Will I Need to Pay Capital Gains Taxes on My Irrevocable Trust?

Older couple considers which kind of trust would be best
Older couple considers which kind of trust would be best

A trust is an estate planning tool that you may consider using if you want to go beyond drafting a last will and testament. One key thing to decide is whether to establish a revocable or irrevocable trust. Both have their pros and cons and one may be more appropriate than the other, depending on your financial situation and needs. If you’re thinking of adding a trust to your financial plan, it helps to know how the two compare.

Consider working with a financial professional to incorporate estate planning into your financial plan. Find a financial advisor today.

What Is a Trust?

Before taking a closer look at revocable and irrevocable trusts, it helps to know what a trust is. In simple terms, it’s a legal entity that allows you to transfer assets to the ownership of a trustee.

A living trust can be revocable or irrevocable. You can act as your own trustee or name someone else to do the job. A trustee – whether it’s you or someone else – assumes a fiduciary role, meaning that they’re required to act in the best interests of the trust beneficiaries.

Beneficiaries are the people you name to benefit from the trust. So, for example, you might set up a trust fund for the benefit of your spouse or children. When you create the trust document, you can spell out exactly how you want the assets in the trust to be managed and distributed to beneficiaries. It’s the trustee’s job to make sure your wishes are followed.

Not everyone needs a trust; for some people, a will may be sufficient. But if you have substantial assets that you plan to pass on, either to your family members or as part of a charitable giving plan, a trust can make doing so easier.

Revocable vs. Irrevocable Trust: What’s the Difference?

There are many different types of trusts you can establish. For example, there are grantor trusts, A/B trusts, testamentary trusts, special needs trusts – but they all have one thing in common. All of these trusts are either revocable or irrevocable.

What is a revocable trust? Simply, it’s a trust that can be changed or terminated at any time during the lifetime of the grantor (i.e., the person making the trust). So that means you could:

  • Add or remove beneficiaries at any time

  • Transfer new assets into the trust or remove ones that are already in it

  • Change the terms of the trust concerning how assets should be managed or distributed

  • Terminate the trust completely

When you pass away, a revocable trust automatically becomes irrevocable. That means no further changes can be made to its terms.

An irrevocable trust is essentially permanent. If you set up an irrevocable trust during your lifetime, any assets you transfer to the trust would have to remain in the trust. You couldn’t add or remove beneficiaries or change the terms of the trust.

Revocable Trust Pros and Cons

The main advantage of choosing a revocable trust is flexibility. A revocable trust allows you to make changes, whereas an irrevocable trust does not. That’s helpful if you’re concerned about your financial situation or needs changing at some point and you want to make sure your trust can still meet those needs.

A revocable trust can also offer peace of mind if you’re worried about becoming incapacitated and not being able to manage your assets. As long as your trust document is clear on what you want, then your trustee is bound to follow your wishes. Revocable trusts can also allow your heirs to bypass probate once you pass away.

One downside is that a revocable trust doesn’t offer the same type of protection against creditors as an irrevocable trust. So if you’re sued, creditors could still attempt to attach trust assets to satisfy a judgment. Also, assets in a revocable trust are part of your taxable estate, meaning they are subject to federal estate taxes when you die. Federal estate taxes are due for any amount above the current exemption, which in 2022 is $12.06 million for individuals and $24.12 million for married couples.

Irrevocable Trust Pros and Cons

In addition to protecting assets from creditors, irrevocable trusts can also come in handy for managing estate tax obligations. From a tax standpoint, assets are owned by the trust, not you, which makes it possible to sidestep estate taxes. Holding assets in an irrevocable trust can also be useful if you’re trying to qualify for Medicaid to help pay for long-term care and want to avoid having to spend down assets.

The downside to irrevocable trusts is that you can’t change them. And you can’t act as your own trustee either. Once the trust is set up and the assets are transferred, you no longer have control over them.

Revocable vs. Irrevocable Trusts: Which Is Better?

Whether a revocable or irrevocable trust will work better for your estate plan depends on what you need a trust to do for you.

A revocable trust might be preferable when,

  • The value of your estate is less than the federal estate tax exemption

  • You want to retain the use of and control over your own assets without restriction after establishing the trust

  • You want the transfer of your assets to your heirs to be private and avoid the probate process in any state where you have assets

An irrevocable trust might be preferable when,

  • The value of your assets exceedss the federal estate tax exemption

  • You don’t mind giving up use or control of your own assets after establishing the trust

  • You want to protect your assets from creditors. Since assets in an irrevocable trust aren’t considered available to you, they are protected from certain creditors and lawsuits.

Talking with an estate planning attorney can help you decide whether a revocable or an irrevocable trust is best or whether you even need a trust at all. From there, you can further explore the different trust options you can set up to manage your assets.

The Bottom Line

A multi-generational family
A multi-generational family

Revocable and irrevocable trusts can serve different purposes in an estate plan. They can be used alongside a last will and testament to make sure your wishes are followed. When considering a trust, think about what you need it to do for you and your beneficiaries in the short- and long-term.

Tips for Estate Planning

  • Consider talking to your financial advisor about incorporating trusts and other estate planning tools into your financial plan. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors who serve your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.

  • There are certain things a will can do that a trust can’t, so it’s important to make sure you’re covering all the bases in your estate plan. For example, you can use a will to name legal guardians for minor children.

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The post Revocable vs. Irrevocable Trusts appeared first on SmartAsset Blog.

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