When is an irrevocable trust a good idea - or a bad one?

A trust is a type of legal relationship where someone hands over control of property to someone else for the benefit of a third party. Sounds confusing, but it'll make more sense after we explain the parts of a trust.

There are four parts to a trust: the creator of the trust, a trustee, a beneficiary and the trust property.

The creator of the trust is exactly what it sounds like. Also referred to as the grantor or settlor (these terms are interchangeable), this individual (ideally with the help of an attorney) will create the trust, establish the terms of the trust (like choosing a trustee) and provide the property that goes into the trust.

The trust property (sometimes called the “corpus” or “trust res”) can be almost anything of value that the law provides a property or ownership interest in. This means trust property may include things like a car, a home, investment securities, bank accounts or personal property.

A trustee (occasionally called the trust's “fiduciary”) is the person who holds legal title to the trust property. A trustee is often an individual but could be a business or other type of organization. The job of the trustee is to manage the trust property for benefit of the beneficiaries. Exactly how the trustee does this may be set out by the terms of the trust and by law.

A decision a trustee could make might include deciding which stocks to buy and sell to increase the value of the trust property. Another potential decision could be choosing when to distribute some of the trust assets to the beneficiary.

The final part of the trust is the beneficiary. A trust can have one or more beneficiaries, who are the individuals receiving the assets from the trust. For instance, if a trust holds stocks and bonds, the interest and dividends from these investments could be something the beneficiary receives every few months. If the trust property is a house, the beneficiary might be someone who lives in the house.

Depending on the type of trust and how it's set up, there can be some overlap in the parts of a trust. A trustee could also be a trust beneficiary, although if this happens, there will be at least one other beneficiary to the trust. Or with some trusts, the grantor could also be the beneficiary.

There are many different types of trusts. One reason there are so many is because trusts are controlled primarily by state law. Despite all the different types of trusts out there, there are three main types of trusts:

• Testamentary trust: This is a trust that's created by the terms in someone's will. So a testamentary trust goes into effect only after the grantor dies and the will is probated.
• Revocable trust: This is a trust where its creator can change the terms of the trust at any time during the creator's lifetime. Revocable trusts can automatically turn into irrevocable trusts if they are intended to continue existing after the death of the grantor.
• Irrevocable trust: An irrevocable trust is a type of trust that can't be changed or revoked. In very limited situations, a court can sometimes modify an irrevocable trust.

Most trusts are a combination of these types of trusts, so there can be plenty of overlap, although there can be some inherent limitations. A living trust can be either a revocable or irrevocable trust. Yet a testamentary trust will always be an irrevocable trust.

It might seem like the best thing to do when making a trust is to make a revocable one. After all, who knows what the future holds and you might want to change your mind later about how the trust works. But irrevocable trusts have several advantages over revocable trusts.

The single biggest difference between an irrevocable and revocable trust is that in an irrevocable trust, the grantor has no legal right to control how the trust property is used or spent. This lack of control might seem like a bad thing, and it can be in certain situations. But it also gives irrevocable trust three key advantages.

First, an irrevocable trust can reduce the grantor's tax liability.

Because property placed into an irrevocable trust is no longer under the grantor's control, that property is generally ignored for tax purposes.

For example, let's say John owns 10,000 shares of Acme Inc. and every year they pay out a dividend of $5 per share. That's $50,000 in taxable income that John has to pay. But if John places those 10,000 shares into an irrevocable trust, he pays no taxes on that $50,000 dividend income. Instead, it'll be the trust that owes the taxes and the trustee will make arrangements to pay the IRS the taxes owed.

Irrevocable trusts also help with estate taxes. If a grantor dies with enough assets, the grantor's estate will owe an estate tax. As of 2022, the estate tax exemption is $12.06 million. This means if an estate is worth more than that, an estate tax is owed. But if a grantor places property into an irrevocable trust, that property doesn't get counted toward the $12.06 million exemption cap.

Finally, there's the charitable tax benefit. If you create an irrevocable charitable trust, the contributions you make into that charitable trust are eligible for the charitable tax deduction. If you make these donations while alive, you get the tax deduction. If the donations are made after your death, your estate gets the tax deduction.

Second, an irrevocable trust can be helpful when trying to qualify for certain government benefits.

For example, Medicaid is a government program that offers health care services for those who demonstrate financial need. The problem for some people is that they have too much money to qualify for Medicaid, but not enough to pay for their medical care. One way to address this problem is to create a Medicaid trust.

By placing assets in a Medicaid trust (also called a Medicaid asset protection trust, or MAPT), a person can reduce their income and/or property assets that Medicaid uses to determine eligibility. This is commonly done to receive Medicaid's long-term care benefits and avoid Medicaid estate recovery when the Medicaid benefits recipient passes away. One of the key characteristics of a Medicaid trust is that it has to be an irrevocable trust. This requires that the creator of the Medicaid trust cannot also be its trustee.

Third, there are the asset protection benefits that come with the irrevocable trust.

Imagine you become legally liable for a monetary debt. Maybe you got sued in a personal injury case or you defaulted on a loan and now the creditor wants to collect what you owe. Depending on circumstances surrounding the legal obligation, most (if not all) of your property could be subject to collection by the creditor.

For instance, let's say the bank forecloses on your home, but your home was underwater (was worth less than what you owed on it) at the time of foreclosure. Even after taking away your home, the bank could have the right to go after other assets that you own to recover the rest of your debt. But the bank would be limited to assets that you owned. But what if you had assets owned by the trustee of your trust?

In this case, the bank couldn't touch that property. But only if the trust was set up such that you had no control over the property, such as with an irrevocable trust.

Irrevocable trusts are popular for many professionals who are constantly exposed to potential legal liability. Think of highly successful lawyers, accountants or doctors, all of whom could potentially be sued for malpractice. Business owners are also potentially liable for the debts of their businesses. So to prevent a business creditor from going after the business owner's personal assets, the business owner might place their assets inside an irrevocable trust.

Irrevocable trusts have clear benefits and advantages, but in certain situations, it's probably best that you use a revocable trust or other financial or estate planning tool.

The single biggest reason to avoid using an irrevocable trust is if you want to maintain full control over the trust property. While exceptions exist, you should assume for estate planning purposes that whatever property you place into an irrevocable trust is no longer yours. This limitation could pose a problem in a multitude of ways:

• The reason for the irrevocable trust no longer exists. Did your net worth take a big hit such that you no longer need to worry about an estate tax when you pass away? Sorry, the property stays in the irrevocable trust.
• You have a falling out with the beneficiary. Now you hate them and want to choose someone else. In most cases, this isn't possible unless there's a court order or if the beneficiary consents to the change.
• The trustee isn't making the decisions you were hoping they would. It may not be possible to replace the trustee without a court order or the consent of the trustee. Depending on why you're not happy with the trustee, you can also consider using a trust protector.
• You're creating the irrevocable trust to unfairly protect your assets. Depending on state law, there's a time period when property in an irrevocable trust is still subject to creditors trying to collect on a financial debt or legal judgment. The purpose of these laws is to prevent someone from protecting their property after the event creating liability has already occurred.
• You want to protect property from creditors who have special rights to access property in an irrevocable trust. Depending on the state, an ex-spouse or child trying to recover unpaid spousal or child support may still have access to property placed in an irrevocable trust.
• You want any trust income to stay in the trust and not get distributed to beneficiaries. Generally speaking, taxes are higher for income generated in an irrevocable trust than a revocable trust.
• You're trying to keep costs as low as possible. Many irrevocable trusts are more expensive than revocable trusts due to the attorney's fees needed to create an irrevocable trust. Then there's the annual expense likely needed to pay an accountant to file an income tax return for the trust. And depending on who your trustee is, they may charge a fee for their services.

Depending on what you needed an irrevocable trust for, there could be alternatives that still give you what you need, but without the drawbacks of an irrevocable trust. Some of these alternatives are pretty straightforward and you can probably get them set up yourself. But other alternatives might require the services of a professional, such as an attorney or financial professional.

Revocable trust

If you're creating a trust for its privacy advantages or to avoid probate, a revocable trust should work just fine. Any privacy advantage of the irrevocable trust is also available with the revocable trust.

In many cases, a trust can act as a partial substitute for a will. This can help all or most of your estate avoid the probate process.

Also, a revocable trust automatically becomes irrevocable after the settlor/grantor dies. So if you want to protect property from the creditors of your beneficiaries, then a revocable trust may work for you.

While you're alive, you can control the trust and its assets. Then after you pass away, the property in the trust gets transferred to the beneficiaries. But because the trust has turned into an irrevocable trust, its property is protected from the creditors of your beneficiaries.

Insurance

If you're worried about getting sued, getting the right insurance can help reduce the risk of losing your assets to a lawsuit. If you own a business, think about increasing or adding to your business liability coverage. As an individual, you could purchase a liability umbrella insurance policy or increase the coverage limits of your home or car insurance policy.

As for Medicaid and paying for a long-term care facility, one alternative to a Medicaid trust is to buy long-term care insurance as soon as possible. The earlier you buy it, the lower your premiums will be. But you can still ensure you can afford to pay for an assisted living or similar facility as you get older.

Business formation

If your business is a sole proprietorship, then you're personally liable for the legal debts of your business. One way to protect yourself is to incorporate your business or establish some other type of limited liability business form, like an LLC or LLP.

Irrevocable trusts provide several powerful advantages, including asset protection, reducing tax liability and improving your eligibility for government benefits. But there are plenty of situations where irrevocable trusts can have drawbacks that make them an unrealistic estate planning tool. If you're thinking about setting up an irrevocable trust, it might be a good idea to first consult with an estate planning professional.