Although an irrevocable trust is not tailored for everyone, the advantages it offers may be just what the financial doctor ordered for your particular situation. You may have to jump a few hurdles to set up an irrevocable trust, including having to reconcile the loss of control over your own assets. But if your comfort level can clear this primary hurdle, the potential benefits of an irrevocable trust can extend to your beneficiaries as well as to you.
A irrevocable trust gives you the benefit of protecting your assets from creditors and lawsuits. It also lowers your estate's tax liability and provides a plan for handling your estate's assets.
What is a Trust?
A trust is a fiduciary relationship among three participants: a trustor (also called a grantor) conveys authority to a trustee for holding title to property or assets for the benefit of a third-party beneficiary. Trusts have rules, which determine certain parameters such as protecting assets, establishing the terms of an inheritance and managing money. Two types of trusts – irrevocable and revocable – differ in their ability to be changed by the trustor.
Irrevocable and Revocable Trust Differences
As its name implies, an irrevocable trust typically cannot be changed or terminated (revoked) by the creator of the trust (the grantor) without the consent of the beneficiaries. This characteristic can act as a double-edged sword, or it can create the finality that the grantor wants.
On the flip side, a revocable trust is easily changed or terminated (revoked) by the grantor, as long as the grantor is still alive and mentally competent. Revocable trust grantors retain control of their assets whether the trust remains intact or becomes terminated. But upon the grantor’s death, an existing revocable trust becomes an irrevocable trust.
Two Types of Irrevocable Trusts
An irrevocable living trust (also known as an inter vivos trust), is one you create and activate during your lifetime. When you put your assets into an irrevocable living trust, the assets do not go through the probate process. This type of trust includes spousal lifetime access trusts (SLATs), charitable remainder trusts, grantor-retained annuity trusts (GRATs) and irrevocable life insurance trusts.
An irrevocable testamentary trust is one you create during your lifetime as part of your will, but it is only activated after your death. Assets in an irrevocable testamentary trust are not exempt from probate. They are administered according to the terms of your will. A common form of an irrevocable testamentary trust is one that’s established to name a trustee who handles the property you leave to a minor.
Irrevocable Trust Pros and Cons
Just like features of other types of estate plans, there are pros and cons of irrevocable trusts. But unlike other estate planning options, an irrevocable trust requires a firm commitment from you before finalizing it because you’re essentially relinquishing control of your assets. With that in mind, consulting with your tax specialist and/or estate attorney goes a long way toward weighing an irrevocable trust’s benefits against its drawbacks.
Irrevocable Trust Advantages
In addition to providing an estate plan that preserves and distributes an estate’s assets, an irrevocable trust can also lower your estate tax liability and offer asset protection from lawsuits and creditors.
Protection from lawsuits and judgments. For some taxpayers, the very nature of their jobs opens them up to scrutiny from lawsuits. Certain business owners, doctors and attorneys may find protection for their assets in an irrevocable trust. Court orders and judgments cannot remove assets from this type of trust. Even if you have a business loan that you cannot repay, the lender cannot access the assets in your irrevocable trust.
Lower estate tax liability. Generally, taxpayers who have large estates are the ones who benefit the most from having an irrevocable trust. If you leave more than the IRS-allowed lifetime tax-free gift limit in estate assets to your beneficiaries, the amount over this tax-free limit is subject to a federal estate tax of 40 percent. But if you gift your estate to an irrevocable trust for your beneficiaries, the amount is exempt from estate taxes – regardless of whether this amount exceeds the tax-free gift limit.
IRS Tax-Free Gift Limits
During your lifetime, regardless of whether you have an irrevocable trust, you can gift a tax-free total of $11.4 million (as of tax year 2019). If you’re married, this amount increases to $22.8 million ($11.4 million each). This amount, called a lifetime exclusion, represents the total of all gifts you make to any number of people, whether they are related to you or not. In addition to the lifetime exclusion, the IRS also allows a $15,000 annual exclusion (as of tax year 2019), which represents the tax-free amount you can gift each person, each year.
If you give more than $15,000 to any one person during the tax year, you'll have to report only the excess on IRS Form 709 (United States Gift [and Generation-Skipping Transfer] Tax Return. But "report" doesn't mean you'll pay tax on your gift. You'll only pay tax if you exceed your lifetime limit or if your assets are not protected in an irrevocable trust.
For example, you can give each of your children $15,000 each year without having to report this gift. (If you're married, each spouse can give $15,000 per person.) But if you give someone $20,000, you'll have to report $5,000 on Form 709 ($20,000 minus the tax-free limit of $15,000).
Establishing an Irrevocable Trust
You’ll typically work with an estate attorney to set up an irrevocable trust because of the intricacies of this type of trust. As the grantor of the trust, you need two more participants – the trustee you designate and at least one beneficiary. (You can have more beneficiaries, but you need at least one.)
With everyone in agreement – you, the trustee and your beneficiaries – you’ll spell out the terms of the trust and the use of the trust assets. After your attorney drafts the trust agreement, you’ll gift your assets to the trust. As soon as you relinquish your assets, they no longer belong to you; they belong to the trust.
Irrevocable Trust Disadvantages
A discussion of the advantages of an irrevocable trust isn’t complete without mentioning its disadvantages, just to see the overall picture. For many taxpayers, the disadvantages are deal-breakers when deciding whether to establish this kind of trust.
You will find yourself:
- Losing control over assets. As soon as you gift your assets to an irrevocable trust, they are irretrievable to you. You simply cannot reclaim your surrendered assets or even continue to manage them.
- At the mercy of the irrevocable trust’s structure. You are bound to the confines of the trust’s structure, without the power to change it. Any potential changes require the permission of all parties involved. If, for example, one of your beneficiaries doesn’t give consent to make a change, the trust’s structure will not change.
- Possibly rethinking your decision. What’s that they say about hindsight’s being 20/20? Since you cannot peer into the future to glimpse your financial landscape, you could potentially put yourself in financial straits by giving your assets to an irrevocable trust.