A Discretionary Trust is a special type of Trust that gives the Trustee the greatest amount of — you guessed it — discretion. While in most cases a Trust’s beneficiaries have some rights to funds held in the Trust, a Discretionary Trust works differently. So, what exactly is a Discretionary Trust? How does it work, and what are the advantages of using one? This guide will answer these common questions about Discretionary Trusts, and many more.
What is a discretionary trust?
A Discretionary Trust is set up for the benefit of a beneficiary or beneficiaries, but for which the Trustee is given full discretion. The Trustee decides when and how much funds are distributed to the beneficiaries. In turn, the beneficiaries have no rights to the funds held in the Trusts. Further, the funds held in the Trust are excluded from the beneficiaries’ estates.
In most cases, Trusts are set up with specific terms that instruct the Trustee to distribute funds to beneficiaries on a set schedule. The terms also usually set how much should be distributed. Discretionary Trusts are unique from other types of Trusts because there are no such terms. It is up to the Trustee to decide if beneficiaries should receive any distributions, how much, and when.
These Trusts are most useful when the Trustor feels that it is in the best interest of the beneficiaries. For instance, the beneficiary of a Discretionary Trust may have displayed continued irresponsible behavior, is disabled, mentally impaired, has a gambling problem, or has a great deal of debt. The Trustee can help protect the beneficiary from themself, as well as the assets from creditors. It is under the Trustee’s discretion to determine when it is appropriate to provide funds to the beneficiary, and how much.
Beneficiaries of a Discretionary Trust do not have any legal claims over the Trust funds. The Trustee has complete control and is considered the legal owner, although they cannot benefit from the funds in any way.
What is the purpose of a discretionary trust?
The key purpose of a Discretionary Trust is to provide maximum protection for the funds held in the Trust, and to the greater benefit of its beneficiary or beneficiaries.
By giving the greatest amount of power to the Trustee, they can decide how and when beneficiaries should receive funds in such a way that would support them best. Let’s walk through some possible scenarios to illustrate when a Discretionary Trust may be used.
Let’s say that you have an adult daughter who suffers from addiction. She has had several bouts of alcoholism and abuse of other substances. Rehabilitation and therapy has helped immensely, but she has experienced relapses in the past. Your daughter is doing well now, and is working hard to stay sober and maintain her personal well-being. You are an aging parent who is updating their Estate Plan. Although your daughter is on a great path, you worry about what might happen if she relapses again in the future when you are no longer around. Your desire is to leave her your estate, but you are worried that she would have access to large sums of money in the case of a relapse scenario. It keeps you up at night worried that she could possibly squander her inheritance for the purpose of drugs and alcohol. You decide to set up a Discretionary Trust with your daughter’s godfather as the Trustee. You have the utmost trust in him, and know that he will distribute the funds wisely. In the case that your daughter relapses or otherwise is displaying irresponsible behavior, your Trustee can stop distributing funds at his discretion until she gets back on the right track again.
In another example, you have a son who is disabled and is supported by the federal Social Security Disability Insurance (SSDI) program. SSDI has certain income thresholds, and if they are surpassed, then your son would no longer be eligible to receive these benefits. You are preparing your estate, and you suddenly realize that distributions from the Trust fund you originally intended would unintentionally disqualify your son from SSDI. This is because these funds would be treated as income. Therefore, you decide to move the funds into a Discretionary Trust instead. You now have peace of mind knowing that your son will always have a safety net in the form of funds held in the Trust. Your Trustee can distribute funds to your son as needed, so long as they do not disqualify him from government benefits.
There are other examples in which a Discretionary Trust may be used. The above two scenarios help illustrate when a Discretionary Trust would be beneficial to a beneficiary, although they do not have a right to the funds nor the right to demand them.
What are the advantages of a discretionary trust?
Discretionary Trusts are associated with many advantages. In the examples above, you learned about a couple of specific advantages, such as protecting a child from themselves if they suffer from mental health issues or addiction. Alternatively, a Discretionary Trust can be used to benefit a child with a disability in such a way that does not disqualify them from government support.
Here are some of the more overarching advantages associated with a Discretionary Trust to consider:
You can still provide guidelines: Most Trustors create a Trust because they want to assert some type of control over their funds, even after they have passed away. Discretionary Trusts are different because there are no terms set, and ultimate discretion is given to the Trustee. This doesn’t mean that you can’t provide guidelines, however. For instance, you could set the guideline that you want the funds to help with your child’s education. The Trustee would then make their own decisions on how the funds should support the child in any educational endeavors.
Avoid difficult decisions: Making decisions about how to distribute funds amongst your loved ones isn’t easy. If you want to avoid making these decisions altogether, you can. A Discretionary Trust allows you to step away from decision-making about which property should go to which child, and so on and so forth. This can save you a lot of time and effort if you have a sizable estate.
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Avoid probate: The key advantage associated with Trusts, in general, is the avoidance of probate. When you set up a Trust, you transfer ownership of the property and assets to the Trust such that you are no longer the owner. While you still maintain a right to these assets during your lifetime, these assets are no longer a part of your estate. Therefore, any assets owned by the Trust are not subject to probate. This can shelter your assets from certain taxes, creditors, and court fees. More importantly, these funds can be distributed to your loved ones on a timeline that is not controlled by the court system.
Removes possible irrelevant decisions: We’re all encouraged to set up our Estate Plan as soon as possible, to help protect ourselves and our loved ones in case anything unexpected occurs. One slight disadvantage to this, however, is certain decisions you might make today may become irrelevant tomorrow. Although it’s encouraged to update your Estate Plan regularly, there are some things that become irrelevant or obsolete regardless, or perhaps circumstances change completely after your death. The Trustee is able to exercise their discretion such that the Trust works to everyone’s benefit.
What are the disadvantages of a discretionary trust?
There are several significant Discretionary Trust advantages that can easily sway a Trustor. Before you decide to select a Discretionary Trust as a part of your estate planning strategy, be sure to consider the disadvantages:
Lack of control: The nature of a Discretionary Trust forces a Trustor to give up control. You can do what you can by creating guidelines and selecting a trustworthy Trustee, but after things are set in motion, you are no longer in control. This is especially so as Discretionary Trusts are irrevocable, meaning that you can’t change it or revoke it.
Complex: Trusts can already be somewhat complex to set up, and Discretionary Trusts are no different. Some may argue that setting up a solid Discretionary Trust structure can be even more tricky relative to other types of Trusts.
Trustee discretion: Last but not least, Trustee discretion can be a double-edged sword. On one hand, this discretion can be an important aspect of your strategy to protect the funds and your beneficiaries. On the other hand, giving your Trustee absolute discretion gives them the greatest amount of power. You should make absolutely sure that you can Trust your selected Trustee to carry out your wishes and not use the Trust for their own benefit.
Other common questions about discretionary trusts
Now that we have a foundation that sets up the Discretionary Trust definition, you may still have questions that you’d like answered. Feel free to peruse the set of FAQs (frequently asked questions) below!
Who owns the assets in a discretionary trust?
To understand who owns assets held in a Discretionary Trust is to also understand the distinction between legal ownership and beneficial ownership. In the case of a Discretionary Trust, the Trustee has legal control of the funds. Therefore, they are the legal owner. However, the funds are held and distributed to benefit the beneficiaries. The beneficiaries are the beneficial owners. The Trustee breaks the law if they use the funds that they own for their personal benefit and for any reason other than for the benefit of the beneficiaries.
Who can be a trustee of a discretionary trust?
Anyone can be appointed a Trustee of a Discretionary Trust. They are given the power to decide which beneficiaries should receive how much money, and when. They have the power to deny benefits from beneficiaries at any time. Further, the beneficiaries have no claim to the funds, meaning that they cannot try to force the Trustee to distribute funds.
The Trustee has a great deal of power and should be selected very carefully. This should be someone, or an entity, that you can trust to act in good faith. It typically should also be someone who has demonstrated their trustworthiness and loyalty over time, along with their financial astuteness. Many individuals like to consider their closest friends and family members as possible Trustees.
Can you take money out of a discretionary trust?
Yes, money can be taken out of a Discretionary Trust, but only in the hands of the Trustee. The Trustee has the discretion to decide when funds should be distributed out of the Trust, to whom, and how much. Beneficiaries of the Discretionary Trust cannot take money out of it themselves.
Do you pay inheritance tax on a discretionary trust?
Regardless of the type of Trust, a beneficiary should always understand their tax liabilities when receiving distributions from a Trust.
If they receive any distributions that were made from the Trust’s principal, they do not have to pay any taxes. This is because the funds are after-tax. However, they do have to pay income taxes when receiving distributions on any income generated by the Trust. The amount of taxes paid depends on the beneficiary’s personal income tax rate.
Create your trust today
A Discretionary Trust is a great choice for your Estate Plan if you would like to protect assets for your beneficiaries, but cannot determine a set schedule for how these assets should be distributed. Perhaps there are unknown variables, or you can think of situations in which you wouldn’t want your loved ones to receive their distributions. Instead, you can give your Trustee the discretion to determine how much and when those distributions should be made.
If you would like assistance setting up a Discretionary Trust, or any other types of Trusts, we are here to help! Trust & Will makes it easy and affordable to set up a comprehensive Estate Plan which includes a Will, a Trust, and more. Even better, you can do it all online using our intuitive platform! Take our free quiz to see where you should get started, or compare our different estate planning options.
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