Trusts have many purposes, including avoiding probate, reducing estate taxation, or protecting assets from creditor risk. The type of trust and the terms of trust depend on the priority of various planning goals.
When it comes to estate planning, trusts can be a powerful tool for protecting your assets and ensuring that your wishes are carried out after you pass away. In terms of asset protection, a revocable trust is only rarely used as part of an asset protection plan, while irrevocable trusts are useful in several protection contexts.
What Is a Revocable Trust?
A revocable trust, also known as a living trust, is a legal contract that allows you to transfer your assets to a trustee for the benefit of named beneficiaries. Most often, the trustmaker is the beneficiary during their lifetime. After the trustmaker dies, other people become the beneficiaries, often spouses or children.
One of the key benefits of a revocable trust is that you retain control over the assets in the trust during your lifetime. You can make changes to the trust at any time, including adding or removing assets, changing beneficiaries, or even revoking the trust entirely. Additionally, because the assets are held in the trust, the revocable trust allows you to avoid probate, which otherwise could be time-consuming and expensive.
Revocable trusts do not help with asset protection. During the trustmaker’s lifetime, the trustmaker still enjoys full control and use over the revocable trust assets. As a result, the trust assets are freely available to a trustmaker’s creditors.
What Is an Irrevocable Trust?
An irrevocable trust, on the other hand, is a legal contract in which you transfer ownership of your assets to a trustee, while giving up the right to control and benefit from those assets. With few exceptions, once the irrevocable trust is established, its terms cannot be changed.
Unlike a revocable trust, an irrevocable trust can provide significant asset protection. Because you no longer control the assets in the trust, the assets are shielded from judgment creditors and other potential threats. Furthermore, because the assets are no longer considered part of your estate, they may be exempt from estate taxes.
In some states, such as Florida, you cannot be both the grantor and the beneficiary of an irrevocable trust. That kind of setup constitutes a self-settled trust, which is against public policy. A self-settled trust does not provide any asset protection.
Revocable vs Irrevocable Trust
Trusts are initially distinguished by whether they are revocable or irrevocable. A revocable trust conveys assets to a trust expressed by a written trust agreement that expressly reserves the trustmaker’s right to revoke the trust entirely or amend any part of the trust agreement for any reason during the trustmaker’s lifetime. Most estate planning trusts that direct the disposition of the trustmaker’s property upon death are revocable trusts. These estate planning trusts are called “living trusts” because the trustmaker retains complete control benefits of the trust while he is living.
An irrevocable trust is a trust whose trust agreement prohibits revocation or amendment. Transfers to irrevocable trusts are final conveyances, with some small exceptions. A trustmaker cannot change his mind about transfers he makes to an irrevocable trust.
Some trusts are designed to be irrevocable from the beginning; others start out revocable and later become irrevocable. An example of a trust that starts out irrevocable is a trust set up to make gifts to the trustmaker’s children during the trustmaker’s lifetime. Assets transferred to an irrevocable children’s trust are the children’s property. The trustee, as a fiduciary, must use the principal assets and trust income for the children’s benefit and not for the direct benefit of the trustmaker. Of course, using the trust money for the children’s education, for example, usually indirectly benefits the trustmaker.
Another example of a lifetime irrevocable trust in Florida is an “insurance trust.” There are tax benefits and asset protection benefits of owning life insurance in the name of an irrevocable trust. The death benefit of life insurance (the amount paid to family members upon the insured’s death) is part of the insured’s taxable estate, except when the life insurance is owned by an irrevocable trust. Death benefits paid to family members are vulnerable to their creditors upon receipt, but the death benefits are creditor-protected if the money is held inside a properly drafted irrevocable insurance trust.
In summary, here are the key differences between revocable and irrevocable trusts:
- Control. One of the primary differences between revocable and irrevocable trusts is the level of control you retain over the assets in the trust. With a revocable trust, you can make changes to the trust at any time, while with an irrevocable trust, you give up control over the assets permanently.
- Asset Protection. Irrevocable trusts can provide significant asset protection, while revocable trusts do not. Because you retain control over the assets in a revocable trust, they may still be subject to creditors or lawsuits.
- Avoiding Probate. Both revocable and irrevocable trusts can help you avoid probate, which can be a time-consuming and expensive process. However, revocable trusts offer greater flexibility in avoiding probate, as you can make changes to the trust if necessary.
- Taxes. With a revocable trust, you will still be responsible for paying income taxes on any earnings generated by the assets in the trust. With an irrevocable trust, you can choose how you want trust income to be taxed. The trust can be set up such that either trustmaker or the trust pays taxes on the trust income.
When Does a Revocable Trust Become Irrevocable?
A revocable trust becomes irrevocable upon the death of all trustmakers. The trust is “locked” at death, and the trustmaker’s heirs (the future trust beneficiaries) cannot change the terms of such inherited trust, with very few exceptions. The trustmaker’s written notes, memorandum given to family members, or oral instructions given to family members during his lifetime will not change the revocable trust’s estate plan once it becomes irrevocable.
How to Close a Revocable Trust After Death
A revocable living contains written instructions for how the trustmaker desires to distribute his assets after death. The process of transferring assets, paying debts, and following the trustmaker’s instructions is referred to as “trust administration.” Trust administration is directed by the persons the trustmaker nominated to serve as his successor trustee.
Trust administration involves several tasks. For example, the family first must make sure it understands the trustmaker’s written instructions expressed in his trust agreement, and any disagreements regarding the trust instructions must be resolved. The successor trustee must find out if the trustmaker owed money or was subject to any legal claims. The successor trustee must use non-exempt trust assets to satisfy debts and settle claims. The trustmaker’s income tax liability for the year of death must be determined and paid. The successor trustee also must determine if the trustmaker’s taxable estate is subject to estate taxation.
Only after trust administration is substantially completed may the successor trustee distribute trust assets to the trustmaker’s heirs according to the trustmaker’s written instructions. After assets are distributed and administration is complete, the successor trustee can close the trust. Successor trustees should get a written agreement among all beneficiaries that trust administration has successfully completed so that the living trust and all of its trust accounts may be closed.
Sign up for the latest articles.
Get regular updates from our blog, where we discuss asset protection techniques and answer common questions.