If you choose to create a trust instead of writing a will for the disposition of your assets, your beneficiaries may be able to skip the probate process altogether, depending on the type of trust you have. As with any type of estate planning, creating a trust brings a set of pros and cons to the table, based on the type of trust you establish. If you set up an irrevocable trust, once you sign on the dotted line, your assets are no longer your own.
Irrevocable trusts can help you lower your tax liability, protect you from lawsuits and keep beneficiaries from mishandling assets. But you also have to accept the downsides of loss of control and an inflexible structure too.
Irrevocable Vs. Revocable Trusts
True to its name, an irrevocable trust cannot be modified or revoked (terminated or annulled), except in limited circumstances. But on the flip side, a revocable trust can be modified or revoked as long as the creator of the trust (the grantor) is still living and mentally competent. If the grantor terminates a revocable trust at any time, all the estate assets revert to the grantor. Upon the grantor’s death, however, a revocable trust becomes irrevocable.
Setting Up an Irrevocable Trust
If you set up an irrevocable trust, you are the grantor of the trust. You’ll need at least two other people to complete the trust structure – a trustee and at least one beneficiary, although you can have numerous beneficiaries. As the grantor, you’ll decide the terms and uses of the trust assets with the agreement of your trustee and beneficiaries. You'll be able to transfer different types of assets to an irrevocable trust, including cash, property, business investments and life insurance policies.
An attorney typically drafts the trust document because of the complexities and legalities involved. With the help of your attorney, you’ll transfer assets as your gift to the trust. After this transfer, you cannot revoke the trust, and your assets are no longer your own.
Types of Irrevocable Trusts
The two types of irrevocable trusts are the irrevocable living trust and the irrevocable testamentary trust. If you have an irrevocable living trust (also called an inter vivos trust), you create and fund the trust during your lifetime. But if you have an irrevocable testamentary trust, the trust does not actually become funded until after your death, according to the terms of your will. In other words, an irrevocable living trust becomes effective during your lifetime; an irrevocable testamentary trust becomes effective after your death.
Examples of irrevocable living trusts include irrevocable life insurance trusts, grantor-retained annuity trusts (GRATs), spousal lifetime access trusts (SLATs) and charitable remainder trusts. If you have a revocable living trust, your assets avoid probate.
A primary example of an irrevocable testamentary trust is a trust you set up for naming the trustee for property you bequeath to a minor. If you have a testamentary trust, your assets will not avoid probate; they, along with your will, must go through the probate process before the trust becomes effective.
Irrevocable Trust Pros and Cons
There’s no one-size-fits-all reason for deciding to establish an irrevocable trust. What may be a benefit to one person’s situation is a disadvantage to another's situation. Weighing the irrevocable trust pros and cons involves assessing your specific financial and personal goals as well as making sound decisions for providing for your beneficiaries. Scheduling a consultation with a trusted tax attorney, financial planner or estate planner may be a good place to start as you weigh irrevocable trust options.
Benefits of Irrevocable Trusts
Irrevocable trusts help plan for the preservation and distribution of estates, they help lower tax liability, and they help protect against lawsuits.
- If you remove taxable assets from your estate and transfer them to an irrevocable trust, you’ll likely be able to reduce your tax liability, particularly if you have a large estate.
- If you establish the conditions for distribution of the trust’s assets, you may be able to prevent your beneficiaries from mishandling or misusing the assets.
- If you gift a primary residence to your child (or children), you can take advantage of estate tax rules by providing a tax-free gift.
- If you work in a characteristically litigious profession, such as the medical or legal field, you’ll be able to protect yourself from lawsuits, judgments and creditors.
Irrevocable Trust Disadvantages
Weighed against the many advantages of establishing an irrevocable trust are some clear disadvantages, including:
- Inflexible structure. You don’t have any wiggle room if you’re the grantor of an irrevocable trust, compared to a revocable trust. After you move your assets into an irrevocable trust, you lose control over them. If you want to change the terms of the trust, you cannot do this unilaterally. You’ll have to get the permission of all the adult beneficiaries to amend an irrevocable trust. In certain situations, you may also be able to alter the trust by giving the trustee the authority to make changes or by transferring the trust’s assets to another trust. This is where the advice of a skilled attorney is useful up-front – before the trust is established.
- Loss of control over assets. You have no control to retrieve or even manage your former assets that you assign to an irrevocable trust. Depending on how your trust is established, you may be receiving income from the trust. But if you experience financial difficulty, for which your trust income is insufficient, you cannot access any of your former assets, for example, to sell them for raising the money you need.
- Unforeseen changes. Priorities, goals, finances and family relationships are only a few items on the list of unforeseen changes in life. And you don’t have the luxury of gazing into a crystal ball to predict exactly how your future will unfold. So if you establish an irrevocable trust, you can’t change it to align with your future circumstances.
Estate Taxes and Gift Limits
You do not have to establish an irrevocable trust to give tax-free gifts. Taxpayers can make tax-free gifts to anyone, regardless of whether the recipient is a relative or a beneficiary of an estate. The IRS sets robust limits on the dollar amount of these gifts, which can include cash or cash equivalents such as real estate or personal property.
For tax year 2019, a taxpayer may gift any number of individuals up to $15,000 each – tax-free – without even having to report these gifts on an income tax return. (If you’re married, you and your spouse can gift $15,000 each, per person.) It’s only if you exceed $15,000 per person that you’ll have to report the excess amount on IRS Form 709 (United States Gift and Generation-Skipping Transfer Tax Return). But you still won’t owe any tax if you exceed the $15,000 limit unless you also exceed the lifetime limit of $11.4 million for the total of all the gifts you make.