My, how things have changed. When I was growing up, if you found out someone had a trust, well, that person must be rich—they must be a millionaire (that’s back when a million dollars was really worth something). Today, though, trusts of all kinds are a common planning tool providing specific benefits to a multitude of situations. But boil it all down and trusts fall into two camps—revocable and irrevocable.
A trust, as a legal entity, can own things just like you can—real estate, investment accounts, life insurance, vehicles, personal property, bank accounts, and collectibles. When you set up a trust you transfer ownership of your assets to the trust. You also give instructions about how you want those assets distributed after you die.
There are three main players in a trust.
- The Grantor—that’s the person placing assets into the trust.
- The Beneficiary—the person or people who will receive assets and income from the trust.
- The Trustee—the individual or organization that oversees the trust, maintains the trust and carries out the instructions you listed when the trust was set up.
The decision you have to make is whether the trust will be revocable or irrevocable.
Revocable Trust
Control
The revocable trust gives you lots of flexibility. As the Grantor, you can amend the trust or if you change your mind, you can revoke the trust anytime you want to. If you lose confidence in the person you named as trustee, you can name another one. If you have a falling out with one of your beneficiaries, you can remove them. In other words, you maintain control.
Taxation
The grantor’s social security number is used and all income is taxed at the grantor’s tax rate.
Change your mind
If you decide you’ve made a mistake and the Trust isn’t for you, you can take the assets out of the Trust and put them back in your name. Usually, there are no tax consequences for switching back because only after-tax assets can be put into a trust while you’re alive. Pre-tax funds such as IRAs and 401ks can’t go into a Trust because it would require the Trust to become the owner of those accounts rather than you. The IRS considers that kind of ownership change a taxable withdrawal and taxes have to be paid.
Benefits of a revocable Trust
- If you die or can’t handle your affairs, a successor trustee steps in and manages the assets according to the instructions you put in the trust document. It prevents a court fight among family members who may want to manage your assets if there’s no Trust in place.
- The trust does not go through probate when you die. That’s very convenient if you own homes or property in several states. Everything can be handled in your state of residence. If there was only a Will, every piece of property would have to go through probate court in the state where the property is located.
- The details of your estate remain private. Since Trusts assets don’t go through probate, no one knows about your estate or where the assets went. Estates going through probate are public record and anyone can go to the courthouse and see exactly what you had and who got it.
- No probate cost. If your estate goes through probate, there will be fees for attorneys, appraisers, and executors plus probate fees that can be 5% or more depending on the state.
- Assets in a revocable trust receive a step-up in cost basis when the Trust Grantor dies.
Downside
Even though you put assets into a revocable trust, those assets are still considered part of your estate and are not sheltered from estate taxes or creditors.
Cost
In general, the cost for an attorney to set up a revocable Trust is $1,000 to $1500, depending on where you are in the United States.
Irrevocable Trust
Control
As the name implies, there is very little flexibility with an irrevocable trust. You give up control of the assets; the term “written in stone” comes to mind.
Taxation
An irrevocable trust has to have its own taxpayer identification number and file an annual tax return using IRS form 1041. Taxes due are paid at a trust rate, which is a different schedule than an individual rate. Irrevocable trusts only pay taxes on any income that is not distributed out, so most irrevocable trusts pay no taxes and the recipients of the income are taxed at their individual rate on what they receive. In effect, the trust acts as a pass-through for tax purposes and issues K-1s to the beneficiaries.
Change your mind
Even though a trust is irrevocable, it can be changed during your lifetime, but it’s a big mountain to climb. You have to get all the beneficiaries and the trustee to agree to any change you want to make. You can even take the assets out of the trust and put them back in your name, but all the beneficiaries and the trustee have to agree.
Benefits of an irrevocable Trust
- Assets in an irrevocable Trust are not included in your taxable estate at death.
- Assets are protected from lawsuits and creditors. Because the assets aren’t in your name, claims can’t be filed against them.
- Assets titled to the trust for the benefit of your heirs are also protected from claims if the heirs are involved in a lawsuit or divorce.
Downside
- Generally, assets in an irrevocable do not get a step-up in cost basis. Instead, the grantor’s taxable gains are passed on to heirs when the assets are sold.
- Assets in an irrevocable trust can be claimed by Medicaid if they have been in the trust for five years or less.
- Under federal bankruptcy law, assets in an irrevocable trust can be attached by creditors if the assets have been in the trust for two years or less.
- Capital gains on the sale of a house held by an irrevocable trust may not qualify for the $250,000 exclusion.
- At the death of the Grantor, an irrevocable trust does not receive a step-up in cost basis.
Cost
Because irrevocable trusts are tailor-made for your specific situation, they are often more expensive than revocable trusts. Ballpark figures are $3,000 to $6,000, and can go higher depending on how complex the trust is.
No matter which type of trust you set up, there is one final step. You have to move assets into the trust. The trust document may have all the instructions about who gets what, but unless there’s something in the trust to give away, the instructions are meaningless and all your estate planning effort goes to waste.
This article is presented as information only and should not be considered tax, legal or financial advice.
