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What in the world is a trust?

Trust. It's often the bedrock of family relationships.

But in this case, we're not talking about simple faith in one's word, but rather a legal arrangement dealing with transfer of control.

Used most frequently to avoid estate taxes after you kick it, trusts allow your assets to be passed on to specified beneficiaries under conditions determined by you. While the nature of a trust limits some of your control over those assets -- once established, the trust owns whatever you've put in it -- it can serve as a nice shield against liabilities like owing taxes or forfeiting assets if you get sued.

Trusts generally are not do-it-yourself projects, nor are they cheap. They primarily apply to the relatively well to do -- under current rules if you have an estate valued at more than $1 million, you would do well to shelter the excess under a trust of some kind as your heirs will face estate taxes that could reach 50%. In the coming years, the estate exemption value will rise to $3.5 million (in 2009) and the tax rate on the excess will drop incrementally (to 45 percent that same year) until the estate tax is eliminated in 2010. If those numbers sound too enormous to ever apply to your puny assets, remember that "estate" means basically everything you own -- the house or condo, your retirement funds, your life insurance policies, your investment portfolios, even your furniture. Adds up, don't it?

If you're not Richie Rich just yet, don't ignore the trust concept altogether. As your parents age and retire you'll need to familiarize yourself with the ins and outs of their estates, especially if they become seriously ill. What's more, if you've opened your IRA or 401(k) -- the way every single one of you should have -- you've already turned your sights to planning ahead. And as you approach the age when you'll own a home or have significant others relying on your significant assets, you need to start planning your estate to make sure your money gets to the folks you love.

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It's not a problem, though. Getting yourself a will  is pretty easy and relatively cheap. Soon afterward -- if you work hard, are lucky, or both -- you'll have gobs of dough worth sheltering with trusts.

As your parents age and retire you'll need to familiarize yourself with the ins and outs of their estates, especially if they get seriously ill.

So what are the most popular types of trusts? A lot of folks begin with a bypass trust, one for you and one for your spouse. Normally, if you die without a trust of any kind, your spouse collects your estate assets tax-free. But that only puts things off until he or she dies, at which point there's a huge estate ripe for whittling by Uncle Sam. A bypass trust lets all the assets in the trust "bypass" your spouse for the benefit of your children, while at the same time giving your spouse access to the interest on those assets and even some of the principal. In other words, your spouse gets to use the bucks even as the money is safely earmarked for your kids. When both of you create bypass trusts, you'll be able to double your estate tax exemption from $700,000 to a full $1.35 million (by 2006, you can make that $2 million).

Frequently paired with bypass trusts, a QTIP trust allows assets to pass into your spouse's estate, but you get to choose who ultimately gets the trust's assets. Usually if you want to call the shots on who gets the dough, that money has to be considered part of your estate not that of your spouse -- not so with the QTIP. The bypass/QTIP combo is sometimes referred to as an A-B trust arrangement.

Living trusts help you scoot your heirs out of probate -- the often lengthy process by which courts decide if your will is valid after you die. Putting your entire estate in a living trust makes the process much quicker, allowing your beneficiaries to get at your assets sooner. Living trusts, however, offer only speed and convenience. No tax breaks here.

A trust's status as revocable or irrevocable refers to whether you can change your mind once the trust is set up. Irrevocable trusts are the more sure-fire way to go since revocable, or changeable, trusts often don't hold water with courts. Why not? Well, a not so trustworthy citizen could decide to set up a quickie trust to shelter assets temporarily and then revoke it later when the need passes. For example, if you set up a revocable trust to shelter some of your moola when your kid is applying to colleges, you could fool Whatsamatter U. into giving your child a sweeter financial aid package by appearing to have less in the bank than you really do. Sounds good until the IRS finds out.

Kay Bell contributed to this story.

-- Updated: Jan. 6, 2003

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See Also
Preparing a will
Estate planning: Avoid these grave mistakes
The basics of estate taxes
Investing glossary
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