Irrevocable trusts are estate planning documents. They are powerful tools that can be very beneficial in certain situations. In this article, we will go over how irrevocable trusts work, some of their benefits, and some of their pitfalls.
How Irrevocable Trusts Work
An irrevocable trust is a type of trust. After you create it, it is irrevocable, or unchangeable. There are three main people that are involved with an irrevocable trust. The grantor, which is the person who creates the trust and funds it with their assets. The beneficiary, which is the person, or people, who benefit from the trust. Finally, there is the trustee. This is the person who is responsible for administering the trust according to the grantor’s specifications.
The grantor will lose all rights to ownership of an asset transferred into the trust. Additionally, irrevocable trusts cannot be modified or undone unless certain very specific circumstances are met, such as a change in trust law. Even though the grantor losses power over the asset, they set out the terms, rules, and uses of the assets when they initially create the trust. Because it is a separate entity, it will have its own EIN and file its own tax returns each year. Irrevocable trusts are much more complex than revocable living trusts and you must create them with great care.
How to Use Irrevocable Trusts
Irrevocable trusts have several benefits. These benefits vary from creditors protection to estate tax planning. Below you will find a summary of the ways to use an irrevocable trust for your benefit.
- Creditor Protection: Because the assets are no longer under your name and no longer under your control, they are no longer considered yours. This keeps the assets in the irrevocable trust safe from your creditors and any judgments against you.
- Tax Planning: By placing an asset into an irrevocable trust, you remove it from your tax liability. This includes any tax liability for income the assets produce after they are put in the trust.
- Estate Planning: For 2018, the estate tax exemption is $11.2 million. This means if your estate is in excess of that amount, your beneficiaries will have to pay 40% tax rate on anything over that amount. An irrevocable trust can help to reduce this tax liability. By putting assets into an irrevocable trust, they can be left out of your estate, reducing the tax.
- Qualifying for Benefits: There are certain government benefits that you may not be able to qualify for if your assets are worth over a certain amount. An irrevocable trust can take those additional assets out of your name, allowing your worth to be low enough to qualify. However, it is important to note that some of these programs, such as Medicaid, have a look back period. This means that you cannot put planning off. If you do, you may find that you are too late and still will not be able to qualify.
- Special Needs Beneficiary: An irrevocable trust can also be a way to help you care for a special needs beneficiary. It can protect assets that you set aside specifically for their care, while simultaneously allowing them to continue qualifying for any assistance programs they are eligible for. It also protects against the waste of your assets due to the beneficiary’s poor management skills or addictive behaviors.
Pitfalls of Irrevocable Trusts
The main pitfall of an irrevocable trust is that it is not easily changeable. If you are setting out to create one, you need to be 100% sure of what you are doing and how you want to do it. The second pitfall is that you lose all control over any assets placed in the trust. This means that you need to have complete faith in the trustee you choose to manage the assets and you need to be positive that you will not need any of those assets in the future.
Third, you need to be aware of issues with taxation. If the assets in the trust generate over $600 in income a year your trustee will have to file a Form 1041. They will also have to prepare Schedule K-1s for any beneficiaries that receive distributions. This can be an additional expense that you may want to take into consideration.
The Right Choice for You
After taking all of the benefits and pitfalls of irrevocable trusts into account, you will have to decide if creating one is right for you. If you find that it is, the next step is to meet with a qualified professional who can draft the trust for you. After you create the trust, be sure to fund it with the desired assets. Not doing so makes the trust useless and negates your hard work.
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