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When figuring out how to transfer assets to heirs, it's common in estate planning to have your will work in conjunction with a trust. But in order to decide whether a trust might fit with your future goals, you’ll need to understand the two main types of trusts: revocable and irrevocable.
Revocable vs. irrevocable trusts: Key differences
The biggest difference between revocable trusts and irrevocable trusts is that a revocable trust's terms and stipulations can be modified at any time, whereas an irrevocable trust's terms can't be changed after set up unless all beneficiaries agree.
What is a revocable trust?
A revocable trust is also known as a living trust, revocable living trust or inter vivos trust. It's an amendable legal document that creates a separate legal entity and allows the creator — or grantor — to retitle assets in the name of that entity, or the trust. The grantor selects a successor trustee to manage those assets on behalf of the grantor and their named beneficiaries.
Benefits of using a revocable trust
There are several reasons a revocable trust can be an effective estate planning tool.
For many, the draw of a revocable trust is that the grantor can change the terms of the trust or dissolve the trust document at any time.
A revocable trust also becomes effective as soon as the legal document is signed and funded, once assets are titled in the name of the trust. Unlike a will, which becomes active only upon death, the trust is able to handle your affairs even if you become incapacitated.
Many people use revocable trusts so they can bypass probate, which can be a time-consuming and costly process in some states. Bypassing probate also allows the details of the trusts to remain private instead of becoming public record available for anyone to view.
Limitations of revocable trusts
Since a revocable trust can be changed at any time, assets within the trust are still considered owned by the grantor. As such, there are no tax benefits to setting up a revocable trust.
Additionally, creditors are still able to make claims against a revocable trust to recover anything owed by the grantor.
What is an irrevocable trust?
An irrevocable trust is a trust that the grantor cannot change or revoke. Only under limited circumstances can exemptions can be made, but it’s very difficult — all beneficiaries need to agree, or there must be a court decree. The grantor appoints a third party to be the trustee and manage the trust.
Once assets are transferred into the irrevocable trust, the grantor gives up ownership of those assets, which are removed from their taxable estate. Irrevocable trusts are often used as a vehicle to facilitate advanced tax planning and gifting for one’s estate.
Types of irrevocable trusts
There are many different kinds of irrevocable trusts, depending on what end goals you’re attempting to achieve. Here are some commonly used irrevocable trusts for estate planning:
Credit shelter trust, bypass trust or AB trust: A trust often used by married couples to sidestep estate tax on certain assets. When the first spouse dies, assets move into trusts for the second spouse to use, but not own. When the surviving spouse dies, any assets that remain can bypass the second spouse’s estate and transfer tax-free to heirs.
Qualified terminable interest property trust, or QTIP: A type of credit shelter trust. Upon the first spouse’s death, the trust provides an income stream and use of property to the surviving spouse, known as the life beneficiary, but avoids estate tax. When the surviving spouse dies, assets transfer to the final beneficiary. This is a common tool used in second marriages — to support a current spouse and children from a prior marriage.
Qualified domestic trust, or QDOT: Similar to the QTIP, but with a surviving spouse who is a noncitizen.
Grantor-retained annuity trust, or GRAT: A GRAT removes assets from a taxable estate to minimize taxes on gifts to heirs. The grantor transfers assets into the trust and specifies their beneficiaries, but earns income for a period of time before the asset is gifted.
Qualified personal residence trust, or QPRT: Similar to the GRAT, but the trust asset is real estate. The grantor can live in the property rent-free for a period of time before it’s gifted to heirs.
Spousal lifetime access trust, or SLAT: A strategy where the grantor creates a trust for the benefit of the beneficiary, usually their spouse or children. This moves assets out of a taxable estate during the grantor’s lifetime, but still provides a buffer as the spouse or children can receive distributions to help support the grantor.
Generation-skipping trust: A trust that a grantor uses to give ownership of assets directly to grandchildren. This way, children can become income beneficiaries but skip or bypass estate tax, since they never owned the assets themselves. Note that these trusts are subject to a generation-skipping tax and exemption.
Dynasty trust: A trust set up to pass assets from generation to generation without the impact of taxes (estate, gift or generation-skipping tax), as long as there are assets remaining in the trust.
Spendthrift trust: A trust set up for a beneficiary who may not be capable of managing the assets on their own. A common example is a parent gifting assets to a child who has demonstrated irresponsible money management.
Special needs trust: For parents of children with disabilities, a special needs trust provides financial support while maintaining the child’s eligibility for governmental assistance.
Intentionally defective grantor trust, IDGT or grantor trust: A strategy that allows the grantor to transfer assets into the IDGT but still pay any income taxes required for those assets. The grantor is considered the trust owner when it comes to income taxes, but not for estate taxes. By covering taxes for the trust, the grantor helps grow the trust’s value faster as there’s no annual tax bill to pay.
Irrevocable life insurance trust, or ILIT: A trust that owns a life insurance policy and receives the death benefit proceeds of the policy. Beneficiaries of the trust are able to receive a sizable inheritance with the policy proceeds helping to cover any outstanding estate taxes.
Charitable trust: Trusts set up to benefit charity and gain favorable tax treatment for the grantor. Frequently used charitable trusts include charitable remainder trusts, charitable lead trusts and pooled income trusts.
Asset protection trust: A trust set up to protect assets from creditors.
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Benefits of irrevocable trusts
Like revocable trusts, irrevocable trusts also avoid probate and preserve privacy. But since the assets placed inside the trust are no longer owned by the grantor or part of their estate, irrevocable trusts can shelter assets from taxes and creditors.
For those with large estates, estate tax can be a concern. In 2022, the estate tax exemption is $12.06 million per person. Federal estate tax of up to 40% will be applied to any taxable amount above that exemption. Additionally, each state also levies its own estate taxes.
Using irrevocable trusts can help because assets moved into a trust will be permanently removed from the estate, reducing or eliminating the estate tax burden. Charitable trusts can provide additional tax breaks.
Since the assets transferred into an irrevocable trust are no longer owned by the grantor or part of their estate, irrevocable trusts also provide protection from creditors. This can be especially beneficial for those in professions that frequently face lawsuits, such as real estate developers, doctors and lawyers.
In order to qualify for certain government programs, such as disability benefits from Supplemental Security Income or long-term care coverage from Medicaid, applicants must have limited income and assets. An irrevocable trust can shift assets away from the individual so they won’t exceed the limits and can still qualify for coverage.
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Limitations of irrevocable trusts
With an irrevocable trust, the grantor must give up control and ownership of their assets, being subject to the will of the trustee. However, the grantor can usually appoint a trust protector to oversee the management of the trust.
As we go through life, many things can change. You might make a child or close friend a beneficiary of your irrevocable trust but then have a falling out. Fortunately for them but unfortunately for you, they remain a permanent beneficiary of your trust.
Similarly, your financial situation could change. Grantors need to balance the amount of assets they remove from their estate with the potential that they might need to use those assets down the road. These examples demonstrate how irrevocable trusts limit the grantor’s flexibility with their own estate.
Another drawback is that many irrevocable trusts involve complicated strategies that can be difficult to comprehend, set up and administer. Irrevocable trusts require their own separate tax identification numbers and the filing of separate tax returns, since assets in the trust are removed from one’s estate. And given the complex nature of these irrevocable trusts, an estate attorney’s expertise is likely needed and can be costly.
On the tax front, even though irrevocable trusts help reduce or eliminate estate tax, trusts can be subject to higher income taxes.
How do you know which trust to use?
The best way to determine which trusts best fit with your estate planning needs is to consult with a reputable estate planning attorney. Working with an estate planning attorney well-versed in trust strategies, alongside your financial and tax advisors, can help you formulate a plan to achieve your estate planning and financial goals.