The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation. This month, we’re focusing on differentiating between two estate planning terms: the revocable trust versus the irrevocable trust.
We’ve taken a deep dive into estate planning before, and as a quick recap: Estate planning is a comprehensive term that covers all of the planning components that involve how an individual’s assets, along with any financial obligations and debts, will be managed, distributed, and preserved after his or her passing or if he or she becomes incapacitated. Examples of tasks associated with devising an estate plan include making a will, electing beneficiaries and naming an executor, setting up trusts, and making tax-efficient charitable donations. To ensure no technicalities are overlooked, most estate plans are created and established with the help of an estate attorney.
First Off, What Is a Trust?
A trust involves a relationship in which one party, known as the trustor, provides another party, known as the trustee, with the right to hold title to specified assets for the benefit of a third party, known as the beneficiary. In other words, a trust is a legal vehicle that enables a third party – the trustee – to hold and direct assets in a fund, known as a trust fund, for a beneficiary. A trust significantly expands your options in terms of managing your assets, and this vehicle is leveraged to provide legal protection for the trustor’s assets to ensure those assets are appropriately distributed according to the trustor’s stated and legally documented wishes.
Trusts are also used to reduce or avoid inheritance and estate taxes in certain situations, especially if you do plan to pass your wealth on to your children and other loved ones. Because of this, trusts are at the crux of many estate plans, the latter also being a misinterpreted term thought to only be for the one-percent population; however, know that if you have any assets that will be passed on after you are no longer here, you need an estate plan, and most everyone falls under this category. Put simply, a trust is a beneficial estate planning tool for families and individuals of a variety of economic backgrounds to leverage.
A grantor sometimes referred to as the trustor, is an individual or entity that creates a trust. The grantor is therefore the one whose assets are put into the trust for the benefit of a beneficiary or beneficiaries. A trustee is a person or entity that holds the legal title of an asset or assets for the benefit of a third party known as the beneficiary, which can be an individual, multiple people, or an entity. One of the primary reasons for creating a trust is to ensure the grantor’s assets are distributed properly, and the trustee is tasked with ensuring the trustor’s wishes are fulfilled and upholding the fiduciary responsibility of making decisions that are in the beneficiary’s best interest. A trustee is given this legal title via a trust, and depending on the type of trust created, the grantor can appoint himself/herself as the initial trustee while he/she is alive. Will dive more into that below.
Revocable Trust
A revocable trust, also known as a living trust, is the most flexible type of trust you can create, as it allows you to change or revoke the trust at any point throughout your lifetime as long as you are competent to make such changes – hence these trusts commonly being referred to as living trusts. A few examples of such changes include designating new and/or removing beneficiaries, transferring additional assets into your trust, selling a property that is included in the trust, or modifying the stipulations for how assets are to be managed within the trust. With revocable trusts, many trustors name himself/herself as the initial trustee of the revocable trust so that he/she is able to use and control the assets in the trust while he/she is alive. In such a scenario, the trustor names a successor trustee to manage the trust if he/she becomes incapacitated and unable to manage the trust and/or if he/she passes. Once the trustor of a revocable trust passes, the revocable trust becomes irrevocable, meaning it generally no longer be changed or revoked. When this happens, the successor trustee will assume his/her role and distribute the trust’s assets according to the trustor’s instructions and wishes.
As alluded to, one of the main benefits of a revocable trust is the flexibility it offers; however, you “pay” for the flexibility. One of the drawbacks of this type of trust is that the assets are considered part of the trustor’s taxable estate, meaning the assets within the trust are subject to estate taxes when the trustor passes. Additionally, assets within a revocable trust are not immune from any lawsuits or creditor claims against the trustor, which means that any outstanding legal settlements and debts owed when the trustor passes can be paid from the trust, depending on the circumstance. Only after these outstanding liabilities are the remaining assets of the trust properly distributed to the beneficiaries.
Irrevocable Trust
An irrevocable trust is fundamentally set in stone the second the trust paperwork is signed. This type of trust can only be changed under rare exceptions, and such changes require court involvement and/or beneficiary approval via a signed legal agreement. An irrevocable trust is similar to a revocable trust in that you transfer assets to the trust in the same way; however, with an irrevocable trust, once your assets belong to the trust, the trustor does not have the freedom to make changes to the assets like he/she has the ability to do in a revocable trust. If the trustor wishes to make changes to an irrevocable trust, he/she generally needs to have the trustee and the beneficiaries sign off on an agreement stating the changes or needs to obtain a judge’s approval for the changes.
Because of their inflexibility and the loss of the trustor’s control, once the trust is established, irrevocable trusts tend to be less commonly used in estate planning than revocable trusts. That being said, this type of trust can be more beneficial for wealthy individuals who want to minimize estate taxes and protect the trust’s assets from creditor claims, as irrevocable trusts offer tax-shelter benefits that revocable trusts do not. When you move assets into an irrevocable trust, the assets are typically no longer part of the trustor’s taxable estate, which means the assets will not be subject to estate taxes when the trustor passes. In other words, taxes are the primary reason a trustor would elect to have an irrevocable trust. In addition to the assets in an irrevocable trust being removed from the trustor’s taxable estate, the assets within the trust are also free of taxes on any income generated by the assets within the estate. Due to the finite nature of these trusts, irrevocable trusts can be challenging to set up and require the guidance of a qualified estate attorney.
Revocable vs. Irrevocable
As detailed above, there are key differences between a revocable and irrevocable trust to be aware of. Beyond the simple contrast of the easily altered nature of a revocable trust and the finality of an irrevocable trust, a revocable trust allows the trustor to be the trustee, while this ability is not allowed with an irrevocable trust. Additionally, privacy is protected when a revocable trust is created, and when the trustor passes, the information and contents of the trust are kept within the family and beneficiaries, whereas with an irrevocable trust, trust documentation may be accessed by other parties if the estate goes through a probate court or other legal processes. For this reason, revocable trusts can be especially beneficial in certain states that have notoriously long and expensive probate processes.
Overall, given the flexibility of a revocable or living trust, it seems like many people would elect a revocable over an irrevocable trust. However, although an irrevocable trust is more rigid than its revocable counterpart, an irrevocable trust can protect the trust’s assets from creditors and estate taxes, while a revocable trust cannot, and this protective benefit of an irrevocable trust alone can justify sacrificing flexibility.
Which Trust Should You Choose?
Unsurprisingly, the best type of trust for you will immensely depend on your unique financial situation and your intentions for the use of the trust. Revocable trusts tend to be more commonly leveraged due to their flexibility and because most Americans’ estates will not be subject to estate taxes. In 2022, the federal estate tax exemption – the amount below which your estate is not subject to taxes upon your passing – is $12.06 million for individuals and $24.12 million for married couples, and this threshold is adjusted annually for inflation.
Taking these points into consideration, you may want to opt for a revocable trust if:
On the contrary, you may feel an irrevocable trust best suits your needs if:
Final Points
Estate planning and navigating the nuances and decisions behind the creation of a trust can be a complicated and challenging endeavor. It is prudent to consult your financial advisor and a local estate attorney to determine the optimal planning strategies for you and your financial life.