In my last two columns, I spoke about the various methods of modifying both revocable and irrevocable trusts. This series of articles provoked the obvious question from a few readers: What is the difference between a revocable trust and an irrevocable trust?
Revocable Trust
A revocable trust is the most common and basic type of trust. When you create the trust, you as the trust maker, reserve the power to change anything about the trust at any time without the need of obtaining permission from anybody.
The beneficiaries of the revocable trust have no legal right to any of the assets of the trust. You can change the beneficiaries at your whim and thus the beneficiaries merely have an “expectancy” of inheriting something from you but are not guaranteed or promised anything.
Because you have full control and because you can change anything about the trust at any time, for the most part, the trust is not considered to be a separate entity from you. All the assets in the trust are still part of your estate and you use your Social Security Number as the Tax Identification Number of the Trust. Your state and federal income taxes, your property taxes, and your estate taxes remain exactly the same as if you never created the revocable trust in the first place. The trust serves as merely a “pass through.”
If everything is the same, why create a revocable trust in the first place? The reason is to create a contingency plan in case you become incapacitated or pass away. Your trust will name a successor trustee and give that person instructions on how to pay your bills, manage your property, and distribute your assets to your beneficiaries. This is the essence of estate planning and in the vast majority of situations, the revocable trust is the most efficient way to ensure that your wishes are carried out smoothly and with the least expense possible upon your incapacity or death.
Irrevocable Trust
An irrevocable trust is a trust that cannot be changed easily by the trust maker once it is completed. As I mentioned in a previous article, you still might be able to change your irrevocable trust, but you need to often obtain permission from the beneficiaries, the Court, or both.
The beneficiaries have an enforceable right to the trust assets, rather than merely an “expectancy” as with revocable trusts. The trustee must take special care as to consider not only the current beneficiaries of the trust but also the remainder beneficiaries: sometimes this can be a very tricky balance.
An irrevocable trust is considered a separate entity from you as an individual. Often, you will need to obtain a new Tax Identification Number for the trust. Transfers of assets into the trust will often be considered taxable gifts and such assets will generally be removed from your estate. The irrevocable trust can be drafted in such a way as to place income tax liability on the trust itself, requiring the trust to file its own tax return, or can be drafted in such a way to keep the tax burden on you as the trust maker.
Reasons for creating irrevocable trusts include tax and gift planning, planning with life insurance, ensuring that assets in the trust are used to carry out a specific purpose such as caring for a pet or providing a person with a legal defense fund, planning for minor children, and – in some circumstances – providing asset protection to the beneficiaries.