When planning your estate to transfer to heirs, you can choose between revocable and irrevocable trusts. It’s important to know the difference to understand if distributions from the trust are taxable to the beneficiary. Trusts are entities you set up to hold your assets during your lifetime and ensure they are used appropriately. Usually, the person that sets up a trust is known as a grantor.
After placing the assets in a trust, a third party (trustee) manages them. Once you pass away or become incapacitated, the trustee determines how to distribute the assets and where to invest them, following the guidelines provided when creating the trust.
Besides deciding what happens to your assets after death, trusts can also reduce your tax burdens and prevent them from going to rebate. Understanding the two types of trusts allows you to make informed decisions when planning your estate. This article discusses the differences between revocable and irrevocable trusts and when to use each option so you can make the right choice.
What is a Revocable Trust?
A revocable trust is a trust that the grantor can adjust at any time. It is the most flexible type of trust, as you can change it anytime as long as you remain competent. Adjustments you can make include transferring more assets into the trust, removing or adding beneficiaries, and even selling the trust property.
Most times, grantors are the initial trustees of the revocable trust, which enables them to use and manage the asset while alive. Note that a revocable trust becomes irrevocable after the grantor’s death. Below are some of the reasons you may use a revocable trust.
- You want to avoid the probate process and want the asset transfer to be private.
- You foresee changes in your wishes for the assets.
- After establishing the trust, you want to manage and use your assets without restriction.
- Your estate value is below the federal estate tax exemption.
What is Irrevocable Trust?
Revocable trusts are trusts that, once established, can only be adjusted with a court order or the approval of a beneficiary. You don’t have the freedom or flexibility to change its terms after execution. Since the grantor loses complete control of the assets after the transfer, irrevocable trusts are less popular.
- An irrevocable trust may be ideal for you if:
Your asset’s value is higher than the federal tax exemption. - You don’t mind giving up complete control of your assets after executing the trust.
- You want to protect your assets from creditors.
Key Differences Between a Revocable Trust and an Irrevocable Trust
Here are the major differences that set revocable trusts apart from irrevocable trusts. They can also help you answer if distributions from an irrevocable trust are taxable to the beneficiary.
1. Trust Modification
While a grantor can make changes to a revocable trust after establishing it, you cannot adjust the terms of an irrevocable trust without the trustee’s approval, beneficiaries, or a judge. A grantor can change or revoke the entire trust in the case of a revocable trust, while the terms remain the same for irrevocable trust even if a grantor changes their mind.
2. Property Ownership
In an irrevocable trust, property or assets such as land, vehicles, and even bank accounts are transferred to the trustee, who becomes the assets’ owner. The initial owner of the assets (grantor) relinquishes control over the property after moving to the trustee. On the other hand, the grantor maintains ownership and control over the assets in a revocable trust even after transferring them to the trustee.
3. Asset Protection
Since the grantor maintains ownership of assets in a revocable trust, a creditor can still reach and execute judgment against the property. As such, it does not protect your assets in case of significant liability. Properties placed in an irrevocable trust are safe from creditors as they cannot execute against the trust’s assets.
4. Federal Estate Taxes
You can use an irrevocable trust to avoid taxes on personal capital gains depending on the estate’s value. For example, if you are required to pay tax for a property valued at more than $22 million, and your estate is worth $30 million, you can avoid paying tax by transferring assets worth $8 million into an irrevocable tax. This benefit is not available for properties of a revocable trust since grantors can modify them at any time.
Taxes on distributions from an irrevocable trust can be complex. Therefore, the best way to understand the protection available on your assets is by consulting a tax professional. Contact Gurian today for a consultation on your first tax issues to ensure you make the right choice and remain compliant as you plan your estate.
