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Summary: How can you guarantee a transfer of wealth to your heirs?  An irrevocable trust can allow you to pass on assets in a way where they remain free from other risks to your estate.

Irrevocable Trust Definition

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The irrevocable trust is an estate planning tool that is frequently misunderstood and often associated only with the ultra-rich.  You may not know that this tool can apply to a variety of different scenarios and estates.

While those of great wealth can use this form of trust to their advantage, so can those of lesser means.  If you have dependents who may require your resources beyond your lifespan, such a trust can help guarantee their future.

In this article, we will not only explain what an irrevocable trust is, but we will also describe the various scenarios in which they are of significant value. 

By the time you get to the last paragraph, you will likely see how such a trust could play a role in planning your estate.

What is an Irrevocable Trust?

First, let's talk about trusts.

A trust is a legal tool that allows you to transfer your ownership of assets to a third party to benefit one or more named beneficiaries.  It is a fiduciary relationship where the trustee holds the assets for the beneficiaries' well-being, following your wishes and instructions.

An irrevocable trust is a type of trust where you cannot change the conditions and terms without the beneficiaries' expressed consent.  This type of trust removes all incidents of ownership from the assets and protects them from creditors and lawsuits.

A revocable trust differs from an irrevocable trust in that you can modify the revocable trust's terms throughout your lifetime.  However, a revocable trust does not offer the same protection for the assets from your creditors or anyone trying to sue you.

How Does an Irrevocable Trust Work?

The most significant benefit of an irrevocable trust is its potentially scariest aspect: loss of control and ownership.  Once you have set out the trust's conditions, you no longer have any claim to those assets.

If there are parts of your taxable estate that you wish to endow without fear of future penalty from tax, creditors, and lawsuits, an irrevocable trust can provide you with peace of mind.  This agreement keeps these items safe per your wishes.

An excellent way to explain an irrevocable trust is using an example of a property sale.  If you sell a piece of property during your life, and then after the sale, you are sued, the new owner of the property is generally safe from the lawsuit that is targeting you.

Proceeds from this property sale (i.e., cash in your bank account) are not safe, but the property under new ownership is.  In an irrevocable trust, you have basically sold, without personal remuneration, - your asset to the trust, which is now outside your control.

Types of Irrevocable Trusts

There are several types of irrevocable trusts.  Each of these types exists for specific purposes, so that we will discuss several common types below.

Testamentary Trust

You have the option of creating a trust after you die by setting out the conditions in your will, which is a testamentary trust. You establish this type of trust after you pass away, so it is irrevocable by definition (because the creator is no longer around to modify it).

Irrevocable Life Insurance Trust (ILIT)

An ILIT can allow you to keep your life insurance proceedings separate from your estate, and therefore free from erosion from estate taxes.  This estate planning strategy can give you greater certainty in the amounts you are leaving the trust's beneficiaries.

Living Trust

A living trust is any trust you establish during your lifetime.  Living trusts can be revocable or irrevocable. It is essential to understand this term. Interchangeably using the words revocable and living is incorrect when describing different trust types.

Grantor-Retained Annuity Trust (GRAT)

A GRAT is a type of irrevocable trust where you receive payments for a fixed term from the trust assets.  Under this arrangement, you can benefit from some of the trust's value and know that your beneficiaries' asset value remains under your conditions.

Charitable Remainder Trust

A charitable remainder trust allows for lowering your taxable income by placing some of your wealth into the trust, having it dispensed to your beneficiaries, and then having the remainder given to a charity.  This trust can provide partial tax relief for the grantor.

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Pros & Cons

Here are some simple pros and cons for irrevocable trusts that can help you decide where such an entity may fit in your life.

Pros

  • Your assets signed over to the trust can remain out-of-grasp from your creditors, potential lawsuits, and taxation.
  • You reduce your estate's value and can potentially reduce the amount of estate tax owing upon your death.
  • You can provide specific conditions for how beneficiaries will receive the wealth in the trust.
  • For those of more modest means, you can use an irrevocable trust to reduce your wealth to the point where you can take advantage of government-provided services for your long-term care.

Cons

  • You relinquish all control over the assets in the trust.
  • You lose the ability to modify your terms after you create the trust.

FAQ's

Now, let's answer some common questions about irrevocable trusts.

What is the downside of an irrevocable trust?

The biggest downside to an irrevocable trust is that, generally, you cannot change the terms of the agreement.  Once signed, you have lost all control over the asset and hope the conditions you outlined in the trust will be appropriate for the rest of your life.

Who pays taxes on an irrevocable trust?

When it comes to taxation, irrevocable trusts can provide you with tax benefits.  Tax relief is a distinct advantage over a revocable trust because an irrevocable trust creates a new, separate legal entity that is at arm's length from you.

For example, appreciating assets in an irrevocable trust can create income tax payment requirements.  If set up as a grantor trust, the grantor can pay the trust's taxes.  A grantor trust offers the benefit of the taxes not eating away at the amount in the trust.

Depending on the trust's setup, the taxation of irrevocable trusts can take different forms.  Trust establishment should involve consultation from professionals such as accountants and attorneys for tax implications.

Can a trustee take money from an irrevocable trust?

Yes, a trustee can take money from an irrevocable trust, but only under the right conditions set out by the grantor.  For example, you can allow the trustee to remove funds from the trust to cover the trust's maintenance costs.

How can an irrevocable trust be changed?

Irrevocable trusts are difficult to change by their nature.  However, there are some ways in which some can modify them. Individual states have different rules, so you must consult local legislation.

A common method of changing an irrevocable trust is to decant the trust.  Essentially, the trustee can, under certain circumstances and with the beneficiaries' permission, alter the trust agreement by creating a new trust.
How are irrevocable trusts taxed?

Irrevocable trusts are individual legal entities, and the Internal Revenue Service requires that these trusts file federal income tax returns.  

Depending on the structure, rules vary, and you should seek professional advice depending on the assets assigned to the trust. If the irrevocable trust owns assets that will generate income, then there will be tax implications for the trust.

When is an Irrevocable Trust a Good Idea?

Irrevocable trusts provide a high level of certainty when you are planning your estate.  While they are complex, you can use these trusts for many different scenarios.

Asset Protection

Suppose you want to ensure that certain assets will be available to your heirs regardless of what sort of legal and financial troubles you may have in the future. In that case, an irrevocable trust can provide this level of protection. 

The trust keeps your assets away from your creditors.

Tax Reduction

An irrevocable trust can help reduce your estate's value because whatever is put in the trust no longer belongs to you.  In a sense, you can pre-gift parts of your estate while knowing that the terms you created will handle the value in the trust.

Security for Dependents

If you have dependents who will require future assistance when you will not be around to provide it, irrevocable trusts allow you to set resources aside for them now. 

Advantageous over a will, the trust will protect its assets separately from your estate.

What's Next?

Irrevocable trusts take many different forms and may be of value to you.  While they can have significant advantages for the very wealthy, those with smaller estates can still take advantage of the security they provide.

A key point to remember is these trusts require you to give up control and ownership over whatever you place in them, but that this arrangement keeps them safe from your creditors.  If someone may sue you, setting one up now can offer your beneficiaries future protection.

We encourage you to do further research by looking deeper into the specific types of irrevocable trusts we described above and clicking the links embedded in this article for additional reading. 

The world of trusts can offer you tremendous power in planning your estate.

Finally, we want to see you happy, in control of your wealth, and able to provide for your heirs as best as you can.  By learning more about how irrevocable trusts work and how they can apply to you, you will prepare yourself for life's uncertainties.

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