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Did you know that probate can take a good 3 to 7% of an estate’s value? This is because the court proceedings are lengthily and therefore costly, thus reducing the amount your beneficiaries stand to inherit. Fortunately, there are ways to minimize this impact, such as utilizing a trust.
A trust is a separate legal entity that can be formed to protect your assets. It ensures that after you pass away your wishes for your assets will be carried out as you intended. The probate process is bypassed which saves time and money, and depending on your circumstances estate taxes could be reduced as well.
There are two types of trusts: revocable trusts and irrevocable trusts. To help you decide which better suits your needs, we’re going to discuss both below.
What Is a Revocable Trust?
Sometimes referred to as a revocable living trust, a revocable trust affords you full control until you pass away or are deemed to be medically incapacitated. It offers more flexibility than an irrevocable trust, as it enables you to make changes as you see fit.
For example, let’s say you want to remove or add a beneficiary. A revocable trust would enable you to do so at any time.
Or let’s say that you wanted to sell some of the assets held in the trust. With a revocable trust, you could do this as well without having to seek permission from another party.
Another feature of a revocable trust is that it can generate income for its owner during their life. The owner, referred to as the grantor of the trust, receives a distribution for income earned by the trust. The beneficiaries of the trust do not receive distributions until after the death of the grantor.
Unlike irrevocable trusts, the assets in a revocable trust are subject to estate tax. So, while revocable trusts do offer more flexibility, they may cost your beneficiaries some money down the line.
Note that, once the owner of a revocable trust dies, that trust effectively becomes an irrevocable trust (discussed below).
It’s also important to consider that revocable trusts do not protect assets from legal disputes filed against the owners of said trusts. So, if a creditor were to win a lawsuit against you prior to your death, the assets that are held within the revocable trust could be seized in order to pay off the liability.
What Is an Irrevocable Trust?
An irrevocable trust is far more rigid than a revocable trust. Once it’s been established, it’s difficult to make modifications. While changes may be made, they require the approval of the beneficiaries or a court order.
What this means is that, once money has been transferred to the trust, it’s extremely difficult to take back. It also means it’s a challenge to remove or add beneficiaries at a later date.
So, why might you go with an irrevocable trust over a revocable trust? The short answer is they have the potential to save money on estate/inheritance taxes.
Assets that are transferred to an irrevocable trust are considered to be separate from your taxable estate, ergo they are exempt from estate tax. This is because you don’t have control of said assets at the time of your death, in contrast to a revocable trust which you have control of until after you pass away.
This makes an irrevocable trust more desirable than a revocable trust for individuals with a net worth high enough to subject them to the estate tax. Such individuals could stand to save a significant amount of money through the utilization of an irrevocable trust.
In addition, the assets in an irrevocable trust are generally protected from lawsuits and creditors. If someone wins a lawsuit against your estate, the assets in your irrevocable trust can’t be taken. This makes an irrevocable trust an attractive option for professionals such as doctors and lawyers who are vulnerable to lawsuits.
There are different types of irrevocable trusts, such as an irrevocable life insurance trust, a grantor-retained annuity trust (GRAT), charitable remainder trust, etc. As the purpose of this article is to give an overview of the two main types of trusts, revocable and irrevocable trusts, we won’t be diving into the different types of irrevocable trusts but wanted to acknowledge their existence.
Pros & Cons of a Revocable Trust
Pros
- Flexibility to change/revoke trust
- Assets held by trust bypass probate
- Can generate income for owner while they’re alive
Cons
- Creditors can seize assets held by trust
- Assets held by trust are subject to estate tax
Pros & Cons of an Irrevocable Trust
Pros
- Assets held by trust are exempt from estate tax
- Assets held by trust bypass probate
- Assets held by trust are protected from creditors
Cons
- Lack of flexibility to modify trust
- Cannot be revoked once established
- Funds cannot be taken back from trust without approval from beneficiaries or a court order
Revocable vs Irrevocable Trust: Which Is Right for You?
As illustrated above, there are benefits and drawbacks to revocable and irrevocable trusts. Determining which type of trust best suits your needs depends on the facts and circumstances surrounding your situation. Such an analysis should be performed by someone with experience in the trust/estate space.
Are you in need of assistance either forming a trust or with an existing one? If so, Gulla CPA has you covered. Contact us now to discuss further.