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What You Need to Know About Revocable vs. Irrevocable Trust Taxation

What You Need to Know About Revocable vs. Irrevocable Trust Taxation

January 09, 2024

Dealing with taxation and the federal government can be tricky even in the simplest of situations. If you have a large estate, you may face even more issues when it comes to trying to minimize the out-of-pocket costs associated with taxes. Forming a trust is one way to help put your affairs in order, but there are a couple of types you may consider.  

What should you know about revocable vs. irrevocable trust taxation?  

Before you meet with a financial or legal professional to form a trust of any kind, here are some of the basics around how they will impact your overall taxes and form your legacy. 

What is an Irrevocable Trust? 

An irrevocable trust is a less flexible way to transfer some of your assets out of your estate. Once the trust is set up, you can no longer make changes to the assets, beneficiaries, and other aspects of the trust. If you do require a change to be made, you might need to seek out a judge’s approval before making alterations of any kind. 

However, there is a major benefit to taxation on an irrevocable trust: whatever you place inside the trust is no longer a part of your larger estate. When you pass away, they will not be subject to the estate taxes on the rest of your belongings, assets, and cash accounts. This is a major perk for anyone who is set on what should happen to their assets after their passing.

Since an irrevocable trust is a separate legal entity, the trust must file annual income tax returns.

A charitable remainder trust (CRT) is a specific type of irrevocable trust that can be beneficial for estate planning. In this trust, you will donate assets that will provide income to a named beneficiary for a set period or for life. You can even act as your own beneficiary. At the end of the term, the remainder is given to a charity (or charities) of your choosing (as required by the 10 Percent Rule). 

A benefit to a CRT is that the trust is tax-exempt. It also allows you to avoid capital gains tax on some assets included within its parameters. And, of course, you can include charitable giving in your estate planning and support a cause you care about.

What is a Revocable Trust? 

A revocable trust offers far more options for maintaining your wealth after the formation of this type of trust. While an irrevocable trust is not easily altered after its creation, a revocable trust allows you to make changes at any point during your lifetime. This means you can continue to add assets, change beneficiaries, and even sell some of the property contained within the trust. 

The only thing to note here is that the trust becomes irrevocable upon your passing. This makes it crucial that you name a successor trustee to inherit the assets and funds contained within the trust before your passing. 

Of course, there is a major downside to a revocable trust: namely, it does not have any of the tax benefits found in irrevocable trusts. If minimizing your out-of-pocket costs on taxes is the primary driving factor behind separating your assets into a trust, then a revocable trust may not be the right move. 

Revocable Trust vs. Irrevocable Trust: Which is Best for You?  

How do you decide which type of trust is the right option for you, your finances, and your loved ones who will inherit it upon your passing? Here is a quick rundown of when you might want to fund both varieties. 

When to Choose a Revocable Trust

If you want the freedom and flexibility to make changes to your wishes over time, a revocable trust is often the best solution. However, there are other reasons to select this as well. 

Some of the primary reasons to choose a revocable trust over an irrevocable trust include:

  • The desire for private transfer of assets without probate
  • Owning assets in multiple states and wanting to avoid probate in another state
  • Using the assets included in the trust without restriction
  • The value is less than the federal estate tax exemption
  • The ability to act as your own trustee with a successor trustee to manage after your passing
  • You like to change your beneficiaries 

When to Choose an Irrevocable Trust

On the other hand, an irrevocable trust may be the better solution for some people even though you will not be able to easily make changes once it is set in motion. Some of the other benefits of an irrevocable trust include: 

  • Protection from creditors
  • Qualification for Medicaid (assets no longer count as part of your estate)
  • Estate value is above the federal estate tax exemption
  • Provide maximum security over multiple generations 

If you still are not sure what type of irrevocable trust to set up, you may want to consider a charitable remainder trust. This is a good option if you want to form a type of irrevocable trust with some excellent tax benefits. 

With a CRT, you can avoid capital gains tax when selling assets (such as real estate) and also remove them from your taxable estate. Since a portion of the assets will be donated to a charity of your choosing, you can also benefit from a charitable tax deduction.

Get Help from the Experts at Magellan

Magellan Planning Group understands how critical it is to select the right type of trust that can minimize your taxes and provide a financial legacy after your passing. We provide comprehensive estate, legal, and financial services with an eye toward tax planning. If you have ever thought that a charitable remainder trust is right for you, we can help with every step of the process. 

If you are ready to tackle estate planning, get professional guidance from Magellan. We are your one-stop shop for everything related to your CRT. Contact us today to learn more about our help and processes for making the most of your assets!

This material provided by Kevin Meaders and written by Axle Eight a non-affiliate of Magellan Planning Group and Cetera Advisor Networks LLC.

For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.