beneficiary. While irrevocable trusts can reduce taxes, they really must be irrevocable and the grantor cannot have the right to retrieve the property or be paid the income.

Income vs. total return. The next category refers to how annual payouts to the beneficiary are determined, if annual payouts are made. Traditionally, the income beneficiaries of a trust receive only income earned by the trust’s assets. Income generally is defined as interest, dividends, and rents. Capital gains are not income. They are added to trust principal. A traditional trust pays all income to the grantor’s spouse for life with possible payments of principal as needed. After the spouse’s demise, the children receive the trust principal, known as the remainder.

The income trust became less feasible as interest rates declined and the cost of living increased. Income stays the same or declines as the income beneficiary’s cost of living rises. The trustee could try to increase income by investing in riskier, higher-yielding income vehicles, but that puts the principal at risk. Another tension is the remainder beneficiaries want some of the trust invested for growth. Otherwise, the purchasing power of their remainder interest declines because of inflation. But the needs of the income beneficiary discourage growth investing.

A total return trust solves these problems. The “income beneficiary” is paid a percentage of the trust assets, a fixed amount, or an amount determined by a formula. The trustee does not worry about restricting payouts only to income. Instead, the trustee invests for long-term growth with a diversified portfolio. The income beneficiaries can be paid from income, capital gains, or principal. The total return trust is the better way to structure trust payouts today.

Discretionary vs. nondiscretionary. This category refers to the trustee’s ability to vary distributions or payouts. In a nondiscretionary trust, the trustee is told in the trust agreement how much to distribute to income beneficiaries each year or how to calculate the distributions, as in the income and total return trusts. The trustee also is told when to distribute the principal and how much to distribute to each beneficiary. For example, the trustee might be required to distribute one third of the principal to a beneficiary upon turning age 21 and the remainder at age 35.

A discretionary trust allows the trustee to exercise judgment at least part of the time. The trustee might distribute to the surviving spouse all income earned by the trust plus whatever principal or capital gains are needed to maintain the spouse’s standard of living in the trustee’s judgment. Or the trustee might be able to withhold any distribution when the trustee believes it is in a beneficiary’s best interest, such as when the beneficiary has a substance abuse or gambling problem. Some trusts are completely discretionary, allowing the trustee to distribute income and principal whenever and in whatever amounts are deemed in the best interests of the beneficiary.

These are the broad ways of categorizing trusts. There are many specialized trusts. There are charitable trusts (several types of them), dynasty trusts, grantor retained annuity trusts, grantor retained income trusts, and many more. These specialized trusts usually are used to accomplish certain goals at a minimum tax cost, and the tax law dictates the details of the trusts. But each of these specialized trusts also can be defined by these categories. They are specialized trusts within the categories.

Now, you know the basics of trusts. You can intelligently review and discuss estate plan options, know the key questions to ask about a trust and the consequences of the answers. You are ready to put together a more effective estate plan and to avoid having a trust you don’t need or that does not meet your goals.