Irrevocable Trusts 101: Everything You Need to Know

8.9 MIN READ

Irrevocable trusts can be a great way to minimize your estate taxes while passing down wealth to your loved ones, but there are also important things to consider.

An irrevocable trust permanently transfers your assets to a trust that can't be easily changed or canceled. Once you place assets into this type of trust, you give up all ownership rights - the trust becomes the legal owner instead of you.

So, is an irrevocable trust a good option for you, or should you consider creating a revocable one? Here's everything you need to know to make the best decision and protect your trust assets.

What Is an Irrevocable Trust?

An irrevocable trust is a legal arrangement where you transfer assets into a trust and give up all rights to those assets. You are called the grantor.

The key difference from other trusts (called revocable trusts) is that you can't easily modify, change, or revoke an irrevocable after it's created. The assets now belong to the trust itself, and the terms you set up at the start are typically permanent.

In 2020, 63% of estate planning attorneys reported an increase in the use of irrevocable trusts compared to the previous year.

How Do Irrevocable Trusts Work?

Let's say you want to leave $500,000 to your children but reduce estate taxes. You create an irrevocable trust and transfer the money into it.

You name your children as beneficiaries and appoint a trustee (usually a bank or attorney - you typically can't play this role yourself) to manage the money according to your instructions.

The money is no longer yours. It belongs to the trust and must be managed based on the rules you established when creating it. If you ever want to change those rules, it's typically hard or impossible.

Who Controls the Money in an Irrevocable Trust?

The trustee controls and manages the trust assets. Typically, that can't be you.

The trustee must follow the trust's terms exactly as written and act in the beneficiaries' best interests. For example, if you set up the trust to pay for your grandchildren's college education, the trustee must use the money only for that purpose.

Can You Withdraw Money from an Irrevocable Trust?

Generally, no. Once you put assets in an irrevocable trust, you can't take them back. Only the beneficiaries can receive distributions, and only according to the trust's terms.

If the trust allows for regular payments to beneficiaries (like monthly income), the trustee handles those distributions based on the rules you established when creating the trust.

Related Article | At What Net Worth Do I Need a Trust?

Types of Irrevocable Trusts

Irrevocable trusts fall into two main categories: living trusts and testamentary trusts.

Living trusts (also called inter vivos trusts) start during your lifetime. Testamentary trusts activate after your death through your will. So, naturally, they serve different purposes.

There are a few different types of irrevocable living trusts:

Irrevocable life insurance trust (ILIT): Holds and owns your life insurance policies. It keeps the death benefit out of the grantor's taxable estate, potentially saving your heirs a lot of money in federal estate taxes.
Grantor-retained annuity trust (GRAT): Allows you to receive annual payments from your assets for a set period, then passes the remaining assets to your beneficiaries with reduced gift taxes.
Qualified personal residence trust (QPRT): This lets you transfer your home to beneficiaries at a reduced gift tax rate, but you can still live there for a specified period of time.
Spousal lifetime access trust (SLAT): Allows you to transfer assets out of your estate and give your spouse access to those assets during their lifetime.
Charitable remainder trust: Provides you with income for a set period, then transfers the remaining assets to your chosen charity.
Charitable lead trust: Gives income to a charity for a specific period, then passes the remaining assets to your non-charitable beneficiaries.

Testamentary trusts work differently because they're created through your will. For example, you might set up a trust for your minor children that only takes effect after you pass away. These trusts become irrevocable upon the grantor's death and must be carried out according to your will's instructions.

Related Article | Spousal Lifetime Access Trust

Advantages of Irrevocable Trusts

Irrevocable trusts have several important benefits for estate planning and asset protection:

Estate Tax Reduction: Moving assets into an irrevocable trust removes them from your taxable estate. This can potentially minimize estate taxes - by a lot. For example, life insurance benefits held in an ILIT bypass estate taxes completely.
Asset Protection: Once your assets are in the trust, they're generally safe from future creditors and lawsuits. This is why people in high-risk professions, like doctors or business owners, often decide to set up irrevocable trusts.
Government Benefits Qualification: Properly structured irrevocable trusts can help you qualify for government benefits like Medicaid.
Control Over Asset Distribution: You can specify exactly how and when your beneficiaries receive the assets. For example, they may need to reach a certain age or graduate from college before receiving distributions. This can help protect them from bad financial decisions.

Overall, irrevocable trusts can be a great option for high-net-worth individuals who want to protect assets and minimize taxes - especially if you don't mind losing a certain degree of control once the trust is set up.

Disadvantages of Irrevocable Trusts

So, what is the disadvantage of an irrevocable trust? There are a few drawbacks you should think about:

Loss of Control: Once you transfer assets into the trust, you can't change your mind or easily modify the terms. This can become a problem if your financial situation or family dynamics change a lot.
Potential Higher Tax Rates: Certain types of irrevocable trusts can sometimes be taxed at a higher rate than revocable trusts.
Complexity and Costs: Setting up and maintaining an irrevocable trust requires legal advisors and ongoing professional management. This can be expensive.

Irrevocable trusts must file their own tax returns (Form 1041). The trust typically pays taxes on retained income but can deduct income distributed to beneficiaries, who then pay taxes on these distributions at their individual rates.

Revocable vs Irrevocable Trusts

The main difference between revocable and irrevocable trusts comes down to control and flexibility. A revocable trust lets you maintain complete control. You can change terms, remove assets, or dissolve the trust entirely. With an irrevocable trust, you permanently give up these rights.

Related Article | Intentionally Defective Grantor Trust

Which Is Better, a Revocable or Irrevocable Trust?

There's no one simple answer to this question because it ultimately depends on your goals and unique situation.

You may consider choosing a revocable trust if you want to have the flexibility to make changes and control over your assets during your lifetime. Irrevocable trusts are a good option for estate tax reduction. They also protect your assets from future creditors and lawsuits.

Related Article | Planning Trusts and Estates

Do Irrevocable Trusts File Tax Returns?

Yes, irrevocable trusts must file annual tax returns (Form 1041) if they earn more than $600 in yearly income.

Typically, if the trust distributes income to beneficiaries, they pay the taxes on their individual returns. If the trust keeps the income, it pays the taxes itself at trust tax rates. Trust tax rates for certain types of irrevocable trusts can be higher than for revocable trusts.

Do Irrevocable Trusts Need an EIN?

Generally, yes, irrevocable trusts need their own Employer Identification Number (EIN) from the IRS. This is because an irrevocable trust is a separate legal entity with its own tax obligations.

Who Pays Property Taxes on a House in an Irrevocable Trust?

The trust pays property taxes on any real estate it owns. The trust becomes the legal owner of the property, so it takes on all ownership expenses - including property taxes, insurance, and maintenance costs. Your trustee handles these payments using trust funds.

Are Irrevocable Trusts a Good Idea?

If you are okay with losing control over the assets in the trust and want to reduce estate taxes and protect assets from future creditors, then an irrevocable trust can be a good idea for you.

If you need more financial flexibility and an option to change your mind in the future, then consider setting up a revocable trust.

FAQs

What Happens to an Irrevocable Trust When Grantor Dies?

An irrevocable trust continues operating the same way after the grantor's death. The trustee continues managing the trust assets according to the original terms. The grantor's death doesn't trigger any automatic changes because the trust already operated as a separate entity during the grantor's lifetime. So, the beneficiaries continue receiving distributions according to the trust's original terms.

Are Irrevocable Trusts Protected From Creditors?

Yes, properly structured irrevocable trusts are typically protected from creditors. You no longer own the assets, so your future creditors generally can't reach them. That said, some states have a waiting period after transferring assets before creditor protection takes effect. If you transfer your assets to avoid existing creditors, the transfer can be seen as fraud.

Are Irrevocable Trusts Public Record?

Irrevocable trusts are typically private documents and stay confidential. Only the trustee, beneficiaries, and other legally involved parties can access the trust documents. However, if the trust becomes involved in litigation, some details might become part of the public court record.

What Assets Should Not Be Placed in an Irrevocable Trust?

Assets you might need to access, sell, or refinance should stay out of an irrevocable trust. This includes your retirement accounts (IRAs and 401(k)s) and any property you plan to sell soon.

How Long Does an Irrevocable Trust Last?

An irrevocable trust can often last for as long as there are still assets held in it and legal obligations that haven't been fulfilled. However, some states have limits on how long irrevocable trusts can last. Your trust document should specify when and how the trust terminates.

How Much Money Can You Put in an Irrevocable Trust?

There's no legal limit on how much you can put in an irrevocable trust, but keep in mind that you won't be able to withdraw this money if your financial situation changes.

The Bottom Line

Only slightly more than half of Americans have a will (40%) or trust (17%) in place, so the fact that you're researching different options shows smart thinking. But is an irrevocable trust the right option for you?

Irrevocable trusts have benefits for estate tax reduction and asset protection, but they also come with a loss of control. If that's fine with you, make sure to work with qualified legal and tax professionals to properly set up your trust in a way that serves your goals.