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Trusts are a popular estate planning tool to simplify the transfer of assets between generations, and two of the most popular types are revocable trusts and irrevocable trusts. Revocable and irrevocable trusts both provide control over asset management and protection from probate and privacy, but they differ significantly in terms of flexibility and tax protection.
What is a Revocable Trust?
A revocable or “living” trust is a common type of trust that allows the grantor (the creator of the trust) to make changes or even cancel the trust, based on his or her preferences. Revocable trusts are often used in estate planning to control and distribute assets as the creator ages. For example, the creator can appoint himself as trustee and distribute trust property to himself during his lifetime. The grantor’s children may be appointed trustees in the event of the grantor’s death, allowing them to distribute assets as directed. The trust may also be directed to donate money to charity or establish a scholarship fund, as the grantor directs.
Revocable trusts can also be used to manage property if the creator becomes incapacitated. A successor trustee is appointed in the event the creator is unable to continue managing its affairs. This prevents a court from appointing a conservator to manage the creator’s affairs.
Positives
- Easy to customize, saving you time and money: A grantor can quickly and easily move assets into and out of the trust by re-titling the assets, and can change the trust structure once it is established.
- Enables continuous management of assets in the event of incapacity: Trusts can be managed by successor trustees or, as is often the case, by those with power of attorney for the trust’s founder.
- Bypasses inheritance law and preserves privacy: Trusts help heirs expedite probate through probate, which can otherwise take months, if not years. They also help keep the nature of the grantor’s assets private, especially valuable for those with larger assets or other private family matters.
- The grantor (the trust creator) can be a trustee: The grantor can serve as trustee during his lifetime and is not forced to relinquish control of the assets placed in the trust.
Disadvantages
- Does not minimize inheritance taxes: If your estate is subject to estate taxes, the trust structure does not protect your assets from them. However, a revocable trust may provide the ability to create sub-trusts upon the death of a grantor (e.g., credit shelters or other irrevocable trusts) that can preserve or reduce future estate taxes, especially for revocable trusts with two grantors who are married.
- Not shielded from creditors: If the grantor owes anything at the time of death, creditors can still pursue the trust for those obligations.
What is an irrevocable trust?
As the name implies, when an irrevocable trust is created, the assets are transferred to a trust that is very difficult to change or terminate by the person who created it. An irrevocable trust can be used when the creator is trying to limit estate taxes and protect assets from being taken by creditors since the trust assets are no longer considered their property. The trust, not the creator, is considered the owner of the assets, and holds those assets for the benefit of the beneficiaries.
Irrevocable trusts can be very complex and offer a variety of options, especially for people with significant assets who want to secure them. These trusts can also form the basis for dynasty trusts, which allow assets to be passed from generation to generation without generating estate taxes.
Positives
- Minimizes inheritance taxes: By transferring assets to an irrevocable trust, the grantors may be able to eliminate estate taxes on assets entering the trust, although this will not eliminate capital gains taxes on assets later withdrawn from the trust by beneficiaries. This approach can be valuable if, for example, you have high-growth stocks that can be included in the trust today but avoid estate taxes later.
- Protects assets from creditors: By ceding ownership and control of the assets to the trust, the grantor can avoid the reach of creditors under certain circumstances.
- Can make you eligible for government programs: Moving assets into the trust allows the grantor to qualify for means-tested programs such as Medicaid, although there may be significant lookback periods before the grantor can qualify.
- Bypasses inheritance law and can preserve privacy: The trust structure can help heirs move the estate through probate more quickly, and the trust can protect the nature of assets from the prying eyes of the public, especially valuable for those with wealth or private affairs.
Disadvantages
- The trust cannot be canceled without the approval of all beneficiaries and the grantor: If a trust needs to be canceled, the approval of all beneficiaries and the grantor is required, which can make it difficult to do so.
- It may be more difficult to establish than a revocable trust and requires an attorney: Irrevocable trusts can be quite complex and require the expertise of an experienced attorney to manage them. For example, there may be a need for a trustee with no economic interest, and there are usually many more involved administrative requirements, including the need for a separate annual tax return.
- Assets are no longer owned or controlled by the grantor: Placing assets in an irrevocable trust means that the owner relinquishes control of them, and the trustee then has control over them (the grantor cannot be a trustee).
- Higher taxes: Irrevocable trusts may be subject to much higher income tax rates than individual income tax rates at the federal level.
Is a revocable trust better than an irrevocable trust?
Which trust is better for you will depend on your individual circumstances, and it is important to discuss your needs with a competent professional. If you want control and flexibility over the trust and have relatively basic needs, a revocable trust probably makes more sense. Some experts advise that you need relatively few assets — $150,000, for example — for a revocable trust to make sense. The grantor can maintain control over the assets, it is relatively easy to set up and change, and it helps move the probate process faster. You get many of the benefits of the trust structure without most of the potential problems and disadvantages.
On the other hand, if asset protection and estate tax mitigation are more important, you are probably best served with an irrevocable trust. For example, this type of trust may be more valuable if you have rapidly growing assets that you want to leave to heirs and avoid estate taxes. But once an irrevocable trust is established, it can be difficult to modify or cancel, and it requires the grantor to give up control of the assets, a step that many individuals may be unwilling to take.
Whether one type of trust is better than another depends on your needs and circumstances. That said, it’s not a binary choice: if you have the resources, you can have either type of trust; you are not limited to just one.
In short
Revocable trusts offer benefits such as the ability to be easily amended, saving time and money by avoiding court, while irrevocable trusts offer the benefit of minimizing estate taxes and protecting assets from creditors. Whether one type of trust is better than another depends on your needs and circumstances. Consider discussing your situation with a financial professional to help you decide.
