Irrevocable Trust: Purpose, Use Cases & Examples

We can't take our money and assets with us when we pass on, and nobody wants their inheritance going to the government instead of loved ones. Failing to set up a plan for your assets at the end of your life can lead to an expensive, stressful, and potentially painful probate process for your family. Estate plans are crucial for asset protection and reducing your taxable estate. One of the core elements of any estate planning strategy is setting up trusts.

A trust is a legal arrangement that allows a person to transfer assets to a trustee to manage on behalf of beneficiaries. There are many types of trusts, each with different purposes and nuances. One of the most common is the irrevocable trust.

What Is an Irrevocable Trust?

A trust typically has three parties: the grantor, the trustee, and the beneficiaries. The grantor is the person who establishes the trust and transfers their assets into it. The trustee is the appointed manager of the trust. The beneficiaries are the individuals or entities that stand to benefit from the trust's assets.

An irrevocable trust cannot be modified once established. That means the terms are fixed and typically require beneficiary consent or court approval to alter. This is distinct from a revocable trust, which allows the creator to change or cancel the trust at any time during their life.

The purpose of an irrevocable trust is to help the grantor limit estate taxes and protect assets from creditors since the trust's assets are technically no longer considered theirs. Rather, it owns the assets transferred to it and holds them on behalf of its beneficiaries. A trustee has a fiduciary duty to manage the trust's assets in the interest of the beneficiaries. They may not access or control assets for the purpose of their own enrichment or make changes to the trust without the permission of all beneficiaries and the grantor.

Revocable vs. Irrevocable Trust

While the ability to make changes is the most significant difference between revocable and irrevocable trusts, there are a few other key differences:

• Irrevocable trusts offer estate tax benefits not offered by revocable trusts.
• Irrevocable trusts protect assets from creditors, while revocable trusts do not.
• Irrevocable trusts are much more complicated to set up, although both should be set up with help from an estate planning attorney.

Ultimately, both have specific benefits for different types of people and estates. However, irrevocable trusts are generally preferred by those with more considerable assets at greater risk of taxation and asset seizure because they offer built-in protection. They provide greater security when planning to pass assets down to other family members.

How Does an Irrevocable Trust Work?

When a grantor sets up an irrevocable trust, they transfer ownership of choice assets to the trust, which legally removes all incidents of ownership. This removes these assets from the grantor's taxable estate and makes them not taxable for any income generated by assets, such as stock holdings. Tax rules vary, but generally, the grantor may not receive these benefits if they are also the trustee.

Legal ownership of the trust is held by a trustee, who has a fiduciary duty to manage the trust in the best interest of the beneficiaries. Neither the grantor nor trustee may control or change the assets once they've been moved into the trust unless approved by the beneficiary or a court.

Irrevocable trusts today are more flexible than older versions, allowing greater flexibility in trust management and asset distribution. For instance, decanting allows a trust to move into a newer one with more modern or advantageous positions, and other features may allow you to move the trust's state of domicile to get additional tax savings or other benefits.

However, there are also some newer controls due to the Setting Every Community Up for Retirement Enhancement (SECURE) Act. This recent law changes some of the tax-saving benefits of see-through trusts. Before, some non-spousal beneficiaries of retirement accounts placed in an irrevocable trust could opt to receive distributions over their life expectancy. Today, SECURE Act rules require many beneficiaries to take a full distribution by the end of the tenth calendar year following the year of the grantor's death. This gives beneficiaries slightly less control over how they receive proceeds from retirement accounts but will also provide access to a more significant part of their inheritance earlier. Combined with life insurance policies, it can give beneficiaries greater financial stability after a grantor's death.

Types of Irrevocable Trusts

There are several types of irrevocable trusts, each of which is considered a living trust. This means that it originated and is funded by an individual during their lifetime. Some examples include:

• Irrevocable life insurance trust (ILIT): Holds life insurance policies to reduce estate taxes.
  
  
• Asset protection trusts: Holds assets to shield them from creditors, lawsuits, or any judgments against your estate. (These can be especially useful for doctors, lawyers, and others who work in litigious professions and can't risk forfeiting assets in a lawsuit.)
  
  
• Charitable remainder trust: Can donate assets while still receiving income from the trust for a set period. At the end of the term, remaining assets are donated to charities of the grantor's choosing.
  
  
• Charitable lead trust: Provides income to a charity for a set period. At the end of the term, the remaining assets are given to the donor or their heirs. These are often used to make large charitable gifts while reducing estate and gift taxes.
  
  
• Special needs trust: Sets aside assets earmarked for the healthcare and support of beneficiaries with special needs or medical difficulties. They can allow heirs to remain eligible for Medicare.
  
  
• Testamentary trusts: Trusts created after the death of the grantor and funded from the deceased estates in accordance with their last will and testament.

Setting up an irrevocable trust is exceedingly complex, so working with professionals, including an estate planning attorney and financial advisor, is vital. There are many potential client issues with irrevocable trusts. The trusted partners at Arden Trust will help you reduce potentially costly errors and save you time and money.

Pros and Cons of Irrevocable Trusts

We've touched on some of the benefits of irrevocable trusts, especially as they relate to revocable trusts. Different types of trusts may have additional benefits, such as if you're interested in donating part of your wealth to your favorite charity or establishing long-term care for a special needs family member after you pass on.

Generally speaking, however, there are some pros and cons of an irrevocable trust.

Benefits of an Irrevocable Trust

• Reduces estate taxes: When you transfer assets to an irrevocable trust, you may be able to eliminate estate taxes on those assets. It will not eliminate capital gains taxes on assets later taken out of the trust by the beneficiaries. Still, it will reduce the likelihood of assets being taxed twice. For example, if you have valuable stock holdings that are growing rapidly, when they go into the trust, they will not be liable for estate taxes at a higher value when you pass on.
  
  
• Protects assets from creditors: Moving assets to a trust cedes ownership of those assets, meaning creditors or collectors cannot come in demand of those assets. This is especially valuable if you're concerned about debts or fear litigation.
  
  
• Supports eligibility for government programs: Moving assets to a trust may reduce your income and asset holding significantly. This may make you eligible for government plans and programs like Medicaid, provided you meet lookback requirements. This is one reason why it's a good idea to start planning early. The Medicaid lookback period is five years.
  
  
• Avoids probate: The probate process can be expensive, messy, and public. Setting up an irrevocable trust dictates clear beneficiaries and establishes an end-of-life plan to move your assets where you want them to go. That avoids family infighting and shields your business from prying eyes, which can be especially valuable for wealthy or famous individuals.

Drawbacks of an Irrevocable Trust

• Little flexibility: You cannot cancel a trust without the approval of all beneficiaries and the grantor, which would likely be you in this case.
  
  
• More complex: Irrevocable trusts are typically more complex than revocable trusts and require the expertise of an experienced attorney. You may need to hire a corporate trustee to avoid potential conflicts of listing a family member as trustee or to set up power of appointment for certain assets. There are many more administrative requirements than revocable trusts.
  
  
• Forfeiture of assets: As the grantor, you essentially forfeit assets when you place them in an irrevocable trust. You no longer legally own or control them. Instead, you give control to the trustee. You may not pay yourself an income through the trust, so it's imperative to have another source of income or money set aside for retirement.
  
  
• Higher taxes: At the federal level, irrevocable trusts are typically subject to higher income tax rates than individual income tax rates.

Why Would Someone Want an Irrevocable Trust?

There are several key benefits of irrevocable trusts, which we have covered here. Irrevocable trusts are not for every person or family, but they can be useful financial instruments, especially for those with considerable means and assets worth protecting:

• Reduce estate taxes: Despite higher tax rates, irrevocable trusts may protect many assets from being subject to estate tax. Beneficiaries will still have to pay capital gains taxes on appreciable assets when they remove them from the trust, but they'll avoid the double taxation of estate and capital gains tax.
  
  
• Protect assets from beneficiaries: Irrevocable trusts protect assets from creditors or litigators who may target your personal assets but also protect assets from your beneficiaries. Sometimes, people need protection from themselves, and an irrevocable trust allows you to set conditions by which beneficiaries receive their inheritance. For instance, if you want a grandchild to finish college before they can access a trust fund, you may stipulate that. If you want to avoid a messy fight over a particularly beloved piece of real estate, you can set rules for its transfer upon your death.
  
  
• Qualify for government benefits: Moving assets to an irrevocable trust may lower your income and asset thresholds enough to qualify for government benefits like Medicaid. However, it's essential to begin working on this early because Medicaid has a 5-year lookback period to prevent people from starting a trust and immediately trying to qualify for Medicaid. You'll need to show you've met the qualifying standards for at least the five years prior.

Depending on your particular situation, an irrevocable trust could have a host of financial and personal benefits. While these are common benefits, you may discover that an irrevocable trust supports even more of your end-of-life goals.

Make an Informed Decision With Professional Guidance

There are pros and cons to both irrevocable trusts and revocable ones. Irrevocable trusts offer greater tax benefits and asset protection than revocable trusts, making them a preferred option for people with large or particularly complex estates.

If you are interested in an irrevocable trust, work with an experienced estate planning attorney and trust professionals. We can ensure your trust is legally compliant and meets your specific requirements. Arden Trust Company's primary mission is to meet our clients' needs and vision. Contact us today to discuss your trust needsand make an informed decision.