Updated June 18, 2020
Trusts are valuable financial tools that can help you manage assets while avoiding lengthy and expensive probate proceedings. Trusts can help secure your property for the purpose you desire. You may also be able to pass a larger inheritance to your descendants with a trust. However, not all trusts are the same. Generally, you have two basic types: Those that are revocable, and those that are not. Here are the main differences between the two:
Revocable vs. Irrevocable Trusts: 6 Key Differences
- Control over Assets
- Asset Protection
- Medicare Planning
- Life Insurance
What is a trust? A living trust, or inter-vivos trust, is a legal entity that can be used to control your assets while you are alive. Trusts offer a way to manage your assets up to and even after your death. A trust is created by the trustor or grantor who funds the trust with assets. A trustee is appointed to manage the trust for the grantor. This is done to the benefit of either the grantor or beneficiaries. Once the trust is created, the grantor must fund the trust by moving assets into it. In addition to creating a trust, it may be beneficial to also prepare a pour-over will to catch any assets that may be left outside of the trust, and direct those assets into the trust in the event of the grantor’s death.
Avoiding probate is one of the main benefits of trusts. They allow for detailed explanations of how assets are to be distributed, which removes the need for a court to decide how best to handle your property. In tandem with avoiding probate, trusts allow you to specify how your estate will be dispersed without court interference (unless there is a dispute). Many different assets can be placed in a trust, such as houses, vehicles, bank accounts, life insurance policies, and investment accounts.
There are two types of trusts, those that are revocable or changeable by the grantor, and those that are irrevocably set.
1. Control over Assets
There are many differences between a revocable trust and irrevocable trust. One of the main differences is in how much control the grantor has over the assets. A revocable trust is as its name implies: revocable. The grantor can usually withdraw any of the assets as needed or make changes to the trust itself. Because of this flexibility, both federal and state governments disregard revocable trusts for taxation and other issues and consider those assets part of the grantor’s estate. A revocable trust can be used to manage your assets in the case that you become incapacitated. This can include mental issues, allowing the designated trustee can step up to manage the trust on your behalf and for your benefit. The revocable nature of the trust allows you (the grantor) to retrieve control once you are able. Without such a trust, a court would appoint someone to manage your assets and most decisions would require court approval.
In contrast, an irrevocable trust cannot be changed easily. In essence, this form of trust takes assets and moves them to a separate legal identity that the grantor cannot control. Instead, a third party known as the trustee will manage the trust for the benefit of the beneficiaries. The grantor or trustor who created the trust and funded it cannot get those assets back and the assets are not considered part of their estate. A revocable trust can become an irrevocable trust when the grantor dies because they cannot make changes to it after that. While giving up control of your assets may sound unappealing, irrevocable trusts have several potential benefits.
Once an irrevocable trust is funded, you generally cannot withdraw those assets. There are cases where assets moved to an irrevocable trust are needed but unreachable. To some extent, it’s possible to work around this restriction without sacrificing the benefits of the trust. For example, you could place a house into the trust for your children while you still live there and then pay “rent” to them. Be sure to read this useful article on using trusts to purchase real estate.
2. Asset Protection
Another major difference between revocable and irrevocable trusts comes down to how the assets are protected. A revocable trust is not protected from creditors or other lawsuits, and the assets are considered part of your estate. Since a revocable trust remains open to the grantor, it leaves little in the way of asset protection. However, both types of trust allow assets to avoid probate court which also leaves them off the public record.
An irrevocable trust, like an asset protection trust, offers an advantage in protection at the cost of giving up control of those assets. With an irrevocable trust, the property is moved outside of the grantor’s estate and placed under the care of a third party. This offers tax advantages as well as protection for those assets from creditors and liability lawsuits. However, in the case of fraudulent transfers, a court may ultimately allow the assets to be considered.
A revocable trust does not offer the same tax advantages as an irrevocable trust. Because the assets in a revocable trust are still under the grantor’s control, they are also considered on the grantor’s income tax return as part of their estate. When the owner dies and the assets are dispensed to beneficiaries, there are multiple tax considerations, such as the estate tax, gift tax, and generation-skipping tax.
An irrevocable trust offers multiple tax benefits. First, you may be able to maximize your exemptions and avoid certain estate taxes. Estate tax planning can be used to maximize the estate tax exemptions available to you and your spouse. You may also need to consider state exemption limits.
Assets in an irrevocable trust are not considered part of the grantor’s estate. With proper estate planning, you can leave more of your estate to your descendants. Irrevocable trusts differ from revocable trusts in that they need their own tax identification number (TIN) since they are a separate entity. A revocable trust is taxed as the grantor’s income so no such TIN is needed.
When considering the tax benefits of irrevocable trusts, it is important to note that not all states treat trusts the same. Some states have taxes and laws that offer greater benefits for forming irrevocable trusts in those states. If you live or have property in other states, you may want to reach out to a qualified tax planning attorney to ensure your trust will offer the benefits you desire. There are extreme cases where lawyers from one state may be able to claim assets held in trust in another state to settle a debt. You may also consider using remainder trusts as part of your charitable estate planning. This will help protect assets from certain taxes while generating income for the settlor.
Another difference between these two trusts is that a revocable trust only lasts as long as the grantor is alive. Then, the assets are either dispersed or the trust becomes an irrevocable trust. An irrevocable trust has the potential to last for many generations, depending on how it is designed. A family or dynasty trust is an irrevocable trust designed to pass wealth through the course of many years. Dynasty trusts benefit from estate tax-free growth, and when paired with a smart investment option for a trust, such as tax-free investments, that growth can be even greater. Certain states limit how long a trust can last, but some states allow for very long durations.
Perpetual trusts, like dynasty trusts, take extra considerations because they are irrevocable and plan for many years into the future. It is possible to word these trusts to take into account many different variables, such as protecting trust assets from a future beneficiary’s divorce and other lawsuits, as well as stipulating conditions that must be met. Such conditions could include requiring beneficiaries to have enrolled in college or prove they are drug-free. How you want your assets to benefit your descendants is a complicated decision. To ensure your trust is worded correctly, and to maximize those benefits, you should consult with an experienced financial advisor.
5. Medicaid Planning
Medical costs are rising at a time when people are able to live longer and maintain active lifestyles. A serious issue facing end-of-life care is how much money you have available to be used towards medical costs. It’s important to balance your need for medical care with the desire to leave your family an inheritance. For example, nursing homes and other long-term care facilities can be expensive, and health issues are difficult to predict. Qualifying for medical care under Medicaid depends on meeting allowable limits. Irrevocable trusts offer a way to manage your estate legally while still qualifying for Medicaid. Because the assets are placed outside of your estate, they may not be counted towards applicable limits. There are exceptions to this rule, including transfer penalties. The time periods for transfers or gifts to a trust can range from up to five years, during which the trustor or grantor may have to pay nursing home or other medical costs privately before Medicaid funding kicks in.
There are many types of irrevocable trusts. A special needs trust is irrevocable after transferring assets but can be set aside for a qualified special needs individual. Property used to fund this type of trust may be exempt from Medicaid transfer time limits. For more information, or to learn how to take advantage of the benefits these trusts offer, it’s important to consult with a tax advisor. The professionals at Anderson Advisors have the knowledge and experience to ensure your trust will do what you want it to do.
6. Life Insurance
A common use of irrevocable trusts is to manage life insurance policies. Without a trust, a life insurance policy will pay out on the holder’s death and be subject to taxes, which will severely limit the benefits received. Instead, having an irrevocable trust as the beneficiary on a life insurance policy will ensure a much larger amount is funded to the trust upon death while avoiding certain taxes. In addition, these funds will pass the lengthy and expensive probate process and become available to the family much more quickly. This can help them pay for needed expenses such as funerals, business, and living costs. Life insurance trusts offer another way to secure income protection for a spouse and descendants.
Frequently Asked Questions
Can you have both a revocable and irrevocable trust?
Yes, you can have multiple trusts. It pays to consider using different trusts to accomplish different goals when planning your estate. You can even set up a living revocable trust to split into multiple irrevocable trusts after you die. A revocable trust becomes irrevocable on death, but you can also set up an irrevocable living trust as well.
Can a trustee change an irrevocable trust?
A trustee may be able to change an irrevocable trust, but not easily. It might require all of the adult beneficiaries to agree to the change, or court approval that the change was in the best interest of non-adult beneficiaries. Some long-term trusts have language that gives the trustee certain powers, such as dynasty trusts, which allow for future descendants to be added as beneficiaries long after the grantor has passed. You may wish to consult with a lawyer to set up such a trust, or for more information on how to change irrevocable trusts once they are created.
How are irrevocable trusts used in estate tax planning?
Irrevocable trusts are used to avoid probate, protect assets, and remove them from the grantor’s estate so they will not be considered for some taxes. These funds will often be available to your loved ones much faster than through the probate process. The recent tax reform has greatly increased the estate and gift tax lifetime exemptions, and as such has decreased the benefits of using trusts to avoid those taxes. You may still be able to benefit from a trust in other ways, such as avoiding probate and specifying how your assets are passed to your heirs. You can also use irrevocable trusts to set aside funds for charitable contributions.
Who pays income tax on an irrevocable trust?
The trustee is responsible for paying the income tax on an irrevocable trust. Since the trust is irrevocable, it is considered a separate entity with a unique tax identification number. The trustee would manage filing the taxes but could take appropriate deductions for the trust, such as when there is a charitable contribution component to the trust. If there is a qualified business held in trust, the trustee may also claim the new 20% deduction for pass-through businesses. When distributions are made to beneficiaries, they will be taxed on it as income.
What is the tax rate on an irrevocable trust?
Under new tax reform rules, the tax rate on irrevocable trusts has decreased from the range of 15%-39.6% and is now in the range of 10%-37%, depending on income produced. A properly managed trust will also be able to claim various deductions, like the charitable income tax deduction.
Can the IRS take money from an irrevocable trust?
Generally, an irrevocable trust is considered separate from another taxpayer. The IRS and state tax agencies would not be able to pursue those assets to settle a separate tax debt. However, if the assets that were placed into the irrevocable trust have taxes that are due, the IRS may attempt to seize or levy those assets to settle the debt. There are cases where the transfer of property to a trust may be fraudulent, which could impact their ability to reach those assets. For more information, or if you need assistance with tax debt relief, reach out to one of our lawyers today.
Can you sell a house in an irrevocable trust?
Selling assets held in an irrevocable trust depends on the language of the trust document. Also, the proceeds from the sale would remain in the trust. The terms of the trust can also stipulate that a house or houses can be purchased under certain conditions. It is important to note that capital gains are taxed differently, depending on whether the trust is revocable or irrevocable.
Is it better to have a will or a trust?
The answer depends on your unique needs and financial situation. It’s most likely better to have both. You may want to have a will, as well as a trust, to catch any assets that are not placed in the trust. A will also allows you to specify other conditions, such as guardians for your children in the case of an unforeseen accident or illness.
Revocable vs Irrevocable Trust
There are many benefits to using both a revocable or irrevocable trust, including bypassing probate, avoiding some taxes, protecting assets, and passing your money to your loved ones the way you want. Choosing a trust type depends on your financial goals.
Revocable and irrevocable trusts vary in several key areas. These factors include the control you have over assets, asset protection, taxes, longevity, Medicaid planning, life insurance, and more. In general, irrevocable trusts tend to offer more tax advantages and benefits at the cost of loss of control over those assets. Revocable trusts allow you to maintain control over assets but does not shield them as effectively from taxes. Carefully consider your entire estate and long-term goals. For the best tax and estate planning, consult with the professionals at Anderson Advisors today.
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