Revocable vs. Irrevocable Living Trusts
To Change or Not to Change a Trust
Trusts come in all shapes and sizes, and many are formed with specific purposes in mind. All living trusts are either revocable or irrevocable, and there are some major differences between the two.
A living trust is one that the grantor—the individual who creates and funds the trust—sets up during their lifetime. These are also sometimes called "inter vivos" trusts, and they're different from testamentary trusts which are created under the terms of an individual's will after death.
Revocable Living Trusts
A revocable living trust can be changed at any time. You can modify it with a trust amendment if you have second thoughts about a provision in the trust's terms, such as if you change your mind about who should be a beneficiary.
You can even revoke or undo the entire trust if you decide that it just doesn't serve your purposes any longer.
It's common for the grantor of a revocable trust to personally act as trustee, managing its assets, after the trust is formed and funded.
The downside is that all assets transferred to the trust are still considered your own personal property because you continue to have absolute control over them. This means that creditors can still reach them, and that they constitute your estate at the time of your death so both state estate taxes and federal estate taxes might come due.
A revocable trust offers no protection if you're sued—your assets are at risk just as if you still owned them in your own name. They're considered for Medicaid planning purposes. The law takes the position that if you can undo or change the trust at any time, you still own the assets.
What Can a Revocable Trust Do?
A revocable trust allows you to plan for mental disability. Assets held in the name of the trust can be managed by a successor trustee when and if the grantor becomes mentally incapacitated. The grantor can name the trustee, someone they trust to take over in the event that they can no longer personally manage the trust themselves.
Revocable trusts also avoid probate of the assets they hold. Although they're still taxable for estate tax purposes, they'll pass directly to the beneficiaries named in your trust agreement without probate court involvement.
A revocable trust can protect the privacy of your property and beneficiaries when you die as well. Because it's not subject to probate, your trust agreement remains a private document. It doesn't become a public record for all the world to see.
Your assets and who you've decided to leave your estate to will remain a private family matter.
Contrast this with a last will and testament that has to be admitted for probate. It becomes a public record that anyone can see and read as soon as it's submitted to the court.
An irrevocable trust can't be changed by the grantor after the agreement has been signed and the trust has been formed and funded. For the most part, it's forever, although there are a few rare exceptions.
You can't take property back that you've placed into an irrevocable trust. You can't act as trustee and manage the trust's assets. You form the trust and step aside for all time.
A revocable living trust becomes irrevocable when the grantor dies because the grantor is no longer available to make changes to it, but a revocable trust can be designed to break into separate irrevocable trusts at the time of the grantor's death for the benefit of children or other beneficiaries.
Irrevocable trusts can take on many forms and can be used to accomplish a variety of estate planning goals.
Irrevocable Trusts and Estate Tax Avoidance
Irrevocable trusts are commonly used to remove the value of property from a person’s estate so that property can't be taxed when the person dies.
The individual who transfers assets into an irrevocable trust permanently gives those assets to the trustee and to the beneficiaries of the trust. Because they no longer own the assets, they don't comprise or contribute to the value of the estate. They're therefore not subject to estate taxes when the individual dies.
Irrevocable Trusts and Government Assistance
Because you're effectively giving away your property for all time, its value can no longer be counted against you for purposes of qualifying for government programs in a time of need. For example, eligibility for Medicaid is restricted to those with negligible assets and income.
You can ensure that your property ultimately will go to your beneficiaries, not to a nursing home, when you place it in such a trust.
There's a caveat here, however. Medicaid imposes a five-year "look back" period in 49 states and Washington D.C. as of 2020. The value of property that's given away within this time period still counts against the applicant for qualifying purposes. Many states make an exception for irrevocable funeral trusts, however, where you can set aside enough for your burial within this five-year period.
Another common use for an irrevocable trust is to provide asset protection for the grantor and their family. This works in the same way that an irrevocable trust can be used to reduce estate taxes.
By placing assets into an irrevocable trust, the grantor gives up complete control over and access to the trust assets. They therefore can't be reached by the grantor's creditors because the grantor no longer owns them. But the grantor can name their family as beneficiaries so they're still providing for them—the assets are just outside of the reach of creditors.
Common Types of Trusts: AB Trusts
An AB trust is created for the benefit of a surviving spouse and it's irrevocable. It can make full use of the deceased spouse's exemption from estate taxes through funding of the B part of the trust at the time of death with property valued at or below the estate tax exemption.
Then, if the value of the deceased spouse's estate exceeds the estate tax exemption, the A Trust will be funded for the benefit of the surviving spouse and payment of estate taxes will be deferred until after the surviving spouse dies.
For example, the estate tax exemption is only $1 million in Massachusetts as of 2020, compared with the federal $11.58 million exemption in the same year. The first $1 million of an estate would go into the B Trust to protect that portion from estate taxes. The next $10.58 million would go into the C trust, and anything over the total of $11.58 million would go into the A Trust.
Life Insurance Trusts
Irrevocable life insurance trusts are set up to accept life insurance benefits at the time of the grantor's death. This can take a sizable chunk of value out of an estate that's potentially subject to the estate tax, bringing the value down below that year's estate tax exemption threshold.
You would name the trust as the policy's beneficiary, then you can set terms for the trust dictating who ultimately gets the proceeds at the time of your death.
Charitable Estate Planning Trusts
An irrevocable trust can accomplish charitable estate planning through a charitable remainder trust or a charitable lead trust.
As the names suggest, beneficiaries are paid first from a charitable remainder trust, with the balance going to a cited charity or charities. The charity is paid first in a charitable lead trust, then the beneficiaries get their shares of the remaining assets.
The grantor can claim a charitable income tax deduction in the year the transfer is made to the irrevocable trust if the initial funding of assets into the trust is made while they're still alive. The estate will receive the charitable estate tax deduction instead if the initial transfer of assets into a charitable trust doesn't occur until after the grantor's death.
Trusts are governed by both state and federal law. These laws can change periodically and you should always consult with a tax professional or an attorney for the most up-to-date advice. The information contained in this article is not intended as tax or estate-planning advice, and it is not a substitute for such advice.