What Is an Irrevocable Trust? Definition, Benefits and How It Works

“Irrevocable trust” – it has a serious, no-turning-back ring to it. And it’s a serious thing! Not many decisions in life can’t be undone. This is one of them.

But irrevocable trusts can be a very effective tool in estate planning. Let’s see why, and whether it could be the right step for you.

WHAT IS AN IRREVOCABLE TRUST?

Imagine locking up money in a vault and throwing away the key. That’s what happens when you set up an irrevocable trust. Once it’s in place, you have no more control over the assets you place there. And the terms of the trust can’t be changed.

On the surface, that might seem like a pretty bad deal. But the potential upside of an irrevocable trust can be huge in the right scenario: asset protection for beneficiaries, transfer tax savings and peace of mind.

We’ll cover a few potential “right scenarios” below. Generally, these are some of the situations that irrevocable trusts can be useful for:

• Couples with an estate tax exposure
• Children at risk of a divorce, creditors or lawsuits
• Special needs family members

HOW AN IRREVOCABLE TRUST WORKS

Here’s the basic structure:

You, the grantor, create the trust and transfer assets into it. Those assets could include real estate, investments or even life insurance policies. Once they’re inside the trust, they’re no longer yours – you’ve officially given up ownership.

A trustee or multiple trustees, appointed by you, manage the trust according to the rules you set when you created it. The trust is now the official owner of the assets.

The beneficiaries (again, designated by you when you set up the trust) receive the assets under the terms you set. The trust must be managed for their benefit.

An irrevocable trust can also be – and often is – the beneficiary of your Last Will and Testament.

BENEFITS OF AN IRREVOCABLE TRUST

Let’s dive into those powers.

First, there’s asset protection. If you’re worried about a beneficiary’s creditors or lawsuits, assets inside an irrevocable trust are generally off-limits. They don’t belong to the beneficiary, so they can’t be taken. If the irrevocable trust is properly structured, the assets are also generally not subject to a property settlement in a divorce proceeding, either.

Then there’s the potential for estate tax reduction. For married couples who live in a state with a state-level estate tax, an irrevocable trust can be utilized to maximize both spouse’s estate tax exemption amounts.

And finally, control. Want to make sure your kids don’t blow through their inheritance in one weekend? You can set rules to prevent that. You can also provide that the funds within an irrevocable trust continue for the benefit of grandchildren and future generations.

IRREVOCABLE TRUSTS AND TAXES

There’s a lot to know about irrevocable trust taxes.

Depending on how it’s set up, the trust itself may become its own tax entity, like an individual person, which means it may need to file its own return.

Who pays taxes on the income that a trust earns on investments? It could be the grantor, the beneficiaries or the trust itself, again depending on how it’s set up and managed.

Funding the trust – moving assets into it – can also trigger transfer tax implications. 

As you can see, professional guidance is essential to make sure you’re playing by the rules and maximizing the benefits, because the right set-up and strategies are based on your specific goals for the trust.

DRAWBACKS AND CONSIDERATIONS

Of course, it’s not all sunshine and tax savings. Setting up and maintaining the trust can also be complex and costly. And remember, you’ll need to designate a trustee to oversee it. While many people automatically turn to a family member or friend, remember that the trustee(s):

• Have to manage all the assets in the trust
• Are legally required to act only in the best interests of the beneficiaries (and can be sued – and held personally liable – if they’re not)
• Have to file annual tax returns for the trust

The good news is that you can assemble a professional team so your family is more protected from heartache. Here are a few roles to consider.

• An estate planning attorney should set up the trust. This one’s not really optional – an irrevocable trust is way too complex and important to DIY.
• A corporate trustee can be entrusted instead of (or in addition to) naming a friend or family member. By designating a professional to act as trustee for the trust, they take over the managerial duties and the potential emotional labor.
• A financial advisor can help manage the trust’s investments.
• A tax professional can prepare tax returns and other filings for the trust.

3 TYPES OF IRREVOCABLE TRUSTS

There are way too many kinds of irrevocable trusts to cover them all in one article, and they’re all useful in different situations. Here are three kinds that are very common.

SPECIAL NEEDS OR SUPPLEMENTAL NEEDS TRUST

This type of irrevocable trust is designed for loved ones with disabilities that will prevent them from supporting themselves. It allows you to provide financial support (immediately or as a future inheritance) without jeopardizing their eligibility for government benefits like Medicaid or Supplemental Security Income, which are designed to cover basic expenses like shelter, food and medical care.

CREDIT SHELTER TRUST

Also called a bypass trust, this option is popular among married couples who want to minimize estate taxes. Here’s how it works: when the first spouse passes away, assets up to the deceased spouse’s estate tax exemption amount are placed in the trust. The surviving spouse can retain access and control but is not the owner. And because the surviving spouse is not the owner, the assets within the credit shelter trust are not includable in the estate of the surviving spouse for estate tax purposes. It’s a smart way to maximize transfer tax savings and keep more wealth in the family.

TRUSTS FOR YOUNG ADULT BENEFICIARIES

If you’re leaving assets to children who are just stepping into adulthood, an irrevocable trust can help prevent a “lottery winner” scenario. Instead of handing over a lump sum at age 18 or 21, you can structure distributions over time – maybe some funds for college, then more for buying a home or starting a business. This approach encourages financial responsibility and can protect your hard-earned wealth from impulsive spending.

IRREVOCABLE TRUST VS. REVOCABLE TRUST

Revocable trusts and irrevocable trusts are two very different things – and with very different purposes.

A revocable trust is a companion to a Last Will and Testament: its purpose is to make things a little easier on your fiduciary when you pass away.

An irrevocable trust is an entity into which an individual receives a gift or inheritance.

WHEN AN IRREVOCABLE TRUST MAKES SENSE

An irrevocable trust is worth considering if you’re planning for estate taxes, protecting assets for heirs or preserving a special needs family member’s benefits.  

BUILD AN ESTATE PLAN THAT PROTECTS YOUR LEGACY

Setting up an irrevocable trust is a big decision, but it can be one of the smartest moves you make for your family’s future. So, take some time to explore whether this strategy may fit your plan.