Understanding the Differences Between a Revocable Trust and an Irrevocable Trust

Declaration of Trust document image

Trusts can be useful tools to pass assets to the next generation, protect your assets, save on estate taxes, or set aside money for a family member with special needs. The question I hear most often regarding trusts is “What is the difference between a Revocable Living Trust and an Irrevocable Trust.”  Although both are trusts, there are a variety of differences (and many different types of trusts within each category) and every estate plan is different. 

While the two main types of trusts differ in how they are structured and taxed, both types of trusts are tools for setting aside assets and distributing them according to specific wishes and instructions. They can protect one’s property, safeguard a family’s financial future, and provide tax-saving strategies.

Structure
As the name suggests, an irrevocable trust, once established, can’t be canceled or revoked. The person creating the trust, sometimes called the “grantor,” transfers assets into the trust and permanently gives up all claim to them. A trustee is appointed to carry out the instructions spelled out in the trust.

In contrast, a (revocable) living trust offers more flexibility. The grantor of a living trust still owns and controls the assets and can make changes at any time. Successor Trustees will take over the management of the trust if the owner is no longer capable of doing so.

Taxes
Both types of trusts offer tax advantages, although these differ in key ways. An irrevocable trust is considered a separate entity and must have its own tax returns filed annually under its tax ID number. Irrevocable trusts can incur additional costs if a CPA is needed for tax preparation. Because it is a trust and not an individual, the irrevocable trust can’t qualify for the various deductions and exemptions that individuals can claim on their returns.

Assets within a living trust are still considered the property of the trust owner. Any income earned from this trust is filed along with the owner’s other income. Also, the assets of the trust belong to the owner’s estate and are taxed accordingly on the owner’s death. For this reason, wealthy families may choose to transfer a portion of their assets into an irrevocable trust to keep the value of their estate below federal and state exemptions.

Protecting Assets in the Future
One key advantage of irrevocable trusts is that their assets are protected from lawsuits and creditors. A living trust offers no such protection, because the trust assets are still part of the owner’s property. 

A living trust is an option for someone who doesn’t need all the layers of protection but still wants to set up some provisions for the future.  A living trust works well to set aside assets in the event that the grantor becomes unable to manage his or her finances in the future, due to illness or old age. With a living trust, the grantor controls the property while he or she is competent, but a trustee can take over this function if the grantor loses this capacity.

Keep in mind that this is general advice only and that specific situations may be treated differently. Contact me to discuss how your specific situation will be handled using different types of trusts.

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