Revocable Vs. Irrevocable Trust
It is difficult to know whether you need a trust, let alone whether it should be revocable or irrevocable. Irrevocable trusts are often promoted for having certain tax benefits over revocable trusts, with the caveat that you must be comfortable with the rigidity that comes with the trust being irrevocable. Let’s discuss how both of these beliefs are often untrue.
A revocable trust simply means that the trust can be revoked, terminated, or amended by the person creating the trust. Because the trust is revocable, it is not distinguished for ownership or tax purposes from the person creating it. Assets in your revocable trust are taxed to you. Assets in your revocable trust are your assets. Your revocable trust is an extension of you. Revocable trusts are typically created to avoid probate and to ensure the proper people control and receive your assets in the future. A revocable trust is the most common type of trust people create. When the settlor (the creator of the trust) dies, a revocable trust becomes irrevocable. At that point, the trust is treated as any other irrevocable trust.
An irrevocable trust means the trust cannot be revoked, terminated, or amended by the person creating the trust. So why would you want to create an irrevocable trust and give up the flexibility you have with a revocable trust? Well, there are several reasons, each of which could be a 200-page brief, but let’s summarize the concept. When you create an irrevocable trust, the assets in the trust are separate from your other assets in some way. They could be separate for creditor protection reasons, income tax purposes, estate tax purposes, gift tax purposes, or government benefits. However, regardless of the reasons, the concept is that the assets in the irrevocable trust are separate from your other assets. Click to read more about trusts, and how they work in California.
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Types Of Irrevocable Trusts
The types of irrevocable trusts and the naming conventions for each can be overwhelming. To make matters more complicated, attorneys have started to make up their own acronyms (I’m guilty of this as well) to define certain types of trusts. The name we give a trust is simply a way to give you (or other attorneys) some basic understanding of what the terms of the trust may include.
Two people may call the same trust different names. To make it simple, think of the types of trusts like residential architecture. Imagine we both look at the exact same home on the exact same street. I may call it contemporary. You may call it modern. But at the end of the day, the house has not changed. You can think of trusts in the same way.
Oftentimes the same trust will be called three different names depending upon how it is used. A trust may also have a very small change from another trust and be called something completely different.
As explained in more detail below, the type of irrevocable trust you need is based upon the problem you are trying to solve and therefore the rules you must play by.
Do You Need An Irrevocable Trust?
In order to determine if you need an irrevocable trust, you have to ask what you are trying to accomplish.
- Do you have a large estate that will pay estate taxes in the future? Do you have concerns about a future lawsuit against you?
- Are you paying the highest federal income tax rate and also live in a high-income tax state?
- Are you trying to qualify for a needs-based program such as Medicaid?
- Do you want to provide gifts to family members now, but also protect those assets from the beneficiary’s creditors or spouse?
These are all potential reasons to create an irrevocable trust.
What If I Need To Make Changes To The Irrevocable Trust In The Future?
Most people are scared off by irrevocable trusts because they are considered to be rigid and don’t allow for changes in life circumstances. This is probably the biggest myth about irrevocable trusts. Think of an irrevocable trust as the rule book for a given sport. The irrevocable trust identifies what is allowed and not allowed in the administration of the trust. Depending upon the situation, you may want more or less flexibility in the rules of the game. The tricky part is determining which rules are required and how much flexibility you can have in the rules. As an estate planning attorney, we create the rules with your goals in mind, while still following the framework given to us by the IRS.
Most irrevocable trusts can be created to allow flexibility in the two most important decisions that you will make: 1) the person in charge; and 2) the beneficiary. The person with the power to make those decisions varies from trust to trust, but the point is the irrevocable trust can be changed for even the most important decisions.
Even the rules can be changed by the use of decanting. Decanting is when the assets of one trust are distributed to another trust with terms that you prefer. Effectively, decanting allows you to change the rules of the game.
If Irrevocable Trusts Are So Flexible, Then Why Doesn’t Everyone Create An Irrevocable Trust?
The simple answer is cost, complexity, and need.
First, because an irrevocable trust is intended to be separate from you in some way, they oftentimes (not always) require the preparation of separate tax returns. While certainly feasible, you may not want the added layer of complexity or costs associated with preparing tax returns for irrevocable trusts.
Second, oftentimes, you will want to be the beneficiary of the trust you are creating. This is often referred to as a “self-settled trust” or the colloquial term, an “asset protection trust.” The idea is that you put assets into a trust for your own benefit, and those assets are then protected. These types of trust are not allowed in every state (including California, where we practice). So in order to create these asset protection trusts, you must form them in a different state. This comes at a cost. You will typically need to hire a trustee located in the local jurisdiction. These trustees charge an annual fee.
Third, as discussed above, you may not need an irrevocable trust. You may not have a situation that can be improved by an irrevocable trust. When you do, you need to compare that need to the cost and complexity of irrevocable trusts.