American retirees will participate in one of the greatest wealth transfers in history, with $36 trillion going to beneficiaries over the next 30 years. However, leaving a legacy isn’t a simple task. While it can be efficient and seamless, 35% of Americans have reported experiencing or knowing someone who has experienced familial conflict due to poor estate planning.
One way to avoid stress for your loved ones – and mitigate costs – is to use the right trust structure. A thorough and well-thought-out legacy plan strategically using trusts can avoid probate and offer clear instructions for your beneficiaries and executors.
However, you must know their key differences to use these structures effectively. In this article, we’ll cover the two types of trusts: revocable and irrevocable, their advantages, and when to use each one.
Key Takeaways
- Revocable and Irrevocable trusts serve different purposes. Revocable trusts offer flexibility and control during your lifetime, making them ideal for avoiding probate and managing assets if you become incapacitated. Irrevocable trusts, on the other hand, are more rigid but provide benefits like asset protection, estate tax minimization, and long-term planning.
- Trusts must align with your goals and financial situation. Choosing between revocable and irrevocable trusts depends on your specific goals - whether that’s simplifying asset transfer, reducing estate taxes, protecting assets from creditors, or qualifying for government benefits.
- Trust planning requires careful coordination between financial advisors and estate attorneys. A well-structured plan can minimize taxes, reduce legal headaches, and create a lasting legacy for multiple generations.
What Is A Trust?
Before we jump into the differences between trusts, let’s explore what a trust actually is. Simply put, a trust is a legal entity that can own assets, earn money, incur expenses, and support beneficiaries. A few examples of other legal entities would be:
- A partnership
- A Corporation
- You, as an individual
Partnerships and corporations are obvious; we all know of and have heard about these. However, individuals are also legal entities. From the perspective of the law, individuals are recognized as legal entities and can enter into contracts and start businesses as sole proprietors. Usually, the beneficiaries of the individual’s actions are himself or herself and their family.
Partnerships can do all these things, and their beneficiaries are the partners. The Partnership has a legal obligation to act in the best interest of its partners.
Similarly, a corporation has a legal obligation to act in its beneficiaries’ best interests, which are the corporation’s stockholders. If you own stock in a company – even one share – the corporation’s board of directors, executives, and managers have an obligation to make decisions that benefit the stockholders.
A trust is a legal entity with its own set of obligations. It is created by an individual known as the trustor, who appoints one or more trustees to manage the trust. The trustor also names the beneficiaries who will receive the benefits of the trust. The trustee(s) are legally required to act in the best interests of the beneficiaries when managing and making decisions about the trust.
Depending on the type of trust being created, the creator can also be the trustee and the beneficiary. It just depends on what the trust creator is trying to accomplish with the trust.
What are Revocable and Irrevocable Trusts?
Revocable Trust
A revocable trust, often referred to as a living trust, is typically created by someone who also serves as the trustee and is also one of the beneficiaries. In its most common form, a husband and wife create a living trust (they are the trustors) and name themselves as the trustees; they usually name themselves as the primary beneficiaries, with their kids listed as contingent beneficiaries.
A revocable trust can be changed or terminated during the creator’s lifetime. This type gives you more control over trust assets. Because the creators of the living trust can serve in all the roles (trustor, trustee, and beneficiary), they are most often used as a simple estate planning tool to control and distribute assets if the original owner becomes incapacitated or passes away. In addition, revocable trusts help to avoid expensive and time-consuming probate courts.
Irrevocable Trust
In contrast, an irrevocable trust cannot be changed. In most instances, the creators (known as the trustors or grantors) set up the irrevocable trust to benefit someone other than themselves and name someone other than themselves as the trustees. Most grantors use it to minimize estate taxes and protect assets from creditors. This type of trust is more complex than a revocable trust due to its permanent status and the fact that the creators don’t serve as the trustees.
It’s possible to combine the two trust types. For example, you could create a revocable living trust to help with the management of assets while you’re alive and avoid probate, and then inside the revocable trust, create an irrevocable trust that would handle specific assets for a unique set of beneficiaries. In this case, the irrevocable trust would be triggered by the death of the creators.
Key Differences Between Revocable vs Irrevocable Trusts
The primary differentiators between these trusts are purpose and flexibility. Revocable trusts usually focus on management while the creators are alive and avoiding probate. They allow grantors to make changes or cancel the document altogether.
Irrevocable trusts usually focus on estate tax reduction and management of assets after the creators have passed away. In addition, it is extremely difficult, if not almost impossible, for the creators or anyone to make changes to an irrevocable trust.
Therefore, revocable trusts are often more suitable for those with straightforward needs, and irrevocable trusts are better for more complex financial situations.
Benefits and Drawbacks of Revocable vs Irrevocable Trusts
Many clients have asked which trust type is better. But there’s no clear answer – both have advantages and disadvantages. The right trust for you will be the one that fulfills your long-term goals.
Let’s break down the pros and cons of each time.
Revocable Trusts
- Can be changed or terminated.
- Are less expensive to create and manage.
- Do not offer asset protection, as creditors can very easily pursue claims against the assets in the trust.
Irrevocable Trusts
- Offer asset protection and potentially large estate tax reductions.
- Can protect assets and reduce taxes over several generations.
- Can help the beneficiary qualify for Medicaid nursing home coverage and other means-tested government benefits.
- Cannot be changed and requires the creator/grantor to give up control over the assets in the trust, which is why this type of trust protects against taxes, lawsuits, and divorce actions.
Types of Irrevocable Trusts
Irrevocable trusts are sometimes given different names. These are related to the type of assets they will own or the purpose they serve. The top three irrevocable trusts include:
Life Insurance Trusts
These trusts hold life insurance policies. The trustee is responsible for owning and managing the policy. The grantor designates the beneficiaries when they establish the trust. The primary benefit is to keep the life insurance proceeds protected from estate taxes over multiple generations.
Charitable Trusts
Donating your assets to a favorite charity via a charitable trust is also possible. This option creates significant tax deductions without preventing your heirs from receiving trust benefits. You can further subdivide this type of trust. For example, a charitable remainder trust routes money to beneficiaries for a set amount of time before donating the rest to charity.
A charitable lead trust does the reverse – it donates funds to a charity for a set amount of time before routing income to other beneficiaries.
The primary benefit for both is reducing current capital gains taxes on highly appreciated assets the original owner wants to sell to generate cash flow.
Medicaid Planning Trusts
A Medicaid planning trust prevents your assets from being used for long-term care and helps you qualify for Medicaid care. However, it is a complex trust type and requires careful planning and legal advice. The primary benefit is to increase the amount of government aid the beneficiary can qualify for.
Generation-Skipping Trusts
These trusts are created to pass wealth to future generations while mitigating estate and generation taxes for all included generations. It is often designed around grandchildren and great-grandchildren to keep wealth in the family while minimizing tax liability in the long term. The primary benefit is the multi-generational aspect of the tax reductions.
Grantor Retained Annuity Trust (GRAT)
A GRAT allows you to gift property to heirs at a discounted value, reduce estate taxes, and retain the right to receive income for a certain amount of time. During the term of the GRAT, the original owner receives the agreed-upon income. When the term is over, the trust assets transfer to your heirs or beneficiaries. Because of this structure, assets placed in the trust are often discounted in value for IRS estate tax purposes. This is a complex concept, but the primary benefit is usually reducing estate taxes on highly appreciating assets.
Deciding Between Revocable and Irrevocable Trusts
Determining which type of trust(s) to use is complicated. Because of the differences in benefits, control over the assets, and cash flow, it is essential to get this right. Working with an experienced and 100% objective financial advisor will help you make the best decision for your specific circumstances and goals. Some of the key questions you and your financial advisor need to address to determine which trust type is best for your specific situation include:
- What is the composition of your current financial position, including the growth potential, income generation, and tax cost basis of each of your primary assets?
- What are your long-term estate planning and legacy goals?
- What level of control do you want to maintain over each of your key assets?
- What estate taxes and/or generation-skipping taxes are you likely to face?
- What level of asset protection do you want to give to your heirs?
- What retirement income will you realistically need?
- What are the tax implications of each trust type for yourself and your beneficiaries?
Ultimately, deciding which type of trust, or trusts, to use hinges on balancing tax liability, personal control of your assets, your cash flow needs, and your beneficiaries’ needs. This is sophisticated financial planning at its finest. Structuring your estate to benefit your heirs and favorite causes needs to be balanced against your needs and goals while you are alive. It requires a thorough understanding of your assets, income, expenses, cash flow, tax exposure, and lawsuit risk. It should not be done on a napkin or over a round of drinks, and the advisor you pick to help you needs to be experienced in this level of planning and committed to providing 100% objective advice.
The Bottom Line
Revocable and irrevocable trusts are useful estate planning tools, but they serve different purposes. While revocable trusts are flexible and offer control over assets, irrevocable trusts focus on tax mitigation and asset protection. As such, it’s important to consider your long-term goals and circumstances when deciding which type of trust makes sense for your estate plan.
Getting the right type of both legal and financial advice will make the difference between success and failure. Because of the interplay of legal and financial issues, we strenuously recommend a full team of advisors – an estate planning attorney and a fiduciary financial advisor. Together, they will help you achieve all your primary goals, ease your burden, and give you peace of mind.
Book a call with our fiduciary advisors today and discover how we can help you optimize your life savings and leave behind a hassle-free legacy for your loved ones.
Greg Welborn is a Principal at First Financial Consulting. He has more than 35 years’ experience in providing 100% objective advice, always focusing on the client’s best interests.
Greg Welborn is a Principal at First Financial Consulting. He has more than 35 years’ experience in providing 100% objective advice, always focusing on the client’s best interests.
