The world of estate planning has many roads, all of which lead people down different paths of protecting their assets and property in the interest of passing these things on to loved ones. From wills to trusts and beyond and the many variations of each, there are several vehicles a person can use to accomplish this. Each has its own methods, its own rules, and its own benefits for both the assets involved as well as the people involved.
This is why understanding key differences between documents like revocable (living) trusts and irrevocable trusts can be pivotal in effective estate planning.
- What is a trust?
- What is a revocable trust?
- What is an irrevocable trust?
- How are revocable and irrevocable trusts taxed?
- Key features
First off, it’s important to know the basic components and functions of a trust. A trust is most simply a legal arrangement that designates a party (the trustee) to maintain and secure assets for the benefit of an intended beneficiary.
There are four components of a trust: the settlor (also known as the grantor or trustor) is the person establishing the trust and whose assets make up the estate, the beneficiary is the person whom the assets will be given to, the trustee is the person assigned to manage the trust, and the property itself.
While trusts may sound similar in some ways to a will, a trust differs in the protections it offers, like avoiding many of the delays and even expenses of probate, which can cost 10% to 15% of an estate value.1
As mentioned, there are several types of trusts, most notably irrevocable trusts and revocable living trusts.
A revocable trust is a trust that can be amended at any time or even revoked by the settlor. Anyone deemed a competent adult can establish a revocable living trust, and they can name any competent adult as their trustee. Banks or trust companies are often chosen as trustees, but the grantor themself can also act as the trustee.2
A key function of a revocable trust is that even though the grantor places their assets into the trust, they still maintain control of those assets and may still receive any income earned by the principal assets. So the most pivotal component of a revocable trust is that the grantor always maintains some kind of control of its assets.
As its name would imply, an irrevocable trust is one that can’t be amended as a revocable trust can. Once it is created, its terms are set in stone..or at least they’re much tougher to modify. A process known as Trust Reformations can be applied to make changes within an irrevocable trust under certain circumstances.3
Still, the purpose of an irrevocable trust’s permanence is that it affords greater protections for the assets involved, and it separates the relationship between those assets and the grantor. The trust itself can create what’s referred to as shelter, which can exempt assets from the grantor’s or beneficiary’s legal problems, it can protect assets from creditors, or inclusion in divorce settlements when applicable.4 The protections afforded to assets in an irrevocable trust are typically what make them most appealing in estate planning, granted the settlor can relinquish full control (and ownership) of the assets from the time they’ve created their trust.
Since the assets within a trust are afforded certain protections or freedoms based on which type of trust they are placed into, they are also subject to being taxed differently. Oftentimes, this can play a major role in a settlor choosing between creating a revocable trust or an irrevocable trust.
As mentioned before, a grantor maintains control over the assets within their revocable trust even though giving those assets over to the trust technically relinquishes ownership of them. A key benefit afforded to the grantor of this trust is that they may still access any income generated from the assets within the trust, which is also why all items of income, deduction, and credit will be reported on their tax return.5
In contrast to revocable trusts, where the grantor assumes responsibility for income taxes, irrevocable trust must obtain their own tax ID numbers and file their own returns in order to report the income made from them.6 The trust becomes its own tax-paying entity in this case. This also means assets or property within an irrevocable trust aren’t subject to estate taxes.
|Revocable Trusts||Irrevocable Trusts|
|Who pays taxes?||The grantor of a revocable trust will pay taxes on the trust income.||Irrevocable trusts are treated as their own table entity but trust beneficiaries pay taxes on distributed income and the trust itself will pay taxes on any undistributed income.|
|Are assets protected from creditors?||No. Maintaining ownership of assets and property leaves them available to creditors.||Yes.|
|Can terms be changed?||Yes, only by the grantor.||Terms are meant to be set in stone, although Trust Reformations can amend or revoke terms of a trust in extreme circumstances.|
|Who maintains control of the assets?||A grantor will maintain control of the assets in a revocable trust.||The trust itself maintains control of its assets once they have been added.|
Video: Trust Differences