This article was updated on October 6, 2017, and originally published on August 21, 2016.
An irrevocable trust can shield your assets from estate taxes and legal liability, and can help you leave assets to a beneficiary in a clearly defined manner. However, irrevocable trusts are permanent and the assets placed in them technically aren't yours anymore, so it's important to consider the pros and cons before setting one up.
What is a trust fund?
In a nutshell, a trust fund is a legal arrangement set up by one person for the benefit of another, and administered by yet another. The legal terms for the three people involved in a trust fund are:
- Grantor: The person who establishes a trust and contributes assets to it.
- Beneficiary: The person (or people) who will eventually benefit from the assets in the trust.
- Trustee: The person or organization responsible for seeing that the trust is administered as intended.
As a basic example, let's say that you want to leave $1 million to your child, but are worried about them using the money irresponsibly. So, instead of giving the money to them in a lump sum, you set up a trust fund that pays them a certain amount of money each month.
There are many different types of trust funds and reasons you might want to use a trust fund, and you can read a more thorough description here.
What is an irrevocable trust?
Trusts can be broken down into two main categories: revocable and irrevocable. Revocable trusts can be changed or modified during the grantor's lifetime, while irrevocable trusts cannot. Irrevocable trusts can be particularly useful when it comes to estate planning, so let's take a closer look.
There are two basic forms of irrevocable trusts. Some irrevocable trusts are created and funded during the grantor's lifetime, and can come in many forms. For example, a qualified personal residence trust (QPRT) can hold the grantor's primary or secondary residence and reduce its taxable value for estate purposes. A grantor retained annuity trust (GRAT) can potentially allow money to be transferred to heirs without any estate tax liability. There are many different types of irrevocable trusts that can be created, each with its own setup procedures and legal considerations.
By contrast, testamentary irrevocable trusts are created and funded after the grantor's death based on the terms in his/her will. Since the only person who could change the terms is deceased before the trusts are created, testamentary trusts are irrevocable. However, it's important to mention that they can be modified during the grantor's lifetime. By the same logic, a revocable trust automatically becomes irrevocable after the grantor's death, since the grantor is no longer able to make changes.
Pros and cons of an irrevocable trust
An irrevocable trust has some major advantages when it comes to planning your estate and protecting your assets. Just to name a few of the biggest, an irrevocable trust offers these benefits:
- Legal protection: Assets in an irrevocable trust have greater protection from creditors and anyone else seeking to obtain a judgement against you. You no longer own the assets (the trust does), so they are protected to the extent that bankruptcy and insolvency laws don't allow a clawback of such assets. On the other hand, a revocable trust is still considered to be an asset of the grantor, and therefore is not protected from legal action.
- Estate planning: An irrevocable trust typically does not count toward the value of your estate. Estate taxes kick in on estates valued at more than $5.49 million as of 2017, and the top estate tax rate is 40%. Therefore, by placing certain assets into irrevocable trusts before the assets rise in value, it can reduce the tax burden on your heirs if your estate is large.
- Qualifying for benefits: There are several situations where this may be an advantage, and Medicare is one big example. By transferring your assets out of your ownership, you might be able to avoid mandatory depletion of your assets to say, pay for in-home care benefits.
- Preventing misuse of your assets: An irrevocable trust can distribute your assets to heirs or beneficiaries on a conditional basis, as in the example of monthly payments discussed earlier.
The main downside to an irrevocable trust is simple: It's not revocable or changeable. You no longer own the assets you've placed into the trust. In other words, if you place a million dollars in an irrevocable trust for your child and want to change your mind a few years later, you're out of luck.
The bottom line on irrevocable trusts: Be 100% certain
Irrevocable trusts certainly have their advantages, but it's extremely important to be certain of your intentions before creating one. Don't create an irrevocable trust just to protect your assets from potential legal liability or to reduce the value of your estate -- rather, place those assets in the irrevocable trust because you're certain you want the beneficiary to eventually have them, and under the terms dictated by the trust.
The Motley Fool has a disclosure policy.