The difference between a revocable trust and irrevocable trust can be the difference between losing property and protecting it as a legacy for future generations. Although the revocable/irrevocable trust distinction may seem obvious, this article explains the distinction’s importance for a variety of estate planning goals.
Revocable and Irrevocable Trust Examples
Imagine two brothers named Bill and Joe, who each inherit $1 million and decide to create trusts for the benefit of their children. Neither brother has other assets worth as much as their $1 million inheritance. Bill creates a revocable trust and transfers his $1 million to the trust because he wants to control all aspects of his property so that he can remove assets and switch beneficiaries at any time. Joe creates an irrevocable trust and transfers his $1 million to the trust without keeping any rights to alter the trust or even to change his mind.
Example 1. During a downturn in the economy, both brothers fail in their businesses, and creditors come after them as a result.
- Bill loses nearly $900,000 worth of property held in trust for his kids because his retained control of the revocable trust exposed his assets to creditors.
- Joe, on the other hand, has protected his assets for his children by having decided to give up ownership, thereby shielding those assets from creditors.
Example 2. Assume the same facts as Example 1. Both Bill and Joe suffer strokes two years after transferring their inheritances to their trusts. Although their conditions stabilize enough for them to live another decade, the brothers need 24-hour care in a nursing home that charges $81,000 per year for room and board.
- An elder law attorney helps Bill’s wife transfer the remaining $100,000 of Bill’s inheritance to herself as part of her federally-protected resource allowance, and obtain Medicaid coverage to pay Bill’s nursing home fees.
- Sadly, Joe’s $1 million transfer to his irrevocable trust disqualifies him from Medicaid eligibility, so his wife must care for him at home until Medicaid’s five-year look back period expires three years from now.
Example 3. Assume the same facts as Example 1. Both Bill and Joe suffer strokes five years after transferring their inheritances to their trusts and their wives are deceased. Although their conditions stabilize enough for them to live another decade, the brothers need 24-hour care in a nursing home that charges $81,000 per year for room and board.
- An elder law attorney helps Bill’s children salvage about $60,000 of Bill’s remaining $100,000 of inheritance, and obtain Medicaid coverage to pay Bill’s nursing home fees.
- Joe’s transfer of his $1 million to his irrevocable trust before Medicaid’s five-year look back period protects his entire inheritance and he still qualifies for Medicaid assistance to pay nursing home fees.
General Information About Trusts
A trust is a relationship that a person creates by entrusting money or almost any other kind of asset or interest in property to a trustee to manage and distribute under terms and conditions specified by the entrusting person. Language in person’s last will and testament can establish a trust after the person’s death (called a “testamentary” trust). However, this article focuses on trusts that the entrusting person (called the “grantor,” “settlor,” or “trustor“) establishes during their lifetime (called “inter-vivos” trusts) as revocable and irrevocable trusts.
Trust creation formalities differ among states’ trust laws. For example, while the Indiana Trust Code requires written evidence of the trust’s terms and conditions signed by the settlor or the settlor’s agent under a power of attorney, the Illinois Trust Code validates an oral trust if clear and convincing evidence can prove the trust’s existence and its terms. Also, although the Indiana Trust Code includes the presumption that a trust is revocable unless the trust agreement or declaration of trust specifies otherwise, the Illinois Trust Code offers no presumption about a trust’s revocability.
In most states, you can transfer almost any kind of asset to a trust, including real estate, personal property, bank accounts, certificates of deposit, cash, vehicles, boats, planes, antiques, collections, jewelry, or other valuable items or interests.
Differences Between Revocable And Irrevocable Trusts
The definitions of revocable and irrevocable trusts are self-explanatory: a settlor can amend or revoke a revocable trust, but the settlor cannot amend or revoke an irrevocable trust. The consequences of those distinctions include:
- The settlor’s direct or indirect ability to change beneficiaries and trust property;
- The settlor’s unlimited or limited asset availability;
- Estate tax or gift tax consequences; and
- Vulnerability or protection against creditors’ claims.
Most of us like to control our environments. A settlor can modify a revocable trust at any point before their death. For example, a settlor can make these changes to a revocable trust :
- Add, remove or exclude beneficiaries
- Create spendthrift limitations to control a beneficiary’s use of their share of trust property
- Add or remove the type and length of stipulations
- Change how and to whom particular assets are distributed
- Alter specific behavior required of beneficiaries
- Modify terms, timings, and amounts of distributions
Generally, a settlor cannot take any of these actions directly concerning an irrevocable trust during the settlor’s lifetime:
- Amend or otherwise change the irrevocable trust’s provisions concerning beneficiaries or trust elements
- Withdraw or use the trust property for the settlor’s personal benefit or for the settlor’s close family members
However, an experienced estate planning lawyer may suggest including subtle rights and powers for the settlor to influence an irrevocable trust such as:
- Appointment of the settlor as the trustee (with limits on the trustee’s power to take self-interested actions)
- Power to make a Will that overrides some of the irrevocable trust’s provisions after the settlor’s death when the probate court admits the Will to probate (a “testamentary power of appointment”)
- Power to trade property inside the trust for property outside the trust of comparable value (a “power of substitution”)
- Power to remove or replace a current or successor trustee
A specialized kind of irrevocable trust called a “qualified personal residence trust” (“QPRT”) permits a settlor to transfer the settlor’s residence to the trust and continue occupying the residence for a specified period of time.
Another general rule about an irrevocable trust prevents people from terminating the trust until the trust fulfills its purpose. To resolve or avoid unjust outcomes, trust laws include exceptions to modify or terminate a trust such as in cases of fraud, a settlor’s mistake of facts, or an unforeseeable change of circumstances that defeats the trust’s purpose.
2. Trust Property Possession And Enjoyment
The settlor’s rights to possess and enjoy assets that the settlor transfers is another big distinction between revocable and irrevocable trusts. Although the trust is the legal owner of the trust property, a revocable trust gives the settlor almost the same power over the trust property that the settlor held before the transfer. By contrast, a typical irrevocable trust restricts or prohibits a settlor’s right to possess and enjoy the trust’s property (see the discussion of exceptions in Adaptability And Flexibility, above).
A revocable trust settlor’s continued rights to modify the trust and enjoy rights to possess and enjoy the trust’s property expose the trust property to the settlor’s financial vulnerabilities. Ownership rights also allow for the attachment of your assets. Be aware that by retaining ownership, the trust assets lose the protections against seizure by the courts or creditors.
3. Estate Tax And Gift Tax Consequences
A revocable trust settlor’s continued rights to modify the trust and enjoy rights to possess and enjoy the trust’s property expose the trust property to the federal estate tax upon the settlor’s death (and estate tax under state law in states like Illinois). Married couples with wealth above the estate tax exemption ($11.7 million per decedent in 2021) sometimes divide wealth between the spouses’ separate revocable trusts to use each spouse’s tax exemption (a combined exemption total of $23.4 million in 2021). Still, the 40% federal estate tax threatens all assets exceeding the estate tax exemption limits.
Some people transfer wealth to irrevocable trusts to protect their assets from the federal estate tax. Although that strategy may avoid the estate tax, Congress created the gift tax and a generation-skipping transfer tax to prevent wealthy people from eliminating all tax liability. The same tax exemptions and tax rates apply to wealthy people’s gifts as exemptions and tax rates on their estates. Congress also tied the gift tax exemptions to the estate tax exemptions, so large gifts that use the gift tax exemptions reduce the federal estate tax exemptions by the same amounts.
Most wealthy people have assets that produce income and increase the taxable value of their estates. To reduce the growth of their taxable estates, some people transfer their income-producing assets to irrevocable trusts so the trust’s beneficiaries will receive the resulting growth free of estate and gift taxes.
4. Protections Against Creditors
A typical irrevocable trust denies the settlor’s creditors access to the trust’s property because the settlor no longer owns the property. By contrast, a revocable trust settlor’s free access to the trust’s property exposes the trust property to creditors’ claims.
Generally, an irrevocable trust protects its assets from the settlor’s bankruptcy, business failures, and other types of civil liability. However, federal bankruptcy laws and some state laws permit creditors to recover an irrevocable trust’s assets if the settlor transfers assets to the trust near or after the point of the settlor’s financial crisis.
As the examples at the beginning of this article indicate, an irrevocable trust can also shield assets from long-term care expenses if the settlor transfers the assets to the trust more than five years before applying for Medicaid. However, people should not transfer assets to protect them from long-term care expenses without the advice and assistance of an expert elder law attorney.
Probate Avoidance Through Revocable And Irrevocable Trusts
Both revocable and irrevocable trusts remove property from their settlors’ probate estates (see our recent article, “What Executors (Personal Representatives) Need To Know,” for an explanation of probate property and probate administration). If a settlor transfers enough assets to the trust to reduce the probate personal property value below the state limit ($50,000 in Indiana and $100,000 in Illinois), the settlor’s family will not need to open a probate estate to administer the assets after the settlor’s death.
Revocable Trusts And Irrevocable Trusts Are Lawyers’ Planning Tools
An experienced estate planning lawyer uses wills, trusts, and other legal devices as estate planning tools like a master builder uses hammers, saws, and other equipment to construct a building. For almost three decades, Hawkins Elder Law has helped personal representatives, trustees, and guardians fulfill their administrative duties. The firm’s lawyers also work year-round with their estate, trust, and elder law colleagues to study and propose improvements to the Indiana laws that affect their clients.
About the Authors
Jeff R. Hawkins and Jennifer J. Hawkins co-author this blog with Thomas E. Hynes, a lawyer admitted to practice in Pennsylvania, New Jersey and Florida who has a background in estate planning and elder law. Jeff and Jennifer are Trust & Estate Specialty Board Certified Indiana Trust & Estate Lawyers. They are also active members of the Indiana State Bar Association and the Indiana Chapter of the National Academy of Elder Law Attorneys (NAELA). Jeff is also a member of the Illinois NAELA Chapter.
Jeff is a Fellow of the American College of Trust and Estate Counsel and the Indiana Bar Foundation. He is also a member of the Illinois State Bar Association and he served as the 2014-15 President of the Indiana State Bar Association.
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