When most people think about trusts, they’re usually thinking about simple revocable living trusts—the kind that let you control and retain both legal and beneficial ownership of the assets in the trust during your lifetime and then once you die, the assets avoid court-supervised probate.
But what if your situation is more complex? Perhaps you have a family member who needs to qualify for government disability payments the rest of his/her life. Or you work in a profession where you could get sued and creditors could go after your house? Maybe you want to avoid not just probate when you die but getting hit with estate taxes?
For those kinds of specialized purposes, you should consider an irrevocable trust, says Ellen Cookman, JD, LLM, certified specialist in estate planning, trust administration and probate.
WHAT IS AN IRREVOCABLE TRUST?
An irrevocable trust works similarly to a revocable trust. It is a legal entity that holds assets such as real estate, cash, investments, life insurance and valuable personal belongings including jewelry and vehicles. You transfer over the title of these assets to the trust and stipulate what should happen to that property at a triggering event, such as when you die, along with detailed instructions about how and when your beneficiaries receive the assets.
An irrevocable trust also avoids probate so your estate can be distributed quickly and efficiently to your heirs.
Distinguishing features of an irrevocable trust: You must permanently relinquish all control of the assets—you no longer own them…the trust does. What’s more, you can’t amend or revoke the trust in any way. And for some irrevocable trusts, they function properly only if you don’t serve as trustee of the trust.
While all of this sounds punitive, giving up control actually provides legal and tax benefits that can be very useful in certain circumstances and make up for the glaring shortcomings of using a revocable trust.
Important: There are two types of irrevocable trusts. A standalone irrevocable trust goes into effect during your lifetime. If you don’t need a trust while you are alive, you can instead create a testamentary irrevocable trust, which is established after your death, according to instructions in your revocable trust or your will.
ADVANTAGES OF AN IRREVOCABLE TRUST
Assets in an irrevocable trust can avoid estate taxes. The IRS no longer considers it part of your taxable estate. It has its own tax ID number, and a tax return for the trust is filed each year. Very few families will have to worry about paying federal estate taxes in the coming year because the exemption per individual is rising to $15 million. But many states have their own estate tax for which exemption thresholds are much lower. Examples: In Oregon, you pay estate tax on any amount over $1 million per individual. In Massachusetts, it’s $2 million. Most state estate tax is calculated on a graduated scale, with marginal rates ranging anywhere from 0.8% to 16%.
An irrevocable trust provides creditor protection. Unlike revocable trusts, irrevocable trust assets can be sheltered from legal judgments and lawsuits against you or your estate. For people who frequently face lawsuits such as surgeons, attorneys and real estate developers, these protections can be essential. Important: Most states require that assets be owned by the trust for one or two years before they are safe from creditors.
You maintain eligibility for government benefits. Federal and state programs for special-needs and disabled individuals often have very stringent income and asset limitations that are near poverty levels. If a disabled person or someone with special needs receives too much money, he/she can lose his government payments. Assets in a properly drafted irrevocable trust such as a special needs trust are not included in these calculations, so someone with special needs can avoid spending down all his assets to qualify for benefits and preserve those assets for his beneficiaries.
DISADVANTAGES OF AN IRREVOCABLE TRUST
Inflexibility. Once assets are transferred to an irrevocable trust, it’s permanent. That can be a problem if your family dynamics change over time or if you transfer a house to a trust, then fall on hard times and need cash. Your trustee has a legal responsibility to follow the instructions of the trust. Note: In some circumstances, if all the beneficiaries agree to proposed changes to an irrevocable trust, you can petition the court and modify the trust through a judicial settlement agreement—but that can be a very expensive process.
Complicated taxes. Irrevocable trusts often face higher income taxes than revocable trusts if income earned by the trust is not distributed to beneficiaries. Also, if you don’t plan carefully, assets in an irrevocable trust, such as a house, generally don’t get a step up in basis. What that means: If your beneficiaries eventually inherit and sell the house, their capital-gains taxes could be based on the original purchase price of the house, not its stepped-up value when they inherited it.
Higher fees. An estate-planning attorney may charge you $3,000 to $10,000 to set up an irrevocable trust due to specialized tax-planning and complex administrative requirements. A revocable trust, which can be simpler to set up, especially if you serve as your own trustee, may cost $7,000.
FIVE COMMON IRREVOCABLE TRUSTS
There are dozens of different kinds of irrevocable trusts, often identified by common acronyms. Examples…
Irrevocable Life Insurance Trust (ILIT). You establish a life insurance policy and designate the trust as the owner of that insurance policy. By making regular gifts of money to the trust, the trust can pay the life insurance premiums. When you die, the death benefits from the policy remain outside of your taxable estate and the insurance proceeds are protected from creditors. Caveats…
•If you transfer a life insurance policy in the trust and then pass away within the next three years, any proceeds are returned to your estate and become taxable.
•An ILIT can own both individual and second-to-die life insurance policies, which pay a death benefit only upon the second death.
•An ILIT can allow the trustee to access the accumulated cash value of a life insurance policy by taking loans and/or distributions on a cost basis, even while the insured is alive.
Medicaid Asset Protection Trust (MAPT). If you lack long-term-care insurance and worry about having to enter a nursing home in advanced old age, you can use this trust to remove valuable assets such as your house and investments from your estate. That can lower your income and net worth enough to qualify for Medicaid. In the meantime, you can keep the exclusive right to use and live in your home and continue to receive all the tax exemptions on it. Caveat: Medicaid requires that assets be moved to an MAPT at least five years before you apply.
Special Needs Trust (SNT). If you have a child or family member with a disability, this trust allows you to help him/her financially without compromising his eligibility for Supplemental Security Income (SSI) and Medicaid benefits. Assets in the trust can broadly be used to pay for items not covered by government benefits. These range from housing if the trust is drafted properly, food, clothing and education to an automobile, caregivers, and entertainment and travel. Caveat: The trust can be funded by gifts from anyone including yourself, family and friends—but not the beneficiary.
Charitable Remainder Trust (CRT). A CRT allows you to leave some or all of your estate to one or more charitable organizations. While you are alive, you can continue to receive income from the trust. When you die, the remainder of the trust goes to the charities. Caveats…
•You can get an upfront income tax deduction for adding assets to the trust.
•Also, since the assets in a charitable trust can be invested, there is the potential for them to grow over time and you avoid capital-gains tax on the sale of any appreciated assets within the trust.
Qualified Personal Residence Trust (QPRT). You can transfer your primary or vacation home to a QPRT, removing it from your taxable estate. You may continue to live in the home rent-free for a specified number of years. At the end of that term, the house is transferred to your beneficiaries. Caveats…
•QPRTs cannot hold commercial property or rental property.
•You can continue to claim income tax deductions for mortgage interest and property taxes paid on the residence even if it is in the QPRT.
•If you die before the end of the trust’s specified term, the property reverts to your estate and is included in your taxable estate.
•After the term expires, you can continue to live in the home only if the beneficiaries agree and if you pay them a fair-market rent.
