For many people, the concept of starting a trust is confusing enough already without having to decide between revocable vs. irrevocable trusts. Choosing a revocable or irrevocable trust is a big decision when creating a trust to safeguard your assets and avoid the costly probate process. A revocable and irrevocable trust will have benefits and drawbacks with the way they are taxed and operated; however, both a revocable trust and an irrevocable trust can be great choices for specific situations.
This article will briefly review the concept of a trust before discussing the key differences between a revocable trust vs an irrevocable trust and the benefits of either option for estate planning. Finally, it will outline some considerations to make when setting up a trust and choosing the best option for your needs.
Defining a Trust
A trust is an estate planning tool that helps people protect and transfer assets after their death. The concept of a trust is that the grantor creates a separate legal entity for trust assets, and a person appointed by the grantor, called the trustee, takes care of the trust assets based on the laws and regulations concerning the trust. This is set up and protected for the benefit of the beneficiaries, who stand to earn income or other benefits from the trust.
The idea of a trust was created to shield assets from estate taxes and other types of taxes that can harm the grantor’s heirs. They are frequently used today for transferring money effectively at death.
An important distinction to make from the beginning is the difference between a testamentary trust and a living trust. A testamentary trust is a trust that is set up to divide assets among a person’s heirs in a will. It is not usually set up during a person’s lifetime. However, a living trust is a trust that is created during the grantor’s life and may be changed in certain circumstances.
The Difference Between Revocable and Irrevocable Trusts
There are many specific kinds of trusts, such as the asset protection trust, the charitable trust, or the irrevocable life insurance trust, where the asset is a life insurance policy, but all trusts can fall into two categories, revocable and irrevocable trusts.
The major difference between the two types of trust lies in the ability or inability to easily alter or change the terms of the trust. Within a revocable trust, the grantor can change the terms of the trust and add or remove trust property as necessary.
An irrevocable trust does not allow the same leniency and often requires a court order or consent of all the trust’s beneficiaries to change the terms. This major difference also creates several other differences in the way that the trust is taxed and passed.
Revocable Trust
As mentioned above, a revocable trust is a trust that is set up during the life of the grantor and may be modified by the grantor as long as they are competent. This type of trust is often called a revocable living trust because the grantor needs to be alive and competent for the revocable nature of the trust to be utilized. Once the grantor passes away, the revocable trust automatically becomes an irrevocable trust and the trust document becomes the final set of requirements for the trust.
A revocable trust can be particularly helpful if the grantor foresees changing circumstances that will need to be addressed before the trust is finalized, which often is the birth or death of the trust’s beneficiaries or the need to appoint a successor trustee. It allows them to add named beneficiaries or remove beneficiaries.
However, the grantor has not fully transferred ownership of the assets to the trust when they maintain the right to alter or change the trust, so the trust assets are still counted as the grantor’s own assets and part of their own estate, which can interfere with some tax benefits of a trust, as well as not avoiding probate court.
Because the assets are not fully relinquished to the trust in revocable trusts, they are not shielded from income taxes, nor are they protected from federal estate taxes if they are above a certain amount. The assets are a part of the taxable estate when the grantor dies, and they are treated as such for estate tax purposes.
Additionally, they are not protected from certain creditors as they would be if they were not a part of the taxable estate. This means that the trust assets could be seized by creditors while it goes through probate.
Irrevocable Trust
The opposite of a revocable trust is an irrevocable trust. Irrevocable trusts are trusts that are created and then cannot be changed, even while the grantor is alive. This means that the grantor turns over ownership of all assets to the trust and they cannot make changes without a court order or the approval of all beneficiaries.
This means that if circumstances change between when the trust is created and later on the trustee still must follow the language in the trust, even if it goes against the wishes of the trust owner.
Because they have fully relinquished control and ownership of the trust assets, the trust property is no longer considered part of the taxable estate and they are not accessible by certain creditors. The transferred assets can contribute to the financial goals of the grantor and the beneficiaries and can set up a beneficiary for stability in their entire life.
Why Revocable and Irrevocable Trusts Matter
In addition to understanding the differences between a revocable vs irrevocable trust, it can be helpful to understand the reasons that people would use trusts in the first place and how either a revocable trust or an irrevocable trust may best serve those purposes.
Minimize Estate Taxes
One of the biggest draws of a trust is the ability to minimize or avoid estate taxes for the beneficiaries. The estate tax can make an inheritance less appealing because it can cause the inheritance to be less than expected. Trusts allow the beneficiaries to continue to make money off the assets in a trust while also avoiding or mitigating their assets.
Irrevocable trusts are always exempt from estate tax as the trust assets are no longer in the estate. Revocable trusts may avoid estate taxes if the assets are under the level required for the federal estate tax exemption, which is $12,920,000 per person or $25,840,000 for a married couple, and many trusts will hold well under that amount. Each state will also have an amount that they exempt from taxes.
Protect Assets
Another reason that some people will create a trust is to protect their assets from creditors and ensure that they reach the beneficiaries in their estate plan. As stated above, creditors have access to assets in a revocable trust, but the assets in irrevocable trusts are not available to creditors, so an irrevocable trust may be the best way to protect assets if there are creditors that you are concerned about accessing the assets.
Finding the Right Trust for You
When deciding to create a trust, some considerations should be made to decide what kind of trust is the best for your needs. The first thing that you should do is contact an estate planning attorney and work with them to use the estate planning tools to create a trust that will work for you. Estate planning attorneys will understand a revocable trust vs an irrevocable trust and how to get the benefits of either option. Estate plans require careful consideration and should not be done alone.
Another consideration is the issue of taxes. As far as estate taxes go, if the assets do not exceed the fairly high federal estate tax exemption, as most do not, they will not have to worry about federal estate taxes. This is particularly important for trusts that are for the benefit of the grandchildren to avoid the generation-skipping tax that applies when the benefit goes to one generation removed. However, before using living trusts, it is important to understand the potential state taxes that could apply.
It is also important to understand the impact that a trust may have on the surviving spouse after one spouse dies or the impact on the financial situation of surviving spouse. This is particularly important if the grantor and their spouse receive government benefits, such as supplemental security income. These can be impacted by a revocable trust because the trust is considered the asset of the grantor and their spouse if it is both their income. An irrevocable trust transfers these assets, so they are not counted as accessible assets.
Finally, the grantor will need to assess the likelihood that the circumstances surrounding the trust will change. Revocable trusts allow the grantor to make these necessary changes but are not always the best in other situations. Irrevocable trusts can provide more protection in other instances, but they are more difficult to change. However, if the protection is needed, a grantor can name a trust protector to carry out these changes legally and help keep their wishes at the forefront of an irrevocable trust.
Regardless of the needs of the grantor, including a trust in your estate plan can ensure that your wealth and family are protected moving forward, even if you are not around.
If you want to learn more about the differences between revocable vs revocable trusts or alternative dispute resolution, contact ADR Times for educational resources and courses on mediation and negotiation.
While in law school, Emily served as an executive editor on the Pepperdine Dispute Resolution Law Journal and had the opportunity to learn about ADR from world-class professors of the Straus Institute for Dispute Resolution.
emily@adrtimes.com
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