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How to set up a discretionary trust

This type of trust leaves financial decision-making to the trustee, and the setup process can be complex.

A discretionary trust is designed to protect your loved ones from losing their inheritance to creditors, irresponsible spending or other means. Taking advantage of a discretionary trust can set your beneficiaries up for a responsible financial future.

What is a discretionary trust?

As the name suggests, a discretionary trust is one that leaves the division of the assets and income of the trust up to the discretion of the person managing the trust — also known as the trustee.

The beneficiaries are still named when the trust is created by the settlor, but it’s up to the trustee to decide when, how much and if said heirs get assets from it. Hence, a discretionary trust is one in which the beneficiaries of the trust do not have a fixed or specified entitlement to the capital, assets or the income of the trust.

How to set up a discretionary trust

Setting up a discretionary trust to protect your assets can be a complicated process, and you may want to engage a lawyer or a tax consultant to make sure you’re doing it correctly.

Follow these steps to create a discretionary trust:

  1. Choose a trustee. This can be one or more people, or a private company that’s intentionally set up to act as a trustee.
  2. Draft the discretionary deed of trust. A lawyer can help you to draft this legal document.
  3. Sign and settle the trust. After the settler signs off on the trust deed, they must deposit the initial settlement sum into the trust’s bank account. Note that the settler can’t be involved in the trust in any other way, such as being a beneficiary. They’re usually an accountant or relative. As part of this step, the trustee must agree to the terms of the trust deed.

Why should I set up a discretionary trust?

Discretionary trusts are typically established to manage the assets of a large family or for beneficiaries who are either too young or otherwise incapable of managing the inheritance themselves.

Some of the main advantages of a discretionary trust include:

  • Protecting the assets of a family.
    Assets given to a single family member or loved one can be held as a way to pay off debts or other liabilities that a person may have when they die. A discretionary trust keeps the assets from going to any single beneficiary so that none of the heirs are legal owners of the assets.Creditors that may come calling for one beneficiary can’t touch the trust’s assets if they don’t legally belong to the individual. Similarly, if a beneficiary was getting divorced, the assets wouldn’t become part of the proceedings.
  • Controlling assets for those deemed unfit to manage them.
    It may be prudent to maintain control over assets in a trust intended to go to a minor or beneficiary who isn’t the best at managing funds. The amount of money paid out to them can be controlled by the trustee, which helps protect the assets of the trust from potential unwise decisions.
  • To reduce tax liabilities.
    A savvy trustee may be able to divvy up the trust in a way that reduces the overall tax liabilities that can arise from estate income. Tax laws vary by state, so the how and why will be different depending on where you live.If you’re unsure whether a discretionary trust could lower your beneficiaries’ tax liabilities, consult with a professional who knows your state regulations.

What does the trustee have discretionary powers over?

The trustee may have discretionary powers in the following areas:

  • Choosing the beneficiaries of the trust. The trust deed may only specify a class of beneficiaries for the discretionary trust. However, which persons from this group of beneficiaries should receive income from the trust is left to the trustee’s discretion.
  • Choosing the amount and frequency of payments. The trustee is typically given the discretionary power to choose when and how much money, if any, should be distributed among the beneficiaries.

Who chooses the trustee of a discretionary trust?

The main power of a discretionary trust lies with the appointer, who has the power to choose the trustee for the trust. In order to ensure that the assets of the trust are protected and managed properly, it’s seen as advisable to name at least two appointers for a discretionary trust.

Since the trustee of a discretionary trust has the power to choose the beneficiaries and distribution of income, it is vital to appoint a trustee who is honest, responsible and trustworthy — and who will work towards the benefit of all the intended beneficiaries.

It’s also important to note that if one person is a trustee, that one person can’t be the only appointer. However, if there are two trustees, one or both can also be the appointers.

I’m the beneficiary of a discretionary trust. What am I entitled to?

You’re not entitled to anything in the trust, even as a named beneficiary.

However, a trustee is meant to act in the best interest of the settlor’s wishes. That means even as the legal owner, the trustee should be handling the funds in a way that best serves the beneficiaries.

Bottom line

A discretionary trust can help make sure your loved ones are well looked after when planning your estate, but it will require trustworthy appointers and — by extension — trustees. If a life insurance policy is something you’d like to incorporate into your trust, you should compare your life insurance options to find the best fit for your needs.

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