The term “trust” brings to mind images of significant wealth and silver spoons. In fact, a trust is nothing more than a legal entity set up to hold property on behalf of others; its management is overseen by a trustee. You can set up a trust to hold $10 or $10 million in assets – the rules are the same. But some trusts, like irrevocable ones, are more ironclad and complex than others.
Living Trusts vs. Testamentary Trusts
All trusts fall into one of two categories -- either living trusts or testamentary trusts. A living trust – sometimes called an inter vivos trust -- is set up while you’re alive. A testamentary trust only comes into existence after your death. The executor of your estate typically forms the testamentary trust and moves the assets you’ve designated in your will into the trust.
Your directions for a testamentary trust, documented in your will, are changeable at any time during your life. This mimics a revocable trust. However, the actual testamentary trust, once set up after your death, becomes irrevocable.
There’s No Turning Back
A major distinction between living trusts is whether they’re revocable or irrevocable. When you form a revocable trust to hold your property, you can act as trustee. You can take property back from the trust, change the beneficiaries or close the trust down entirely. When you form an irrevocable trust, you give up all these rights. You must appoint someone else as trustee to manage the assets. When you move them into an irrevocable trust, you surrender ownership forever. The only way your trust’s terms might be changed is if the trustee you appointed and all your beneficiaries agree, and even then, they may need court approval.
Why Would Anyone Want Such a Trust?
Your irrevocable trust will presumably earn income after you create it. Bank accounts placed into the trust will earn interest, and stocks, bonds and other investments will hopefully grow in value and appreciate over the years. If you form a revocable trust, all this income is taxable to you because, technically, you still own these assets. If you surrender them to an irrevocable trust, they can grow for your beneficiaries and you won’t be taxed on the gain.
There are also estate tax implications when you form an irrevocable trust. As of 2015, the federal estate tax doesn’t kick in unless an estate’s value is $5.43 million or more and this is indexed for inflation – the exemption increases periodically. Only the value of an estate over this amount is subject to estate tax. If your estate is sizable, you can move assets into an irrevocable trust to bring its value down below this threshold. No estate tax comes due on these assets because the trust now owns them and the trust didn’t die.
Types of Irrevocable Living Trusts
There are as many different types of irrevocable trusts as there are reasons to make them – literally dozens, according to the legal website Nolo. Most can also be revocable or testamentary, but some must be irrevocable:
- Charitable trusts bequeath a portion of the trust’s wealth to a charity, either before or after your other beneficiaries inherit. You can take a tax deduction for the charitable donation during your lifetime, but the Internal Revenue Service doesn’t allow you to take that deduction then reclaim the gift from the trust later, as you would be able to do with a revocable trust.
- Life insurance trusts are set up to purchase a policy on your life, then pay the premiums through financial contributions you make during your lifetime. The policy’s death benefits are ultimately paid to your trust then distributed to your trust’s beneficiaries. If you own the policy, or if you can take it back into your possession at any time, the death benefits may go toward the value of your estate, pushing it over the estate tax exclusion. Your trust must be irrevocable to avoid this.