(MONEY Magazine) – In planning their estates, Terry and Patty MacEwen of Dayton had to solve two problems. First, Terry, 41, and Patty, 37, wanted to make sure that their legacy would be kept safe and managed properly for the benefit of their four children, Anne, 10, Kate, 8, Michael, 5, and Christopher, 1. Second, because the MacEwens' estate will exceed $600,000 -- the amount at which the federal estate tax kicks in -- they needed to shield the money from the tax collector. The MacEwens accomplished both goals by writing wills that establish trusts, the versatile factotums of estate planning. The trusts will let the couple pass as much as $1.2 million to their children free of federal tax. Moreover, should both Terry and Patty die before their youngest child turns 22, the inheritances will be managed by the trust officers at the MacEwens' bank, who will pay income to the children as they need it. Once the youngest reaches 22, the legacy will be divided among all the children. As the MacEwens' case illustrates, trusts can take care of a variety of problems in your estate strategy. After your death, they can keep your estate out of probate, which is the often ponderous process of proving your will valid in court, and keep Uncle Sam out of your pocket. Trusts can help you provide for minor or disabled heirs and, at the same time, put a dependable relative or friend in charge of your finances if you become incapacitated. Clearly, for a full grasp of the variety of choices you have in estate planning, you must get to know the basics of these valuable instruments.

Getting Started

Not surprisingly, trusts differ widely in makeup, depending on their purposes. But they share several attributes. They are all set up and funded by a grantor for the good of one or more beneficiaries. The wishes set down in the trust agreement are carried out by a trustee, who in some cases may also be the grantor. And they all can be broadly categorized as either revocable or irrevocable. In the former, you retain the ability to change or revoke the trust; in the latter, you relinquish that power as well as any benefit from the trust's income or principal. In setting up any trust, one of your first decisions is whom to designate as trustee. For many trusts that go into effect during your lifetime -- called living or inter vivos trusts -- you may be the obvious choice, particularly if you want to keep control of the trust's assets. Otherwise, the ideal candidate for the job is a relative or friend who is both financially savvy and sensitive to the needs of your beneficiaries. Says Lyle K. Wilson, an attorney in Mill Creek, Wash.: ''Even people with trusts large enough to warrant professional management sometimes prefer the personal touch of a financially knowledgeable family member.'' And unlike professional trustees, a friend or ^ relative will probably agree to serve without compensation. If you feel safer with the financial expertise of a professional trustee, you can hire a bank or trust company and name a friend or relative as co- trustee. The two trustees will then make decisions together. Be aware, though, that large banks and trust companies usually refuse to manage trusts of less than $200,000. When you shop for an institutional trustee, compare both long-term investment performance and fees. The average stock-oriented bank trust fund has returned an annualized 15.9% over the 10-year period that ended last Dec. 31, according to CDA Investment Technologies, a Rockville, Md. company that follows 1,345 equity investment managers. As for fees, banks and trust companies generally charge 0.75% to 1% a year on trust assets up to $300,000 to $500,000, depending on the institution. Above that amount, the bigger the trust, the smaller the percentage of assets that the trust must pay in fees.

Trusts That Protect Your Survivors' Inheritances

To safeguard your legacy to young children, you can create a minors' trust in your will. You can establish similar trusts for adult heirs who lack the talent or the inclination to manage a substantial inheritance. In these trusts, the agreement puts your trustee in charge of investing and spending the trust's assets on your children's behalf, which prevents the kids or an irresponsible or inept adult guardian from squandering the inheritance. Trusts can also let you control your children's access to the money until they are old enough to manage it. For instance, Dianne Johnson, 46, of Orange, Calif. plans to leave $3 million of investment real estate in trust to her sons Wayne, 22, and Mark, 19. The trust agreement permits them to make limited withdrawals at 25 and 30 and cash in all of the assets at 35. ''The last thing I would want is for them to inherit this kind of money and not have the maturity to handle it,'' she says. Were she to leave the property to her sons outright, it would be theirs to do with as they please, since they are over 18, the age of majority in California. If you have two or more children, you may want to include a so-called sprinkling provision in the agreement. This permits the trustee to allocate income and principal to each of your offspring based on their changing needs. For example, your trustee might shower more cash on your starving artist son than on your prosperous dermatologist daughter. Providing for disabled children calls for a more complicated kind of trust. That's because property left directly to handicapped heirs might disqualify them from social service programs such as Medicaid, which are generally reserved for people of modest means. You can dodge this dilemma, however, by setting up a discretionary spendthrift trust, which is designed to supplement, not replace, government assistance. Government agencies have periodically gone to court and seized the contents of such trusts to pay for services provided to disabled beneficiaries. You can probably avoid a legal challenge, though, if you include certain provisions in your trust agreement. You should give the trustee the right to distribute income and principal to beneficiaries besides your disabled child, such as other relatives or charities. You should also stipulate that the principal remaining in the trust pass to other heirs upon the death of your handicapped child. In addition, your lawyer should include a clause in the trust agreement terminating the trust if the state successfully challenges it in court. The principal would go to beneficiaries other than your disabled child. You can ask these individuals to spend some of their inheritances on the child, but they are not legally obligated to do so.

Trusts That Keep Your Estate out of Probate

Assets that you place in a trust during your lifetime are disposed of at your death according to terms of the trust agreement -- not your will. A will controls only property held in your own name at your death. As a result, you can use trusts to escape the often costly and time-consuming legal process of probate. Indeed, critics of the probate system recommend that you put virtually all your assets into a revocable living trust. In this kind of trust, you can act as the trustee, keep any or all of the income it produces, change its provisions or even terminate it whenever you like. After your death, the trust can remain intact to benefit your heirs or it can dissolve, with the property disbursed according to your instructions by the successor trustee whom you name in your trust agreement. Attorneys generally charge $500 to $1,000 to draft such trusts, compared with the $25 to $250 they charge for a simple will. The growing minority of lawyers who recommend revocable living trusts argue that despite the higher up-front costs, the trusts actually save your estate money by avoiding the expense of going through probate. Lawyers who favor wills, however, tend to counter that probate is quick and inexpensive, at least in their states. In some jurisdictions that may be true, but you would be wise to check such assertions with friends and relatives who have been through the experience locally. For example, Otto Pribram, 70, of Alexandria, Va., a retired Army intelligence officer who now works as a financial planner, decided to establish a revocable living trust for himself to avoid the probate expenses that were nibbling away as much as 5% of his clients' estates. His trust contains assets worth $600,000. When he dies, the property will pass into a new trust, the income from which will go to his wife Kathryn. After her death, the assets will be divided between the Pribrams' son and daughter. ''Avoiding probate will give me a good return on the $1,000 in legal fees that I paid to set up the trust,'' says Pribram. Living trusts have a second, less ballyhooed advantage: if mental illness or injury ever makes you incapable of managing your financial affairs, the trust can spare you the embarrassment and expense of a court-appointed conservatorship. A conservator is charged with making financial decisions for an adult who has been proved mentally incompetent in a court hearing. To sidestep the whole process, you can include a provision in your trust agreement that permits your successor trustee to take over for you if your physician certifies that you are incompetent. One warning: if you fail to transfer the title of your securities, real estate and other assets to your living trust, the trust won't keep you out of probate. Though transferring assets is simple, if you don't want to be bothered, you should consider a variation of the revocable living trust called a standby or convertible trust. In conjunction with such a trust, your attorney will draw up a durable power of attorney, in which you give a trusted relative or friend the power to act as your financial representative if you become incapacitated. That person can then shift your assets to your standby trust for management by the successor trustee you selected. If you die suddenly, however, there obviously will not be time to place your assets in the trust, and your property will end up in probate.

Trusts That Help Your Children and Grandchildren

Before Congress got wise, clever parents and grandparents used trusts to + shelter their family's college funds from income taxes. Trust income was generally taxed at the trust's rate if it was retained and at the child's rate if it was withdrawn. Both rates were usually lower than the parents' or grandparents'. Unfortunately, the so-called kiddie tax, ushered in as part of the Tax Reform Act of 1986, changed the rules. Today, if a child is under 14, any investment income he or she earns above $1,000 is taxed at the parents' rate. As a result, trusts that shift income away from parents to children have lost some, but not all, of their allure. Consider the remaining advantages of an irrevocable 2503(c) minors' trust, which takes its prosaic name from a section of the tax code: -- Since you give up control over the trust property and the power to change the trust agreement, the trust's assets are not considered part of your taxable estate. -- You can keep the trust's income and principal out of the beneficiary's hands until he or she reaches age 21. The trust can last even longer if the child fails to demand the trust's assets within 30 to 90 days of his or her 21st birthday. -- You still might cut your income tax bill. The first $5,200 of income that the trust earns is taxed at 15%; amounts above that are taxed at 28%. For the most efficient use of the trust's tax-sheltering capacity, New York City attorney Robert E. Friedman suggests splitting the trust's income between the trust and a child who is 14 or older. For example, assume that a trust earns $20,000 a year and retains $5,200, which is taxed at the trust's 15% rate. The remaining $14,800 is distributed to the child and taxed at his or her rate, typically also 15%. An irrevocable Crummey trust, named after the winner of a lawsuit that made such instruments legal, offers essentially the same income and estate-tax benefits of a 2503(c), but it needn't terminate when your child turns 21. Normally, keeping trust assets from a beneficiary creates a gift-tax liability for the trust's grantor, even if the gift is $10,000 or less. Let's say you place $10,000 in trust for your 15-year-old son with the stipulation that he cannot touch the money until he turns 35. The Internal Revenue Service would then deem the $10,000 a ''gift of future interest.'' The $10,000 gift-tax exemption does not apply to gifts of future interest. You could, however, make use of your $10,000 annual gift-tax exclusion by giving your son so-called Crummey powers, meaning he would be allowed to withdraw a portion of the trust principal each year. Your son should be permitted to pull out the least of: 1) the amount added to the trust during the year; 2) $5,000; or 3) 5% of the trust's principal. In practice, though, most beneficiaries choose not to wield this power so that the assets in the trust can continue growing undisturbed. Parents and grandparents must balance the advantages of 2503(c) and Crummey trusts against the fees associated with them. Lawyers charge at least $500 to set up such trusts. You'll probably also have to hire an accountant for $250 to $500 to prepare the trust's annual income tax return. The bottom line: don't bother setting up such a trust unless you can put $50,000 or more in it. If you cannot afford to part with such a princely sum, consider opening a no-fee custodial account at a bank, brokerage or mutual fund. You can set up such accounts under the Uniform Gifts to Minors Act (UGMA) or, in most states and the District of Columbia, under the more flexible Uniform Transfers to Minors Act (UTMA). Assets in custodial accounts automatically go to a child at the age of majority or 21, depending on state law. A caveat: if you set up a custodial account, designate other family members or friends, not yourself, as custodian. That way, if you die before your child reaches the age of majority, property you placed in the account won't be included in your taxable estate.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: Trusts that safeguard your estate Trusts can be shaped to the needs of almost any family -- as you can see from the six stalwarts described below. All but the first two take effect during your lifetime. The final column shows whether you would incur a federal gift- tax liability by giving more to the trust than the annual limit for tax- free gifts -- $10,000 if you are single, $20,000 if you give jointly with your spouse.