Trusts are very robust and handy estate planning tools. If you are not familiar with trusts, perhaps you should read some articles that explain what trusts are (See Trusts Compared to Corporations; The Benefits of Living Trusts; and Avoiding Probate is a Matter of Trust) Even if you are familiar with trusts, the difference between revocable trusts and irrevocable trusts may remain a mystery.
Both kinds of trusts, however, are considered “living trusts”; in other words, they are trusts created by a person who is alive (though all trusts become irrevocable when the grantor dies). Revocable trusts are much more common than irrevocable trusts. In this article, I will explain the difference between revocable trusts and irrevocable trusts and the circumstances in which a person might want to use one or the other.
One primary difference between the two trusts is that the grantor (the person creating the trust) retains control to change the trust. Revocable trusts are generally “grantor trusts”, which means the grantor is the person who created the trust, and the trustee and the primary beneficiary of the trust. The desire to maintain control is why revocable trusts are much more common than irrevocable trusts.
A revocable living trust gives the grantor control during the grantor’s life and continuing after incapacity and death. The grantor exercises full discretion over the assets in the trust during the grantor’s life and exercises continuing control even after the grantor becomes incapacitated or dies through the terms of the trust created by the grantor.
Incapacity means the legal inability to manage one’s own affairs. When the grantor of a trust becomes incapacitated during life, the trust terms control how the assets in the trust are handled. The grantor identifies a successor trustee of the grantor’s choosing to carry on the management of the assets in the trust for the benefit of the grantor. Thus, the grantor retains control over the assets through the terms of the trust even after the grantor loses legal capacity to manage his or her own affairs.
The trust also “lives” on after the grantor’s death with all the instructions the grantor included in the trust for the management of the assets after death. The terms include who will carry out the trust terms (the trustee) and who will ultimately benefit from the trust (the beneficiaries). The terms may also include many other instructions.
Passing assets to beneficiaries (usually family) through a revocable trust provides creditor protection for the beneficiaries. As long as the assets remain in the trust, no creditor or other third party (like a spendthrift or estranged spouse) can touch those assets.
Revocable trusts differ, generally, from irrevocable trusts in the way income is taxed. Income generated from assets in a grantor trust is income to the grantor while the grantor is alive. Owning property in a revocable trust does not change how taxes are done for the grantor. The income is reported on the grantor’s regular tax return.
A primary reason that people create revocable trusts is to avoid probate. Probate is the default process by which assets are passed on after death. It involves a court and requires a lawyer. The process takes anywhere from nine months to a couple of years or more, depending upon the assets in the estate and the complexity of the issues. It can be costly, burdensome and delays the ultimate distribution of the assets to beneficiaries.
By creating a trust and transferring assets into the trust that would otherwise default to the probate process, a trust can be used to avoid the probate process altogether.
Further, a trust maintains privacy. The probate process is public, but trust documents are private. No one needs to know the details of your estate when you have a trust other than the financial institutions you deal with, your beneficiaries and the trustee.
A revocable trust is revocable, just as the name suggests. Revocable trusts are not written in stone; they can be changed at any time. They can be amended, and they can even be revoked. Thus, the grantor retains a maximum amount of control with a revocable trust.
Irrevocable trusts can be used to avoid probate, like revocable trusts, but the biggest downside to irrevocable trusts, as the term suggests, is that they cannot be changed (generally) by the grantor once they are created.
Non-grantor trusts are also generally taxed at higher income tax rates. The income tax rates rise on a steep curve, compared to individual tax rates, and max out quickly. Thus, income tax liability is generally greater in an irrevocable trust (though income can be paid out to the beneficiaries so that it gets taxed at the beneficiaries’ rates).
While revocable trusts are far more common than irrevocable trusts for these reasons, there is a place for irrevocable trusts. The benefit and the goals to be accomplished by an irrevocable trust sometimes outweigh the loss of control to the grantor.
One reason that people set up irrevocable trusts is to minimize estate taxes. Irrevocable trusts are considered completed gifts to the beneficiaries when assets are distributed to them. Thus, any assets transferred to an irrevocable trust are no longer considered in the estate of the grantor, reducing the value of the estate for estate tax purposes.
In this way, an irrevocable trust is a way to get assets out of a person’s estate for estate tax purposes while maintaining some level of control over those assets (by the terms of the trust). The grantor, however, loses the ability to make changes.
Another advantage of irrevocable trusts is asset protection. Because the grantor maintains control over a revocable trust, a grantor cannot transfer assets into a revocable trust and protect those assets from the grantor’s own creditors. A grantor can, however, transfer assets into an irrevocable trust and protect those assets from his or her creditors going forward.
Finally, an irrevocable trust can be used for Medicaid planning, to transfer assets out of the grantor’s estate so that the grantor may qualify for Medicaid in the future. As long as the transfer is done far enough in advance of the need for Medicaid, an irrevocable trust can preserve eligibility to qualify for Medicaid while the grantor remains in the grantor’s home, for instance.
Trusts are the most robust estate planning tools available. Revocable trusts maintain a maximum of control and flexibility during life with very little downside. Even irrevocable trusts provide controls (that are drafted into the trust) to accomplish goals that could not be accomplished in other ways.
If you are interested in learning more about trusts and exploring how trusts might be beneficial for you, please give us a call. We do estate planning, including trusts, for a flat fee (in most cases), so you will know what the cost is up front. We take time to work through the estate planning options with you so that you understand them and know best how to use them to accomplish your goals.
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