Understanding the Nuances of Irrevocable Trusts

Updated: November 24, 2023

When your client has a significant amount of assets or an estate of significant value, passing these on to their heirs without paying hefty taxes can pose a problem. A possible solution to this is to set up an irrevocable trust.  

With an irrevocable trust, not only can heirs pay less or even avoid estate taxes, but they may also benefit from certain government benefits – all this while protecting the assets.  

In this article, we discuss important information about the irrevocable trust; how it works, what benefits it offers, and what disadvantages it may have.  

For financial advisors with some expertise in estate planning, we hope this article serves as a refresher. You can also use it as a client education piece that you can share more widely. 

Terms to Remember 

In a discussion about trusts, here’s a quick review of important terms:  

• Grantor – the individual who transfers ownership of assets to the trust.  
• Trustee – This can be a person or corporation assigned the responsibility of managing the assets in the trust. The trustee must also carry out the terms of the trust, including its purpose and functions. Trustees have a fiduciary responsibility to the beneficiaries of the trust. 
• Beneficiary – The person for whom the trust was created for; the one intended to benefit from the trust.  
• Irrevocable trust – This is a legal arrangement where an individual or corporate trustee holds assets for the benefit of one or more beneficiaries. The purpose of this is usually outlined by an attorney named in the trust’s document. The trust takes full ownership of the assets once they are transferred into the trust.  
• Settlor – The individual or entity that establishes a trust. The settlor can also be called by other names, including donor, grantor, trustor, or trustmaker. Their role is to legally transfer control of an asset or assets to a trustee, who manages them for one or more beneficiaries. 

The interpretation of the trust’s provisions is done in line with state laws. Local courts can refer to the trust document to determine if a beneficiary has control of fund distribution. Should the court rule that the beneficiary does not have control, then:  

• assets in the trust cannot be deemed a marital asset in a divorce 
• assets in the trust are not accessible to creditors 

However, some courts can decide to look beyond issues of control. As straightforward as the provisions in a trust may seem, the design and language of the trust can make it more complex.  

Establishing an Irrevocable Trust 

Establishing or setting up an irrevocable trust can be a simple process. All it requires are these steps:  

1. The grantor establishes the trust by designating a third party as the trustee. 

2. The grantor then names the beneficiary or beneficiaries of the trust.  

3. Finally, the grantor transfers ownership of their assets into the trust. By doing this, the grantor relinquishes ownership of these assets, giving full control of them to the designated trustee.  

Note that once the trust is created, the assets are no longer part of the grantor’s taxable estate. 

Common Types of Irrevocable Trusts 

 There are many different types of irrevocable trusts. The list below is a sampling of some of the most common types of irrevocable trusts available. While most of these types of trusts can deliver the goods, it’s best to consult a lawyer to know which one suits your estate planning needs.

Dynasty trusts / Generation-skipping trusts 

These trusts are meant to shelter your children or even multiple generations of heirs from estate tax. One of the features of a generation-skipping trust is that you can leave money to grandchildren or other relatives who are at least 37 ½ years younger than you.  

Grantor-Retained Annuity Trusts (GRATs) 

Also known as Qualified Personal Residence Trusts (QPRTs), the GRAT is an irrevocable trust that enables the grantor to place certain assets in a temporary trust and freeze its value. By doing this, additional appreciation is removed from the grantor’s estate, leaving it to the heirs with a minimal estate or gift tax liability. During the GRAT’s term, the trust pays an annuity to the grantor, so the assets in the GRAT are considered returned to the grantor.   

Special needs trusts 

Also called supplemental needs trusts, special needs trusts can give financial support to people who have functional needs. What’s more, this type of trust won’t interfere with government benefits they’re already receiving, like Medicaid or the Supplemental Security Income (SSI). 

Spendthrift trusts 

This is appropriate when beneficiaries can’t seem to make good financial decisions for themselves. The main feature of this trust is that the trustee places limits on the assets, according to specific features set by the grantor.  

Charitable Remainder Trusts (CRTs)

Also known as Charitable Lead Trusts or pooled income trusts, this type of trust allows the grantor to leave any remaining assets to a charity they choose.   

What is the difference between Revocable and Irrevocable Trusts? 

In the effort to establish a revocable trust, you may encounter its opposite, the revocable trust. The main difference between them is in the degree of control.  

In a revocable trust, the grantor of the trust retains control of the assets within the trust. Grantors in a revocable trust also have the option to remove these assets from the trust, change any of the beneficiaries, and finally, revoke or terminate the trust.  

As for an irrevocable trust, the grantor relinquishes control of the trust and its assets entirely. If an asset is placed in the irrevocable trust, the grantor cannot remove it from the trust. Likewise, the grantor does not have the option of making any changes or amendments to the trust, such as changing any of the beneficiaries, changing any terms of the trust, or cancelling it.  

Another significant difference between the two is that irrevocable trusts provide tax benefits while revocable trusts do not. Irrevocable trusts pay for their own income tax and a separate tax return is filed, and they are exempt from estate tax.  

Read more: Choosing between a revocable vs irrevocable trust 

Will? Trust? #RevocableTrust? #IrrevocableTrust? Read attorney Luthringshausen’s latest article as she answers a #FAQ re. the difference between #estateplanning documents & which one is right for you or your loved one. https://t.co/ddcI0yF00R #will #trust #protectyourassets

— Lavelle Law (@LavelleLaw) November 6, 2023

Can irrevocable trusts be changed?

Yes. However, the only instances where an irrevocable trust can be modified or amended are if the grantor has the permission of the beneficiaries, or the grantor must do so via court order. 

Benefits of an Irrevocable Trust  

1. It can reduce the potential estate tax 

This is the main benefit of an irrevocable trust. In some cases, assets left to the heirs of an estate can appreciate considerably, which can mean considerable estate taxes. If the assets were placed in an irrevocable trust, they would not be subject to estate tax and can still increase in value.  

Federal estate taxes can range from 18% to 40%. These apply to assets worth over $12.06 million in 2022, $12.92 million in 2023.  

Some states have their own estate taxes and also tax smaller estates. In the future, the threshold for federal estate tax exemptions can become lower, making trusts even more viable for estate planning.  

2. Allows for multi-generational planning 

Irrevocable trusts can be designed to transfer assets to younger family members, thus preserving or creating intergenerational wealth.    

3. Allows for some flexibility in the trust 

There are some features in an irrevocable trust that a grantor can use to make it more suited to their needs. The power of appointment allows the grantor to assign a person or entity they deem fit to serve as trustees or choose beneficiaries themselves. Trust Protectors who assist trustees in delivering the grantor’s wishes may also be included in the trust.  

4. Protects the assets from creditors 

As the grantor no longer controls the assets, creditors cannot touch the assets if the grantor has outstanding debts. This makes the irrevocable trust an effective way to protect the assets.  

5. Allows you to get some government benefits 

In case you need to get Medicaid, you can place assets in an irrevocable trust, so it doesn’t count against your asset limit. By putting assets into the trust, you may not have to use up all your savings and assets before qualifying for assistance.  

Be sure to start the trust at least five years before you plan or need to get Medicaid and avoid the Look-Back Period. This can be extremely helpful in preserving wealth for your heirs. 

Read more: Why an irrevocable life insurance trust is a smart financial move 

Potential Drawbacks and Risks 

1. Irrevocable trusts can be rigid 

While there is some flexibility in designing a trust, there is very little flexibility once the terms are in place. If any adjustments or changes are to be made to a trust, all the beneficiaries must agree to the changes, or a court order must be issued.  

2. Life insurance can be taxable 

If life insurance is included in the assets of your irrevocable trust and you happen to pass away within the next 3 years, the insurance payout returns to your estate and is therefore subject to estate taxes. This is commonly known as the 3-year rule. 

3. Eligibility for government benefits can be impacted 

If you’re a senior citizen and need long-term care from Medicaid, your assets can render you ineligible. This is due to the 5-year rule (or 5-year Look-Back Period) of Medicaid, and its asset or resource limit. To qualify, the assets you have should not exceed this limit.  

Medicaid asset protection trust is one type of asset protection trusts strategies for estate planning. Learn more and try out some other strategies in this guide.

Should you need to go on Medicaid within five years (2.5 years in California) of establishing the trust, you might end up paying for a nursing home yourself.  

Remember that the Look-Back Period is intended to prevent Medicaid applicants from gifting assets or even selling them for less than fair market value just to be eligible for the program. 

Tax Considerations and Implications  

Irrevocable trusts have certain tax implications. In general, these trusts can be classified as Grantor or Non-Grantor Trusts, which have different rules on taxation.  

Grantor trusts 

In a grantor trust, the trust is treated as identical to the settlor, requiring them to report all income and deductions with respect to the trust on their own individual income tax returns. Under current law, the payment of tax liabilities by the settlor that the trust would otherwise pay is, essentially, a tax-free gift to the trust each year.  

Payment of the trust’s tax liabilities by the settlor allows them to further deplete the assets in their own name (which are then subject to estate tax at the time of their passing) without using any of the settlor’s gift or estate tax exemption. 

Non-Grantor trusts 

When classified as a non-grantor trust, the trust is considered as a separate individual taxpayer, and the trustees are required to file annual income tax returns for the trust (these are considered as fiduciary income tax returns). The trustees must report all matters of income and deductions of the trust. 

Generation-Skipping Transfer Tax (GSTT) 

This federal tax is meant to allow grandchildren to receive an inheritance from their grandparents as if it were given by their parents. The GSTT is a flat rate of 40%.  

A grantor wanting to create a trust for their grandchildren’s and more remote descendants’ benefit should consider:  

• Whether it would be more beneficial to make the trust a grantor or non-grantor trust 
• Whether to utilize any unused GST exemption to the transfer of assets to fund the trust  
• Whether an accumulation period should be imposed before the beneficiaries become eligible or entitled to distributions 

The Role of the Trustee

Here are some of the duties of a trustee in an irrevocable trust:  

• Act as a fiduciary: This means that the trustee must administer the trust in accordance with the grantor's wishes. 
• Ensure the assets are safe: Trustees must account for the funds and assets within the trust, as well as know the beneficiaries and their rights. They must also ensure trust assets are managed separately from other assets. 
• Administer the trust: Keeping records of all transactions and distributing assets as required. 
• File reports: Reporting to state and federal regulators as needed, while updating the beneficiaries. 
• Make decisions: Sometimes, trustees must decide on what to do with the assets. These decisions must align with the grantor's wishes. 
• Talk to beneficiaries: Trustees should email, call, or use other communication methods to reach out to beneficiaries. Beneficiaries should clearly understand the grantor's wishes for the trust, and the trustee should be prepared to answer questions. 

Trustees not only have roles, but they also have certain powers that allow them to execute the wishes of the settlor in the trust. In this video from an estate planning attorney in Louisiana, he lists at least six different powers of trustees. These trustee powers can vary from state to state.  

Is an irrevocable trust right for your clients? 

An irrevocable trust can meet an individual’s estate planning needs, but that ultimately depends on their personal circumstances.  

In most cases, an irrevocable trust is best used as an estate planning tool for individuals who have assets that have a high potential for appreciation. Examples of these assets include real estate, mutual funds, life insurance, and shares of stock.  

To avoid problems in estate planning, it’s best to write a will and consult an expert estate planner to help in setting up the trust. 

Read more: Best uses of an irrevocable trust 

Is an irrevocable trust something to consider for estate planning? Let us know in the comments!