You may be thinking about setting up a trust to protect your assets, save on estate taxes, or perhaps set aside money for a special needs family member. Before you commit to a plan, make sure you understand the differences between the two basic types of trusts: the revocable (also called “living”) trust and the irrevocable trust. These differ in how they are structured and taxed, and each offers advantages and disadvantages depending on their purpose.
Both are tools for setting assets aside and distributing them according to specific wishes and instructions. They can protect one’s property, safeguard a family’s financial future, and provide tax-saving strategies.
As the name suggests, an irrevocable trust, once established, can’t be canceled or revoked. The person creating the trust, sometimes called the “grantor,” transfers assets into the trust and permanently gives up all claim to them. A trustee is appointed to carry out the instructions spelled out in the trust. No changes to the terms of the trust can be made without the consent of the trust’s beneficiaries.
In contrast, a living trust offers more flexibility. The grantor of a living trust still owns and controls the assets and can make changes at any time. A living trust also has a trustee, someone who would take over management of the trust if the owner is no longer capable of doing so.
Both types of trusts offer tax advantages, although these differ in key ways. An irrevocable trust is considered a separate entity and must have its own tax returns filed annually under its tax ID number. Irrevocable trusts can incur additional costs if a CPA is needed for tax preparation. Because it is a trust and not an individual, the irrevocable trust can’t qualify for the various deductions and exemptions that individuals can claim on their returns. Also, higher rates apply at lower income levels. For example, an irrevocable trust is subject to the highest federal tax rate of 37 percent if its income exceeds $12,500, a much lower ceiling than for individuals.
Assets within a living trust are still considered the property of the trust owner. Any income earned from this trust is filed along with the owner’s other income. Also, the assets of the trust belong to the owner’s estate and are taxed accordingly on the owner’s death. For this reason, wealthy families may choose to transfer a portion of their assets into an irrevocable trust to keep the value of their estate below federal and state exemptions, to avoid estate taxes on property above those exemptions.
Protecting Assets in the Future
One key advantage of irrevocable trusts is that their assets are protected from lawsuits and creditors. A living trust offers no such protection, because it is still part of the owner’s property. This is an important consideration for families with special needs children. Special needs trusts are generally set up as irrevocable trusts, because the beneficiary with special needs cannot earn a living and thus needs that money for the rest of his life. Also, the beneficiary has access to this money without losing his eligibility for government benefits such as Supplemental Security Income (SSI).
A living trust is an option for someone who doesn’t need all these layers of protection but still wants to set up some provisions for the future. She may want to set aside assets in the event that she becomes unable to manage her finances in the future, due to illness or old age, for example. With a living trust she controls the property while she is competent, but a trustee can take over this function should she lose this capacity.
If there are other considerations, such as estate tax planning, protection from creditors, or providing for a special needs family member, an irrevocable trust might be the better way to go. Your planner will have the best answers for your particular circumstances.
Keep in mind that this is general advice only and that specific situations may be treated differently than those described in this article. It is prudent to have an attorney’s advice on how your specific situation will be handled using different types of trusts.
This information is not intended to be a substitute for specific individualized tax, legal or estate planning advice as individual situations will vary. Neither Royal Alliance Associates, Inc., nor its registered representatives or employees, offer tax or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.
Securities and investment advisory services offered through Royal Alliance Associates, Inc. member FINRA/SIPC. Royal Alliance Associates, Inc. is separately owned and other entities and/or marketing names, products or services referenced here are independent of Royal Alliance Associates, Inc. Special needs consulting services are not offered through Royal Alliance Associates, Inc.
Content provided by the Academy of Special Needs Planners, Copyright 2020