What Is an Irrevocable Trust?
The purpose of an irrevocable trust is to move the assets from the grantor's control and name to that of the beneficiary. This reduces the value of the grantor's estate in regard to estate taxes and protects the assets from creditors.
Irrevocable trusts cannot be modified, amended, or terminated without the permission of the grantor's beneficiary or by the order of a court. The exact rules can vary by state. The grantor, having effectively transferred all ownership of assets into the trust, legally removes all of their rights of ownership to the assets and the trust.
Irrevocable trusts are generally set up to minimize estate taxes, access government benefits, and protect assets. This is in contrast to a revocable trust, which allows the grantor to modify the trust, but loses certain benefits such as creditor protection.
- Irrevocable trusts cannot be modified, amended, or terminated without permission from the grantor's beneficiaries or by court order.
- The grantor transfers all ownership of assets into the trust and legally removes all of their ownership rights to the assets and the trust.
- Living and testamentary trusts are two types of irrevocable trusts.
- These trusts offer tax-shelter benefits that revocable trusts do not.
- Under the SECURE Act, some beneficiaries may have to take a full distribution by the end of the tenth calendar year following the year of the grantor's death.
How an Irrevocable Trust Works
Irrevocable trusts are primarily set up for estate and tax considerations. That's because it removes all incidents of ownership, removing the trust's assets from the grantor's taxable estate. It also relieves the grantor of the tax liability on the income generated by the assets. While the tax rules vary between jurisdictions, the grantor can't receive these benefits if they are the trustee. The assets held in the trust can include (but are not limited to) a business, investment assets, cash, and life insurance policies.
Trusts have an important place in estate and legacy planning. But there is a downside: the cost. Setting up any type of trust can be complicated enough that an attorney is necessary. And this means that people may end up spending a few thousand dollars or more in attorney fees to set them up.
Irrevocable trusts are especially useful to individuals who work in professions that may make them vulnerable to lawsuits, such as doctors or attorneys. Once an asset is transferred to such a trust, it is owned by the trust for the benefit of its beneficiaries. Therefore, it is safe from legal judgments and creditors since the trust will not be a party to any lawsuit.
Today’s irrevocable trusts come with many provisions that were not commonly found in older versions of these instruments. These additions allow for much greater flexibility in trust management and distribution of assets. Provisions such as decanting, which allows a trust to be moved into a newer trust with more modern or advantageous provisions, can ensure that the trust assets will be managed effectively. Other features that allow the trust to change its state of domicile can provide additional tax savings or other benefits.
Although they are commonly associated with the very wealthy, trusts are an important piece of estate planning for anyone—regardless of income status.
Types of Irrevocable Trusts
Irrevocable trusts come in two forms: living trusts and testamentary trusts.
A living trust, which is also known as an inter vivos (Latin for "between the living") trust, is originated and funded by an individual during their lifetime. Some living trust examples are:
- Irrevocable life insurance trust
- Grantor-retained annuity trust (GRAT), spousal lifetime access trust (SLAT), and qualified personal residence trust (QPRT) (all types of lifetime gifting trusts)
- Charitable remainder trust and charitable lead trust (both forms of charitable trusts)
Testamentary trusts, on the other hand, are irrevocable by design. That's because they are created after the death of their creator and are funded from the deceased's estate according to the terms of their will. The sole way to make changes to a testamentary trust (or cancel it) is to alter the will of the trust's creator before they die.
Irrevocable Trust Uses
An irrevocable trust has a grantor, a trustee, and a beneficiary or beneficiaries. Once the grantor places an asset in an irrevocable trust, it is a gift to the trust and the grantor cannot revoke it. The grantor can dictate the terms, rules, and uses of the trust assets with the consent of the trustee and the beneficiary.
Irrevocable trusts can have many applications in planning for the preservation and distribution of an estate, including:
- To take advantage of the estate tax exemption and remove taxable assets from the estate. Property transferred to an irrevocable living trust does not count toward the gross value of an estate. Such trusts can be especially helpful in reducing the tax liability of very large estates.
- To prevent beneficiaries from misusing assets, the grantor can set conditions for distribution.
- To gift assets to the estate while still retaining the income from the assets.
- To remove appreciable assets from the estate while still providing beneficiaries with a step-up basis in valuing the assets for tax purposes.
- To gift a principal residence to children under more favorable tax rules.
- To house a life insurance policy that would effectively remove the death proceeds from the estate.
- To deplete one's property to ensure eligibility for government benefits, such as Social Security income and Medicaid (for nursing home care). Such trusts can also be used to help secure benefits and care for a special needs child by preventing disqualification of eligibility.
An irrevocable trust is a more complex legal arrangement than a revocable trust. Because there could be current income tax and future estate tax implications when using an irrevocable trust, seek a tax or estate attorney's guidance.
Irrevocable Trusts vs. Revocable Trusts
Revocable trusts may be amended or canceled at any time as long as their creator is mentally competent. They do offer the benefit of allowing their creator to cancel them and reclaim property held by the trust at any time before death. However, such trusts do not offer the same protection against legal action or estate taxes as irrevocable trusts.
When using revocable trusts, government entities will consider that any property held in one still belongs to the trust's creator and therefore may be included in their estate for tax purposes or when qualifying for government benefits. Once a revocable trust's creator dies, the trust becomes irrevocable.
SECURE Act Rules
The Setting Every Community Up for Retirement Enhancement (SECURE) Act changes some of the tax-saving benefits of see-through trusts.
Previously, certain non-spousal beneficiaries of retirement accounts that had been placed in an irrevocable trust could take their distributions over their life expectancy. However, under the SECURE Act rules, some beneficiaries may find they must take a full distribution by the end of the tenth calendar year following the year of the grantor's death.
Again, because the tax implications of this can be challenging and can change with the passage of new laws, it's important to consult a tax or estate attorney's guidance when using an irrevocable trust.
How Does an Irrevocable Trust Work?
An irrevocable trust cannot be changed or modified without the beneficiary's permission. Essentially, an irrevocable trust removes certain assets from a grantor’s taxable estate, and these incidents of ownership are transferred to a trust. A grantor may choose this structure to relieve assets in the trust from tax liabilities, along with other financial benefits.
What Is the Difference Between an Irrevocable and a Revocable Trust?
First, irrevocable trusts cannot be changed or altered. Among the primary reasons they are used is for tax reasons, where the assets in the trust are not taxed on income generated in the trust, along with taxes in the event of the benefactor's death. Revocable trusts, on the other hand, can change. Beneficiaries may be removed and stipulations may be modified, along with other terms and management of the trust. However, when the owner of the trust dies, the assets held in the trust realize state and federal estate taxes.
Who Controls an Irrevocable Trust?
Under an irrevocable trust, legal ownership of the trust is held by a trustee. At the same time, the grantor gives up certain rights to the trust. Once an irrevocable trust is established, the grantor cannot control or change the assets once they have been transferred into the trust without the beneficiary's permission. These assets can include a business, property, financial assets, or a life insurance policy.