Estate Planning: Irrevocable Trusts
Many people rely on trusts to ensure that their wishes regarding asset transfer and health care will be followed, along with reducing or eliminating estate taxes that may be due. Correctly set up and managed trusts can leave more assets to survivors and loved ones.
Several different types of trusts may be used, though, so you must have a good understanding of how they work, as well as what they will not do for you before you commit to setting one up.
What are Trusts and How Do They Work?
In their most basic sense, trusts are a type of fiduciary relationship where one party – known as a trustor – gives another party, the trustee, the right to hold title to assets or property for the benefit of a third party, the beneficiary.
Many individuals and couples use trusts for the protection of assets, as well as to ensure that assets and property are distributed according to the trustor’s wishes. Some also use trusts so that they can outline how they want their money to be managed if they are unable to do so because of a physical or cognitive impairment.
Trusts typically have four key components, including the:
- Grantor – The grantor of a trust is the individual(s) who set up and fund it with property and/or assets. This has the potential to remove these assets from your own name.
- Trustee – A trustee is either a person or an entity (such as a bank or law firm) that ensures the trust’s instructions are followed, based on what the grantor has outlined in the trust. If the trustee is unable to fulfill these duties, then the responsibility will be transferred to the successor trustee.
- Assets / Property – The trust’s grantor funds the trust with property and/or assets. There are many different types of assets that may be placed inside of a trust, such as stocks, mutual funds, and bonds, as well as real property.
- Beneficiary(ies) – The beneficiaries are the one(s) who will ultimately benefit from the trust’s assets. Beneficiaries can be individuals, as well as various entities such as charitable organizations.
Understanding the Irrevocable Trust
While there are many ways that trusts can be structured, there are just two primary trust categories. These are revocable and irrevocable. Before you commit to drafting any type of trust, you must understand how both revocable and irrevocable trusts work, as well as why one or the other could be more beneficial for you.
Revocable Trusts
Revocable trusts are more flexible than irrevocable trusts. That is because you, as the grantor, are allowed to make changes to the trust, such as replacing the current beneficiary and adding or removing assets. You could also opt to revoke or cancel the revocable trust altogether.
A revocable trust could also be used for planning ahead for a possible disability. As an example, you could name an individual whom you trust to manage the assets inside of the trust if you are unable to do so yourself because of a disabling condition.
Because the assets in a revocable trust are still accessible by the grantor, therefore, these trusts don’t necessarily provide you with protection against the claims of creditors (although they can make it more difficult for creditors to get to the trust’s assets). In many cases, a revocable trust will become an irrevocable trust upon the death of the grantor.
Irrevocable Trusts
Irrevocable trusts differ from revocable trusts in that once assets or property are placed into it, you cannot make changes. Nor can you remove assets or cancel the trust. Therefore, once you have placed items into an irrevocable trust, they are required to remain there.
The trust then becomes the owner of the property and assets that are placed into it. So, the value of these assets is removed from your estate, which in turn can reduce the amount of estate taxes that may be owed following your passing. You can also gain more protection from creditors and bankruptcy courts when assets are inside of an irrevocable trust. This is because the trust is technically the owner of the assets, not you.
One common variation of an irrevocable trust is irrevocable life insurance trust (ILIT). Using this strategy can remove the proceeds from a life insurance policy out of your taxable estate, and in turn, reduce the amount of tax that could be owed by your heirs.
In this case, an ILIT is created, and a life insurance policy is purchased and owned by the trust. As an alternative, an already-existing life insurance policy may be moved over to the trust, and the ownership of the policy changed over to the ILIT. Money can then be gifted over to the trust to cover the policy’s premium payments.
With the irrevocable life insurance trust as the owner of the policy, the death benefit proceeds are held outside of your taxable estate. So, when the insured dies, the proceeds are paid to the ILIT, rather than directly to individual (i.e., human) beneficiaries.
Typically, the ILIT trust document will include provisions for how the policy’s proceeds should be used. As an example, the ILIT may state that an income stream is to be paid out to loved ones, such as a surviving spouse.
The life insurance proceeds can also provide liquidity for your estate if there are large debts that need to be paid off. Typically, the proceeds from life insurance are received by the beneficiary (or beneficiaries) income-tax free.
Using an irrevocable life insurance trust could also be done to benefit charitable organizations that you want to receive a donation from after your passing. In this case, the ILIT could be created to offset assets that have been given to a charity.
So as an example, you could make a direct gift to the charity directly or you could instead create a charitable remainder trust (CRT). These trusts are tax-exempt instruments that allow you to make current gifts of property or assets to the trust, while at the same time retaining the right to keep an income stream from those assets.
If your spouse survives you, he or she could continue to receive income from the CRT for the remainder of their lifetime, too. Upon the death of the second spouse, the charity would then receive the asset.
In this case, the charity could receive assets directly from you (that are received by the entity tax-free), and the death benefit proceeds from the life insurance policy could pass directly to your survivors, essentially “replacing” the value of the assets.
As an added bonus, provided that a charitable remainder trust is properly set up, there should be no capital gains taxes on the appreciation of assets that are inside of the trust. So, this means that the charity could receive more usable assets, rather than only getting what is leftover after taxation.
Revocable versus Irrevocable Trusts
While the names of revocable and irrevocable trusts may sound somewhat similar, they actually refer to different trusts, and as such, differing strategies for managing the property and assets that are inside of the trust.
The key difference between revocable and irrevocable trusts is the ability to make changes with a revocable trust, as well as the ownership of the assets once they have been placed inside of the trust.
Revocable versus Irrevocable Trusts
| Revocable Trust | Irrevocable Trust | |
|---|---|---|
| Trust provisions can be changed | Yes | No |
| Trust can be revoked | Yes | No |
| Avoids probate | Yes | Yes |
| Completely removed assets from your name | No | Yes |
| Creditors can get to assets | Yes | No |
| Protects your privacy (such as assets and beneficiaries) | Yes | Yes |
Is an Irrevocable Trust Right for You?
There are several reasons why an irrevocable trust may be a good choice for you. Just some of the advantages that come along with irrevocable trusts is the removal of assets from your estate – and in turn, a reduction in the amount of estate tax that may be due.
Plus, given that an irrevocable trust becomes the owner of assets and property that are transferred into it, they are no longer accessible by creditors, bankruptcy courts, or other types of “predators” that could come after your money.
Even with all of the benefits, though, an irrevocable trust might not be right for you. Therefore, in order to determine whether or not you should move forward with the creation of an irrevocable trust, it is recommended that you meet with an estate planning specialist. He or she can then walk you through the pros and cons of this type of legal and financial arrangement.
If you would like to set up a no-cost, no-obligation phone, online, or in-person meeting with an estate planning professional, feel free to contact us directly by phone at <phone number>. Or email us at [email protected] with any questions that you may have. We look forward to assisting you with protecting assets and reducing your potential tax liability.
