An irrevocable trust is a trust that cannot be revoked, altered or amended. The grantor of the trust loses his or her rights of ownership immediately upon transferring assets to the trust.
Under what circumstances would someone establish an irrevocable trust?
Irrevocable trusts are typically established for estate planning purposes, as they remove all trust assets from the grantor’s taxable estate. They can also relieve the grantor of tax liabilities from the income generated by assets in the trust. Assets held in an irrevocable trust can include investments, cash and life insurance policies. Irrevocable trusts are especially useful for people who work in professions that are subject to frequent lawsuits, such as doctors and attorneys, as the assets held in the trust are protected from legal judgements and creditors.
What are the advantages of an irrevocable trust?
Advantages of an irrevocable trust include:
- Estate tax savings – Assets held in an irrevocable trust are not included in the grantor’s estate; therefore, they are not subject to estate taxes.
- Creditor protection – Because the grantor no longer controls the assets held in the trust, creditors cannot make claims against it.
What are the disadvantages of an irrevocable trust?
Disadvantages of an irrevocable trust include:
- Loss of control – The grantor loses control of any assets placed in an irrevocable trust. For example, the only way to revoke an irrevocable life insurance trust (ILIT) is to stop gifting money to the trust. Without the annual gift, the trustee may become unable to pay the premium and the policy will lapse. It is not as easy to revoke an irrevocable trust that includes cash, investments or other assets.
- The three-year rule – If you make a gift of life insurance to an irrevocable trust and die within three years, the proceeds will be brought back into your estate and may be subject to tax.
- The five-year rule – If you make a gift of assets to an irrevocable trust and need Medicaid within five years because your assets have dropped below the Medicaid asset limit ($2,000 in most states), you will have to repay all transfers to the trust that were made over the last five years by paying for nursing home costs. Once you have “paid back” all of your gifted assets for the last five years, you become eligible for Medicaid.
- Cost – In addition to the initial fee to establish the trust, there may be ongoing fees owed to the trustee for managing the trust assets. There may also be accounting costs to cover tax return filings. If you have a potentially large taxable estate, the cost of establishing and maintaining an irrevocable trust is often more than offset by estate tax savings.
How do most people use irrevocable trusts?
Many individuals choose to transfer insurance policies into an irrevocable trust or purchase insurance using the assets in an irrevocable trust. In fact, using irrevocable trusts to shelter life insurance has become so common that this type of trust has acquired its own name – an irrevocable life insurance trust (ILIT).
What are the differences between revocable and irrevocable trusts?
There are several differences between revocable and irrevocable trusts:
- An irrevocable trust is binding – While a revocable trust can be revoked, changed, amended or altered during the grantor’s lifetime, an irrevocable trust cannot (except by court order).
- Gift taxes – The transfer of assets to a revocable trust is not subject to gift taxes. In contrast, the transfer of assets over a certain threshold to an irrevocable trust may be subject to gift tax.
- Creditor protection – Assets held in a revocable trust are subject to claims from creditors. Assets held in an irrevocable trust are protected from creditors , which can include judgment creditors, divorcing spouses and bankruptcy estates.
- Estate taxes – Assets held in a revocable trust are included in the grantor’s estate (however, the grantor can reduce or eliminate the estate tax by implementing bypass trust planning). Assets held in an irrevocable trust are not included in the grantor’s taxable estate and will transfer directly to the designated beneficiaries free of estate tax.
- Tax filings – A revocable trust does not require a separate tax identification number or tax return. The grantor of a revocable trust treats all trust assets as his or her own for income tax purposes. An irrevocable trust may requires a separate tax identification number and may also require an income tax return.
If you have any additional questions about irrevocable trusts, schedule a complimentary, no-obligation consultation and learn more about how Creative Planning can help you.