What Kind of Trust Do I Want?
One frequently asked question I hear is whether the person should have a revocable or irrevocable trust. This is usually followed by the question, what is an irrevocable or revocable trust, and what’s the difference between the two? Let me explain what they are and their advantages and disadvantages.
A revocable trust is, to put it simply, a trust that can be revoked. The settlor (i.e., the person who created the trust) can make changes any time they please, and they can even revoke (i.e., terminate) the trust if they wish to do so. This gives the settlor a lot of flexibility and freedom regarding what they want the trust to say and what they want to put in that trust. In addition, since the settlor can revoke or amend at any time, the IRS treats these trusts as assets of the settlor. In other words, everything in the trust will be taxed at the same rates as if the settlor still owned the assets in their own name.
This all sounds pretty good, so what’s the downside? The problem with revocable trusts is that everything is treated as if the settlor owned the assets in their own name. This is a double-edged sword – while it’s great for tax purposes, it’s not so great if you’re trying to protect your assets from creditors. There may also be good reason to “lock in” your decisions so others can’t make changes for you. For example, you may be worried about someone taking advantage of you, or you may have a blended family, and you want to make sure your spouse doesn’t take away your children’s inheritance after you die. Some trusts also can’t be revocable in order to serve their purpose, such as a Special Needs Trust.
Which brings us to irrevocable trusts. As you probably already guessed, an irrevocable trust cannot be revoked. Because you cannot change an irrevocable trust, it is treated as its own entity in the eyes of the law, similar to a corporation. This means it needs its own tax ID and a separate set of tax returns.
I have already talked about some reasons irrevocable trusts can be beneficial. However, they have their downsides, too. Since they are their own entity, they are taxed at a special rate higher than most individuals’ tax rate. And if you didn’t get the terms quite right when you signed, then making changes and updates is very difficult (there are ways, but you usually have to get the courts involved, which is a lot of time and money – after all, the whole point is to set it in stone from the beginning).
So which one is right for you? Not surprisingly, that is going to depend on your circumstances and end goals, but for most people doing their estate planning, the answer is to have a blend of both. The typical estate plan involves one revocable trust that stays revocable during the settlor’s lifetime but becomes irrevocable after the settlor dies. This way, the settlor can make whatever changes and updates they want throughout their life, but because they are the only ones with the power to make changes, it becomes irrevocable upon their death, and they don’t have to worry about other people mucking things up. Since most trusts don’t keep earning income after the settlor’s death, this also cuts down on the negative tax consequences of an irrevocable trust as well. (Don’t worry, for these kinds of trusts, there’s a solution to the tax problem too, but that’s a subject for another article.)
Have I thoroughly confused you? Hopefully, this article answered your question, but if it didn’t feel free to contact me at kaway@kawaylaw.com, and I’ll be happy to explain it again and discuss which one is best for your needs.
