What is an Irrevocable Trust?

What is an Irrevocable Trust?

Irrevocable living trusts are for a variety of purposes. Both irrevocable trusts and revocable trusts avoid probate, but an irrevocable trust has other advantages. In addition to avoiding probate, an irrevocable living trust can reduce taxes and protect assets.

Basic Types of Trusts

The person who creates a trust is called the grantor, the person who manages the trust is called the trustee (who may also be the grantor), and those people or organizations for whom the trust is created are called beneficiaries.

A trust may be either revocable or irrevocable. With a revocable trust, the grantor retains full control of the assets placed in the trust, may remove assets from the trust, may change the beneficiaries, and may cancel (or revoke) the trust entirely. With an irrevocable trust, the grantor gives up this type of control. Once ownership of an asset is transferred to the trust, the grantor may not remove it from the trust. The grantor may not change beneficiaries, alter any of the terms of the trust or revoke it.

A trust may be a living trust or a testamentary trust. Living trusts become effective while the grantor is alive. Testamentary trusts are set up along with a will and do not become effective until the grantor’s death. (A revocable living trust becomes irrevocable when the grantor dies.)

Death and Taxes

Whether any taxes need to be paid when someone dies depends upon the value of their estate, and which state’s laws apply. In 2015, the federal Unified Gift and Estate Tax will apply if the value of the estate exceeds $5.42 million. This amount changes from year-to-year.

Some states also levy some form of tax, also based upon the value of the assets in the estate, usually referred to as a death tax or an inheritance tax. The state tax applies if the deceased person’s primary residency was in the state, or if he or she owned property in that state.

Avoiding or Reducing Taxation

There are several types of irrevocable living trusts designed to avoid or reduce state and federal estate taxes. These are used by those wealthy enough to be subject to the taxes, and include:

AB or Bypass Trusts. Used by spouses, these provide for a surviving spouse to receive income from (or the use of) trust property, but upon the death of the second spouse the property passes to other beneficiaries (typically children or charities). Taxes are delayed until the second spouse dies. This is a complex arrangement, where the original trust indicates what property belongs to each spouse. Property is divided between two trusts when the first spouse dies. However, if the property appreciates in value between the spouses’ deaths, the amount of the tax may by higher.

QTIP and QDOT Trusts. Also used by spouses, a Qualified Terminal Interest Property (QTIP) trust allows estate taxes to be delayed until the second spouse dies. If one of the spouses is not a United States citizen, a Qualified Domestic Trust (QDOT or QDT) is used instead.  

Generation-Skipping Trusts. With this type of trust, the child of the grantor receives income from the trust property. Upon the death of the child, the trust property goes to grandchildren. This avoids taxation when the child dies, but it is only delayed until the grandchildren die. However, there is a federal generation-skipping transfer tax that applies.

Charitable Trusts. These have a charity as a beneficiary. With a charitable remainder trust, a person (such as a spouse or child) receives income during his or her life, and upon that person’s death the trust property goes to the charity. With a charitable lead trust, the charity receives the income for a certain amount of time, then the property goes to a person or group of persons. With a pooled income trust, two or more grantors place property in the trust and receive income for a specified period of time, then the property goes to the charity.

GRITs. A Grantor Retained Income Trust (GRIT) allows the grantor to receive income from trust property for a specified period of time. To be effective in delaying taxes, however, the grantor must live past the specified period. There are two forms of the GRIT. With a Grantor Retained Annuity Trust (GRAT), the grantor receives a set dollar amount of income (paid at least annually). If the amount of payments varies, typically because the grantor receives a fixed percentage of trust assets (revalued annually) it is called a Grantor Retained Unitrust (GRUT).

QPRTs. In a Qualified Personal Residence Trust, the grantor transfers title of his or her home to the trust, but retains the right to live in the home rent free for a specified period of time. At the end of the period, the home goes to the designated beneficiaries.

Life Insurance Trusts. The trust owns a life insurance policy on the grantor. Since the proceeds of the policy do not go to the grantor’s estate, they are not taxable. Such a trust must exist for at least three years before the grantor’s death. If a previously owned policy is transferred to the trust, the trustee cannot be the prior policy owner.

Protecting Property

A living irrevocable trust can also protect and preserve property that might otherwise be lost to creditors or to requirements for receiving certain government benefits.

Protection from Creditors. Once you transfer property to the trust, you no longer own it. Therefore, your creditors may not go after that property. Living trust forms also have provisions so that creditors of beneficiaries cannot go after trust property.

Medicaid Planning Trusts. Medicaid has certain eligibility rules, which require that you use most of your assets for your care before you will be able to receive benefits. If you transfer assets to an irrevocable trust, you no longer own them and they are not counted in determining eligibility. However, assets must be placed in trust a certain number of years before you apply for Medicaid.

Spendthrift Trusts. These are used to protect gifts to individuals you don’t believe will be capable of managing their finances, or who are at risk from creditors. The trustee will manage the property.

Special Needs Trusts. These are designed to provide funds to support a person with special needs, without compromising their ability to satisfy income and asset qualifications to be eligible for government benefits.

Successor Beneficiaries

Since the irrevocable trust may not be modified, it is important to cover the possible death of beneficiaries by designating successor beneficiaries. If all beneficiaries die before the grantor, the property goes back into the grantor’s estate. It will then be subject to probate, the claims of creditors, and estate taxes.  

The “Pour-Over” Will

Most people don’t transfer all of their property into a trust, therefore, it is a good idea to have a “pour-over” will that leaves any remaining property to the trust.

Conclusion

Anyone with significant wealth should evaluate the potential benefits of an irrevocable living trust. But even those of more modest means may benefit from the asset protection and Medicaid planning features offered in any irrevocable living trust form. It is best to consult a lawyer, as there are many complexities to creating a trust.

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