Revocable Trust vs Irrevocable Trust

Trusts can help ensure your assets are distributed according to your wishes but it’s important to choose the right trust for your financial situation. You may have heard of both revocable trusts and irrevocable trusts, wondering how they compare and, more importantly, which makes sense for you.

First, let’s be clear on what a trust is and how it’s used in estate planning. A trust is a legal arrangement where the creator (called the grantor or settlor) gives assets to another party (the trustee) to hold and manage them for the benefit of a third party (the beneficiary).

But it’s important to understand the difference between the main types of trusts because they have very different purposes and benefits. So, let’s break down the key features of revocable and irrevocable trusts and why you might choose to use one or the other.

WHAT IS A REVOCABLE TRUST?

A revocable trust (also called a revocable living trust) is a legal arrangement used in estate planning to manage and distribute your assets during your lifetime and after death. You might want one in addition to a will because it gives you more flexibility, efficiency and privacy and could make life easier for your loved ones when you’re gone. 

In a revocable trust, you are the grantor, trustee and beneficiary. 

Revocable trusts offer some advantages and, of course, have their downsides.

Pros:

• Potential to avoid probate (saves time and allows more privacy for your heirs)
• Gives you flexibility in your estate planning (can be changed or revoked at any time)
• Provides for management of your assets if you become incapacitated
• Usually saves some money in the estate settlement process (no probate court and attorney fees for probating the will)

Cons:

• Requires legal fees to draft the trust agreement
• Requires time to fund the trust during your lifetime (you must proactively retitle assets into the name of the trust)

You’ll need to work with an estate attorney to create the legal documents needed to set up a revocable trust.

COMMON USES OF A REVOCABLE TRUST

Revocable trusts aren’t necessary for everyone, but most people can probably benefit from one. They could be right for you if:

• You have privacy concerns
• You would like to ensure a continued management of assets if you become incapacitated.
• You own property in multiple states or have an operating business
• You live in a state where probate is especially tricky
• You have a complex family structure or dynamics
• You want your fiduciary to have quicker access to funds after you’ve passed away

WHAT IS AN IRREVOCABLE TRUST?

An irrevocable trust is an entity by which an individual receives a gift or inheritance. This type of trust cannot be changed or canceled once it's set up and funded.

When used in the right situation, an irrevocable trust can help provide asset protection, tax savings and peace of mind. 

Irrevocable trusts offer some advantages and, of course, also have their downsides.

Pros:

• Provides asset protection for beneficiaries
• May help reduce estate taxes
• Allows you to control a beneficiary’s inheritance

Cons:

• Cannot be changed
• Requires the grantor to give up control (if funded during the grantor’s lifetime)

Again, you’ll need to call on professional help here; only an attorney can create the documents needed to set up an irrevocable trust.

COMMON USES OF AN IRREVOCABLE TRUST

An irrevocable trust is created for a specific purpose that is often connected to estate tax, charitable planning or a grantor’s concern about a family member. An irrevocable trust may be created and funded during the grantor’s life or upon the grantor’s death.

Common uses include:

• Asset protection for the beneficiary
• Estate tax reduction
• Control over distributions
• Charitable giving

Common types of irrevocable trusts include:

• Crummey Trust: Structured to accept annual exclusion gifts, often times for younger individuals
• Life Insurance Trust: Designed to provide liquidity upon the policy owner’s death by removing the death benefit from the estate for estate tax purposes
• Qualified Personal Residence Trust: A transfer tax mitigation technique
• Special Needs Trust/Supplemental Needs Trust: Designed to hold gifts and inheritances of someone who may be receiving or may in the future receive means-tested public benefits like Supplemental Security Income or Medicaid
• Generation Skipping Transfer Exempt Trust: Designed to preserve the grantor’s generation-skipping transfer tax exemption
• Charitable Remainder Trust: Designed to benefit one or more individuals for a period of time, with the remainder passing to charity.
• Marital Trust: Designed to hold a deceased spouse’s assets for the benefit of the surviving spouse, while preserving assets for the deceased spouse’s heirs
• Bypass Trust/Credit Shelter Trust: Designed to preserve the deceased spouse’s estate tax exemption
• Spousal Lifetime Access Trust: Equivalent to a lifetime credit shelter trust
• Qualified Domestic Trust: Designed to defer an estate tax liability for a non-citizen spouse

KEY DIFFERENCES BETWEEN REVOCABLE AND IRREVOCABLE TRUSTS

Often, people confuse revocable trusts with irrevocable trusts, but as we’ve covered, they are quite different – and have very different purposes.

To review:

• A revocable living trust is like a will substitute – its sole purpose is to make things easier on your executor and heirs when you are gone.
• An irrevocable trust is used to enable beneficiaries to inherit wealth. For example, it’s common for parents of young adults to direct a child’s inheritance into an irrevocable trust until a certain age. Irrevocable trusts are often created for a special needs individual.
• It is not uncommon for the beneficiary of a revocable trust to be an irrevocable trust. 

Here’s a quick comparison:

TAX AND LEGAL IMPLICATIONS

HOW EACH TRUST AFFECTS TAXES

• Revocable trusts:
  • Have no income tax implications
  • All assets are part of the grantor’s estate for estate tax purposes 
  • Funding of a revocable trust is not a taxable gift (there was no transfer of ownership)
• Irrevocable trusts:
  • May remove assets from the taxable estate
  • Once the grantor is deceased, the irrevocable trust becomes its own taxpayer
  • Assets within an irrevocable trust are not considered an asset of the grantor or beneficiary for transfer tax purposes
  • If the irrevocable trust is funded during the grantor’s lifetime, there may be a gift tax implication

LEGAL PROTECTIONS AND LIMITATIONS

• Since a revocable trust is merely an alter-ego, the revocable trust does not offer any protections against creditors and lawsuit judgments.
• Assets within an irrevocable trust are not owned by a beneficiary, so assets within an irrevocable trust are generally not subject to the claims of a beneficiary’s creditors.

HOW TO KNOW WHICH TRUST IS RIGHT FOR YOU

It’s not a matter of deciding whether your trust should be revocable or irrevocable. Instead, it’s about deciding whether you would like to make life a little easier on your fiduciary when you pass away. If so, you probably want to have a revocable trust as a companion to your Last Will and Testament. If you have concerns about how a beneficiary will inherit wealth or receive a gift from you, you probably want to think about directing that person’s gift or inheritance into an irrevocable trust.

HOW A FINANCIAL ADVISOR CAN HELP

If you haven’t already picked up what we’re putting down, estate planning – and trusts in particular – get complex fast. So, you really don’t want to go it alone. We recommend collaborating with your estate attorney and tax professional to help ensure any trust strategy you pursue is appropriate. A financial advisor can also help you evaluate how each trust type may fit into your overall financial plan and how it aligns with your long-term goals.