One of the simplest ways that a person can protect their family is to purchase life insurance. But did you know that the death benefits of your life insurance policy can be included in your gross estate? And that taxes on your estate could be as much as 40%? And even after your loved ones receive your life insurance proceeds, their creditors may be able to reach those assets? All of these issues can jeopardize the very steps you took to protect your loved ones.
This is where irrevocable trusts come in. This special type of trust may be able to help you minimize estate taxes and protect your beneficiaries. However, irrevocable trusts do not come without risks. Once you place assets in an irrevocable trust, you might not be able to reclaim them, so you want to be sure about the irrevocable trust before taking such action. Here is all the information you need on what irrevocable trusts are, their benefits, their risks, and how to create one.
Irrevocable Trust Definitions
Here are a few terms that will be referenced below that you’ll need to know to have a good understanding of irrevocable trusts.
| Term | Definition |
| Grantor | The person who creates the trust document |
| Trustee | The person responsible for administering the trust according to its directions |
| Beneficiary | The person who benefits from the trust’s assets and/or income |
| Gross estate | Per IRS tax rules, the gross estate is everything you own at the time of your death. This represents the grantor’s taxable estate. |
| Living trust | A trust created during the grantor’s lifetime |
| Testamentary trust | A trust created at the time of the grantor’s death |
What Is an Irrevocable Trust?
Generally speaking, an irrevocable trust is a trust in which the grantor cannot change or revoke the trust after creating it, except in certain scenarios such as where the beneficiaries agree or the trust provides the trustee discretionary power to decant the trust (distributes trust property to another trust with more advantageous terms).
In most cases, the purpose of an irrevocable trust is to transfer assets out of the grantor’s estate in furtherance of a goal such as estate tax reduction or asset protection. This is often to transfer“incidents of ownership,” which refers to certain rights or benefits a person receives over property.
For example, incidents of ownership with respect to life insurance policies include the right to:
- benefit economically from the proceeds
- change the beneficiary
- surrender the policy
- cancel the policy
When a person distances themselves from such incidents of ownership, the asset will not be counted against them, such as when they are trying to apply for need-based government benefits.
Additionally, when property is transferred from the grantor to an irrevocable trust, the asset is removed from the grantor’s gross estate, thereby decreasing the value of the estate and the potential estate tax imposed on it.
Irrevocable trusts can’t be modified, amended, or terminated without the beneficiary’s permission or court order.
Benefits of Irrevocable Trusts
Irrevocable trusts are not for everyone. They are a sophisticated estate planning tool, but their unique characteristics, difficulty of changing them, and the potential costs associated with creating them may outweigh their benefits.
Some of the key benefits of irrevocable trusts include:
Minimizing Estate Taxes
Irrevocable trusts are often used for tax purposes. Many different irrevocable trusts can help minimize estate tax. This is because the assets are removed from the grantor’s gross estate, which reduces the value of the estate. For example, with an irrevocable life insurance trust, the grantor can remove the proceeds from their gross estate, which could potentially represent millions of dollars of value.
In 2023, the federal estate tax exemption is $12,920,000, so people generally don’t have to worry about this tax unless they have a large estate and the value of their estate (and lifetime gifts) exceeds this amount. However, many states have state estate tax limits that have much lower exemption limits, such as $1 million. Jurisdictions that currently have state estate tax include:
- Connecticut
- District of Columbia
- Hawaii
- Illinois
- Maine
- Maryland
- Massachusetts
- Minnesota
- New York
- Oregon
- Rhode Island
- Vermont
- Washington
Another tax advantage is that with certain types of irrevocable trusts, the grantor is relieved of the tax liability on the income generated by the trust assets.
Protecting Individuals from Creditors
Another benefit of irrevocable trusts is protecting the assets in the trust from creditors. To prevent creditors from reaching trust assets, a trust must usually be irrevocable. The grantor cannot have the power to make or demand distributions. This is particularly helpful for people who work in professions that may make them vulnerable to lawsuits, such as:
- Surgeons and other doctors
- Attorneys
- Real estate developers
- Architects
- Business owners
Once an asset is transferred to an irrevocable trust that is optimized for asset protection, it will usually be owned by the trust for the beneficiaries and is generally safe from legal judgments and creditors.
The grantor can also set conditions for distribution to provide a layer of creditor protection for beneficiaries.
Helping Beneficiaries with Disabilities Qualify for Government Benefits
Paying for long-term care, especially in a nursing home can be very expensive, so many people may want to try to position themselves to become eligible for Medicaid and other public benefits to help pay for these costs. Irrevocable trusts can be used to shelter income and trusts, which may help a beneficiary qualify for certain government benefits, including Medicaid or Supplemental Security Income (SSI).
These programs have strict income and asset limits. Trust funds can be segregated from the beneficiary’s assets and income, allowing them to qualify for the program while still benefiting from the trust.
Avoiding the Probate Process
Probate is the court-administered process to wrap up an estate. The executor or administrator is appointed to carry out the terms of the last will and testament. They are responsible for notifying heirs and creditors of the death and their appointment, inventorying assets, resolving claims against the estate, and filing the estate tax return.
The probate process is often complex and expensive because it is overseen by the court. The executor or administrator may have to file many documents with the court. By transferring property to an irrevocable living trust, your beneficiaries will avoid the probate process entirely on the transferred assets, saving them from the hassle and expense.
Potential Uses of Irrevocable Trusts
Irrevocable trusts may be used for many different purposes, such as:
- To remove the value of assets from the gross estate, such as life insurance proceeds, to take advantage of the estate tax exemption
- To remove appreciable assets from the estate
- To gift a home to children with more favorable tax treatment for a principal residence
- To spend down an estate to qualify for government benefits
- To gift assets to beneficiaries while retaining income for the grantor
- To protect assets from creditors
Types of Irrevocable Trusts
There are various types of irrevocable trusts, including:
Asset Protection Trusts
For a trust to protect assets from legal claims and creditors, it must typically be irrevocable. Also, the trustee and beneficiary must usually be unrelated parties. These trusts are usually created in states that have favorable trust laws, such as Delaware, Nevada, and North Dakota.
Life Insurance Trusts
A life insurance trust owns and controls a life insurance policy and can also set terms on how the proceeds can be used. A life insurance trust can potentially minimize estate taxes and avoid gift taxes. There is generally a three-year lookback period if the grantor transfers an existing life insurance policy to the trust.
Living Trusts
Most trusts are living trusts, including many irrevocable trusts. An irrevocable living trust is created and becomes effective during the grantor’s lifetime.
Testamentary Trusts
A testamentary trust is created after the death of the creator and funded from the creator’s estate. They are included in the terms of the creator’s last will and testament.
Grantor-Retained Annuity
This trust gives the grantor a set income stream for many years to come. Some of the principal may benefit other beneficiaries estate tax-free.
Charitable Remainder Unitrust
A charitable remainder trust pays income to beneficiaries during the grantor’s lifetime and leaves the funds that are in the trust at the time of the grantor’s death to a pre-selected charity.
Charitable Lead Trust
A charitable lead trust is the opposite of a charitable remainder trust. A charitable lead trust makes payments to the charity for a certain period. Then, the remaining assets are provided to beneficiaries. This trust may reduce the beneficiary’s tax liability.
Grantor-Retained Annuity Trust
A grantor-retained annuity trust allows a grantor to make large financial gifts to family members. The grantor places the assets in the irrevocable trust and receives annual annuity payments. When the trust term expires, the beneficiary receives the assets with no or little gift taxes owed on the asset.
Qualified Personal Residence Trust
A qualified personal residence trust allows a creator to remove a personal home from their estate to reduce gift taxes. The grantor continues to live in the residence for a specified term. Because the grantor retains a fraction of the value due to their possessory interest, the gift value of the property is lower than the property’s fair market value, so the gift tax is lower.
Spousal Lifetime Access Trust
A spousal lifetime access trust allows spouses to reduce the size of their estate by making large gifts. One spouse makes a gift to the trust and names the other spouse as the beneficiary. Any appreciation to the gift that accumulates after the asset is placed in the trust is excluded from the estate of both spouses. The gift to the trust is usually not taxable because the spouse making the gift uses their federal gift and estate tax exclusion to make the gift.
Revocable vs. Irrevocable Trust
Revocable living trusts offer more flexibility than irrevocable trusts because they can generally be changed or revoked during the grantor’s lifetime. That said, you should know that the revocable living trust only becomes irrevocable at the time of the grantor’s death. However, they do not offer the same type of tax savings and characteristics as irrevocable trusts. That said, once a revocable trust becomes irrevocable upon the grantor’s death, it can provide asset protection for the beneficiaries if drafted correctly
Some of the major differences between irrevocable trusts vs. revocable trusts are:
| Key Differences | Revocable Trust | Irrevocable Trust |
| Modification | Can generally be modified as long as the grantor has capacity. | Cannot usually be modified unless the beneficiary agrees, a court order grants the right, or the trustee can decant the trust. |
| Revocation | Can generally be revoked as long as the grantor has capacity. The grantor can reclaim property at any time before their death. | Cannot usually be revoked unless the beneficiary agrees or by court order. |
| Ownership of trust assets | The grantor transfers all ownership rights of assets into the trusts and loses all of their rights to ownership. | |
| Tax benefits | Minimal estate tax savings | Irrevocable trusts might reduce estate taxes. You also don’t have to pay income tax on the assets as they appreciate. |
| Control over the trust | Grantor retains the right to control the terms of the trust agreement and can freely modify it as they see fit. | Grantor gives up a substantial amount of control over the trust. |
| Creditor Protection | Only limited creditor protection | Can protect assets from creditors and legal claims. |
| Eligibility for government programs | Government programs generally consider property held in revocable trusts as still belonging to the creator because they still have incidents of ownership. | Government programs usually do not consider property held in irrevocable trusts as the property of the creator because they have forfeited ownership of the assets (However, beware of look-back rules). |
Dangers of an Irrevocable Trust
While irrevocable trusts can provide many advantages over revocable trusts, they do also have some significant drawbacks, including:
- You lose control and ownership of the property.
- You may not be able to revoke the trust or make changes if your situation changes and you need access to trust assets.
- You may not need to worry about estate tax savings if your estate does not exceed the federal estate tax exemption or live in a state with estate tax. While the federal estate tax exemption is set at $12.92 million, the laws that establish this amount are set to sunset in a few years, so the federal estate tax exemption may be significantly lower in the future.
- If you do not qualify for Medicaid, you may still have your principal locked up if you created an irrevocable trust for this purpose even when not receiving the contemplated benefits. It may be necessary to create a special needs trust with the help of an experienced elder law attorney to accomplish your objectives, which can come at an additional cost.
- Irrevocable trusts may be expensive to create and administer due to their complexity.
- A court may be able to reclaim assets in an irrevocable trust if it finds the assets were unjustly transferred to the trust in contemplation of a lawsuit, thereby eradicating the asset protection benefits.
- You may have to follow specific rules to qualify for an irrevocable trust’s benefits. If you fail to follow them, you have tied up your assets but may be ineligible for the benefits.
Can I Make Changes to an Irrevocable Trust?
There may be limited exceptions that allow you to change or even revoke an irrevocable trust. For example, you may be able to get the beneficiaries of the trust to agree to changes that are in their best interest or get the court to change the trust. A trust protector may have the power to modify the trust.
The trust may contain language that allows it to transfer to another state with more advantageous rules or decanting that allows the trust to move into a newer trust with better provisions. State law may allow the revocation or modification of a trust if the costs to administer it outweigh the benefits or if the trust’s purposes are frustrated. These are complex situations that often require the assistance of an experienced estate planning attorney.
Takeaway
Irrevocable trusts provide advantages not available through revocable trusts. However, they also have drawbacks that should be carefully considered before implementing them.