When it comes to estate planning, it’s crucial to consider how your plan will affect your hard-earned legacy and the future of your beneficiaries. Forming a trust is one way to secure regular income for your loved ones and protect your estate from heavy taxation, but what should you really know about an irrevocable trust before you form one?
In other words, what is the downside of an irrevocable trust?
Before making any big moves with your money, knowing the ins and outs of irrevocable trusts helps you make an informed decision about whether this is right for you. Here’s a quick overview to help you decide if an irrevocable trust is the right move for your estate planning.
What’s an Irrevocable Trust?
In general, a trust in estate planning is designed to funnel some of your assets out of your taxable estate. They move funds and assets into a new and separate legal entity for your beneficiaries down the line. Of course, trusts are not a one-size-fits-all solution for everyone. There are two overarching categories that can be established known as revocable and irrevocable trusts.
A revocable trust allows you to change the terms of the trust at any given time. Since it is not a separate legal entity, it has more flexibility and freedom than an irrevocable trust. However, a revocable trust is retained in your estate for tax purposes. We would call it tax-transparent.
On the other hand, an irrevocable trust does not have this same degree of flexibility. As soon as the ink is dried on your legal documentation, no further changes to the trust can be made – at least, not without significant work and headache. It takes the assets out of your estate and allows your beneficiaries to forgo estate taxes on those assets, assuming the gifts occurred at least three years before death.
There are several types of irrevocable trusts you might investigate when it comes to your estate planning. These can include:
- Charitable remainder trusts
- Grantor-retained annuity trusts
- Spousal lifetime access trusts
- Life insurance trusts
Downsides of an Irrevocable Trust
If you have already decided that an irrevocable trust is the best tool for maximizing your estate and setting up beneficiaries for financial freedom in the future, you should know the downsides of this type of trust.
Here is what you should plan for before you set up an irrevocable trust for your loved ones.
More Difficult to Set Up and Modify
The most significant difference between a revocable and irrevocable trust is the difficulty of the initial setup and the difficulty in modification. Irrevocable trusts require more paperwork and legwork to get them funded and started.
However, you want to make sure you do it properly the first time because it is extremely difficult (and sometimes impossible) to make modifications to this type of trust.
Keep in mind that once you donate assets to an irrevocable trust, you automatically lose ownership of them. In this way, you lose some of the control when it comes to maintaining your finances. For example, if you’re considering funding a charitable remainder trust with real estate, you may not be able to live in the property.
Make sure you are positive about what you want to place in the trust before you make any decisions.
Filing Additional Tax Returns
You also have to think about the annual requirements of maintaining your irrevocable trust. In the eyes of the IRS, an irrevocable trust is a separate legal entity which means it needs its annual income tax return filed separately. You will need to file Form 1041 at a minimum and maybe also a Schedule K-1 for the trustee.
Upsides of an Irrevocable Trust
At first glance, it might seem as though an irrevocable trust is more hassle than it is truly worth. However, there are some great benefits that you will want to keep in mind when thinking about the formation of one of these trusts.
Protection from Creditors
Are you worried that your beneficiaries might be the victim of a lawsuit in the future? The good news is that an irrevocable trust is protected from creditors whereas a revocable trust might not be.
If your beneficiary works in an industry where they might be sued or you worry that they will rack up significant debt, this protects your financial legacy. An irrevocable trust may even be protected in the event of a divorce during the distribution of all assets.
Put your mind at ease and know that your beneficiary’s trust is protected by losing some of the control right now for their long-term gain.
Medicaid Qualification
If your loved one may require long-term care in the future, it is often best to allow them to qualify for Medicaid. Unfortunately, a substantial revocable trust fund may disqualify them from any kind of coverage under federal programs like Medicaid because these resources will be included in the assessment of income and assets.
On the other hand, an irrevocable trust does not qualify as an asset that would discourage you from applying to Medicaid for long-term care like a nursing home. Each state administers Medicaid a little bit differently, so you may want to check with an Elder Law attorney in your state.
Better for Taxation
Are you worried about how your loved ones will face taxation after your passing? One of the best benefits of an irrevocable trust is that you can transfer your assets into this trust and avoid paying estate taxes on them, no matter how large your overall estate may be. A revocable trust does not have this same benefit and may incur estate taxes.
Get in Touch with Magellan
When you’re ready to move forward with your estate planning, collaborate with experts to help set up your estate without spending all your hard-earned money on legal fees. If you want a one-stop shop for all your legal, financial, estate, and tax planning services, then Magellan is the right fit for you. We specialize in charitable remainder trusts (CRTs) to guide you in making strategic choices for your estate and your beneficiaries’ futures.
Contact us today to learn more about how we can help you establish an irrevocable trust to make the most of your estate!
This material provided by Kevin Meaders was written by Axle Eight, a non-affiliate of Magellan Planning Group and Cetera Advisor Networks LLC.
Estate planning/Legal Advice- This article is designed to provide accurate and authoritative information on the subjects covered. It is not, however, intended to provide specific legal, tax, or other professional advice. For specific professional assistance, the services of an appropriate professional should be sought.
Charitable Remainder Trusts- Such trusts are used to develop a vehicle for donations to a favorite charity, which also allows for the reduction of income taxes through a charitable deduction and favorable tax treatment at the date of the gift by non-recognition of built-in capital gains. AND The use of trusts involves a complex web of tax rules and regulations. You should consider the counsel of an experienced estate planning professional before implementing such strategies.