Paul Tarins, RICP®,WMCP®,CSRIC™
Trusts are a vital tool used in estate planning and managing your wealth. The two most basic types are named according to the level of control the owner of the trust retains to make changes. Revocable trusts allow for flexibility and changes; irrevocable trusts do not. What are the advantages or disadvantages of each, why should you use each type and when? We make it simple.
The Basics of a Trust
Before we discuss how revocable and irrevocable trusts differ from each other, let’s try and understand the various elements in a trust.
What Is It?
A trust is a fiduciary arrangement or a legal entity that enables you to transfer the ownership of your assets to a trustee. This individual must act in the interests of the beneficiary for whom the trust has been created. They are also responsible for managing the assets in the manner you intended and ensuring your requirements are followed.
Who Are the Parties Involved a Trust?
Three parties are involved in a trust. These include a settlor, a trustee, and a beneficiary.
A settlor is an individual who created the trust. They are the original owner of the assets included in the trust. A settlor is also known as a trustor or grantor. Settlors can create a trust through an inter vivos transfer (when both grantor and beneficiary are alive) or by drafting a will.
A trustee is a person who is the legal owner of the assets transferred. There needs to be at least one trustee for managing a trust fund.
Finally, a beneficiary is an individual(s) meant to benefit from the trust.
What Are the Benefits of a Trust?
A trust offers many advantages. Some of the reasons why you can consider including a trust in your estate plan are:
- You get to specify the terms and conditions of how your assets are utilized and prevent their mismanagement.
- You can avoid probate and transfer your assets to the beneficiary more easily. Probates tend to take more time and can be more costly due to court fees and taxes. The cost of a probate is usually between 3 percent and 5 percent of the value of your estate. A trust is also more private than a probate.
- Depending on the type of trust you create, your assets may be subject to reduced or even zero estate and gift taxes.
- Establishing a trust for your children or other family members can allow you to create a source of income that helps secure their future.
- Creating a trust will enable you to transfer your assets more securely to a beneficiary currently incapable of managing them (for example, a child or disabled individual).
- Your assets remain protected from creditors and lawsuits. This is subject to the type of trust created.
What Are Revocable Trusts?
A revocable trust is a type of living trust that can be amended by the settlor during their lifetime. Living trusts are those trusts that are created while the settlor is alive.
As the settlor of a revocable trust, you can add or remove beneficiaries, transfer new assets or remove current ones, or terminate the trust altogether. You can also make changes to the terms and conditions defining how your assets are to be managed or distributed.
Revocable trusts get converted into irrevocable trusts when the settlor passes away. This trust can also be converted into separate irrevocable trusts to benefit individual beneficiaries.
What Are Irrevocable Trusts?
As the name suggests, an irrevocable trust is a type of trust that cannot be amended by the settlor once it has been created.
Revocable Vs. Irrevocable Trusts
The inability to make changes in an irrevocable trust is essentially a trade-off for the advantages this type of trust confers. Since you no longer have control of the assets and they are not in your estate, beneficial tax, creditor treatment and reduction of net worth are some of these advantages. We compare the two below:
More flexible since you retain control of your assets.
Mostly permanent, and you no longer have control of your assets with a few rare exceptions.
The assets in the trust are considered your property and are therefore accessible to creditors. They can also be subjected to a lawsuit.
The assets are not accessible to creditors and cannot be subjected to a lawsuit
The assets may still be subject to federal and state estate taxes once you pass away.
The assets will not be subject to taxes once the settlor passes away and can be used for reducing estate taxes.
You retain ownership of your assets and, therefore, may not be able to qualify for government assistance programs.
The assets no longer contribute to your net worth, and you can qualify for government assistance programs such as Medicaid if you have negligible assets and no income.
Note: While irrevocable trusts can help you qualify for government programs such as Medicaid, you should note that these programs tend to check the state of your finances during the last 5 years. If you have transferred your assets in this period, you may not qualify for the program.
When Can an Irrevocable Trust Be Amended?
An irrevocable trust can be modified in the following cases:
- A provision in the trust agreement may allow the trustee to modify its terms and conditions under specific circumstances.
- An independent third party, known as a trust protector, may be appointed by a court, the beneficiaries, or the trustee. This individual is designated with the task of reviewing whether the trust agreement can be modified.
- If the trust beneficiaries or the trustee have been granted a “power of appointment,” they can change the agreement to benefit existing or future beneficiaries.
- If the assets held within a trust are disposed of or sold, then they will no longer be subject to terms and conditions of the trust.
Wrapping It Up
Trusts are a useful way of protecting your assets against creditors and lawsuits and reducing estate taxes. They also allow you to secure your family’s future and ensure your legacy remains intact.
Paul Tarins is an investment adviser representative of and offers investment and advisory services through Portfolio Medics, a registered investment adviser. Nothing contained herein should be construed as a solicitation for investment advisory services. Sovereign Retirement Solutions and Portfolio Medics are not affiliated.