In trust law, one of the most fundamental and significant distinctions is the revocable trust vs. irrevocable trust distinction. A revocable trust (or living trust) is a type of trust that allows the creator (or “grantor“) to revoke the terms at any time and for any reason. An irrevocable trust is a type of trust that cannot be amended or revoked by the person who created it. In exchange, the grantor can gain significant tax, estate-planning and asset-protection benefits.
In this article, we will explore the key differences between revocable and irrevocable trusts so that you can make an informed decision about which type is right for you.
Key Differences: Revocable Trusts vs. Irrevocable Trusts
- Revocability: The most obvious difference is that while revocable trusts can be amended or canceled at any time, irrevocable trusts are much harder to modify. Contrary to popular belief, however, it is possible to modify an irrevocable trust after it has been created. Some irrevocable trusts include provisions allowing someone (often a trustee or trust protector) to make certain changes to the trust. Often times, it’s possible to “decant” a trust, which means pouring the trust’s assets into a new trust with somewhat different terms.
- Estate Tax: Revocable trust assets are considered part of the grantor’s estate for estate-tax purposes, which means that the assets inside of it will be subject to estate tax to the extent that the grantor’s estate exceeds the estate-tax exemption amount on his or her death. Assets in an irrevocable trust are not necessarily part of the grantor’s estate for estate-tax purposes. That’s why irrevocable trusts are often a component of estate-tax-planning strategies.
- Income Tax: Revocable trusts are inherently grantor trusts, which means they’re disregarded for income-tax purposes. Irrevocable trusts can be either grantor trusts or non-grantor trusts, which means they may or may not be disregarded for income-tax purposes. Non-grantor trusts can generate income-tax savings in certain situations.
- Asset Protection: Irrevocable trusts can be used to shelter assets from creditors, while revocable trusts cannot.
- Control: Revocable trusts allow the grantor to remain in control of the trust assets. Some irrevocable trusts restrict the grantor’s control over trust assets.
Why Do People Set Up Revocable Trusts?
There are a few reasons people create revocable trusts. By far the most common reason is probate avoidance. Revocable trusts allow their grantor’s estates to avoid probate when the grantor dies. (Probate is a legal process that occurs when someone dies without a revocable trust; it is time-consuming and expensive for heirs to navigate.)
Another fairly common use of revocable trusts is disguising ownership of an asset. By putting assets into a revocable trust, a grantor can retain ownership of the asset while disguising the fact that they’re the owner. For example, a celebrity might create a trust, name his accountant as trustee, call the trust something generic like the “12 Main Street Trust,” and then transfer real estate into it. The deed will be public, but it won’t be apparent from looking at the deed who really owns the property.
Why Do People Set Up Irrevocable Trusts?
The most common reason people set up irrevocable trusts is tax avoidance. Irrevocable trusts have a number of powerful tax benefits. Certain types of trusts, like charitable remainder trusts, have the power to defer capital gains taxes. Non-grantor trusts have the power to reduce state income tax (and, in some cases, federal income tax, too). Intentionally defective grantor trusts (IDGTs), including irrevocable life insurance trusts, can minimize future estate tax.
Another common reason that people set up irrevocable trusts is to protect assets from creditors. For most people, asset protection is secondary to tax mitigation, but for some people, asset protection is the main reason they set up their trust. Irrevocable trusts provide powerful asset protection because they’re not “owned” by the grantor or the beneficiary. Instead, legal ownership is vested in a trustee. As a result, neither the grantor’s creditors nor the beneficiary’s creditors can easily reach a trust’s assets, and the trustee’s creditors can’t reach them either because the trustee acts in a fiduciary capacity, not in his or her individual capacity.
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