By Jamie Johnson, WCI Contributor
When people hear the term “trust,” they might imagine spoiled teenagers waiting to receive an inheritance from their wealthy parents. But trusts can be an important part of estate planning, and you don’t have to be rich to set one up. There are two main types of trusts you can pick from—revocable and irrevocable trusts.
This article will review some of the pros and cons of each type of trust and help you determine which is the right option for you.
What Are Trusts?
A trust is a fiduciary relationship where a third party—known as the trustee—holds assets on behalf of a beneficiary. Many people utilize trusts to shield their assets and create a legacy for their families.
If you plan to transfer your assets to your children after you die, you could leave it to them in your will. But trusts offer several advantages that you won’t get with a will. For one thing, your beneficiaries will typically get access to the assets sooner with a trust. Plus, trusts allow you to decide how and when the funds will be paid out to your beneficiaries. If you’re worried one of your kids will blow through the money, you can direct the assets to be dispersed over time.
You can also prevent your beneficiaries from paying taxes and court fees with a trust, and certain types of trusts will shield your assets from any creditors your heirs may have.
What Is a Revocable Trust?
A revocable trust is often referred to as a “living trust” because it describes a trust you create during your lifetime. If you set up a revocable trust, you can change the terms at any time.
You can add new beneficiaries, remove existing ones, and change the terms for how the assets will be dispersed. You can also dissolve the trust at any time. But once the trustee dies, the trust becomes irrevocable.
Benefits of Revocable Trusts
- Avoid probate: A revocable trust helps your beneficiaries avoid a lengthy, expensive probate process—where a judge would decide which part of the estate goes to which heirs—and avoid them having to argue over the assets.
- More control: You’ll have more control over a revocable trust, meaning you can add or remove beneficiaries and even dissolve the trust altogether.
- Safeguards your wishes: A revocable trust ensures your wishes are carried out if you become incapacitated or die.
- Hold a variety of assets: Revocable trusts can hold various assets like real estate, bank accounts, investment accounts, and life insurance, among many others.
Disadvantages of Revocable Trusts
- No asset protection: A revocable trust will not protect your assets from creditors.
- No tax benefits: Revocable trusts don’t offer any tax benefits—your assets are still subject to income and estate taxes.
What Is an Irrevocable Trust?
An irrevocable trust is a trust that cannot be changed or dissolved once the document has been finalized. The only way you can alter the terms of the trust is with the permission of the trust’s beneficiaries.
When you set up an irrevocable trust, you give up control over your assets and create a separate tax entity. Most people do this to remove assets from their estate and minimize their estate taxes.
Benefits of Irrevocable Trusts
- Tax benefits: Assets you place in the trust may reduce your income tax liability (unless it is an intentionally defective grantor trust) and your estate tax liability, so it may be a good option for anyone with a large estate. Note that assets in the trust do not get a step-up in basis at the time of your death.
- Creditor protection: An irrevocable trust shields your assets from creditors and even legal claims related to your professional liability. The money is no longer yours, so it is no longer accessible to your creditors.
- Tax-free gift: If you leave real estate to your children, they won’t have to pay estate taxes on that property.
Disadvantages of Irrevocable Trusts
- Lack of control: Once you set up an irrevocable trust, you lose at least some control over those assets. Changes to the trust become harder or even impossible.
- Your financial situation could change: There’s always the chance that you could experience financial hardship in the future. Even still, your assets will remain locked up in the irrevocable trust. Irrevocable trusts need to be carefully drafted to account for all possible future scenarios.
Revocable vs. Irrevocable Trust
The main difference between a revocable and irrevocable trust is that you can change a revocable trust at any time. In comparison, you can’t change or cancel an irrevocable trust without permission from the beneficiaries.
Another big difference between these two types of trusts is who owns the assets within the trust. You’re creating an entirely new tax entity when you set up an irrevocable trust. The trust itself owns any property, bank accounts, or assets held within the trust.
The same is technically true with a revocable trust as well, but you’ll continue to have some level of control over those assets. And since the trust can be altered, the ownership can be changed.
Finally, an irrevocable trust will protect your assets from creditors and taxes. With a revocable trust, you still retain control over the assets, so it will not provide that same level of protection.
Can a Revocable Trust Become Irrevocable After Death?
Many people like revocable trusts because you have the option to amend or even dissolve the trust whenever you want. However, the trust will not stay revocable forever—it becomes irrevocable after the grantor dies.
Once the trust becomes irrevocable, it cannot be changed. Beneficiaries cannot be added or removed, and any assets included in the trust will stay in the trust. At this point, the trust becomes its own tax entity.
Should I Have a Revocable or Irrevocable Trust?
Trusts are a valuable estate planning tool, and they provide benefits that you won’t get with a will alone. If you want to maintain a high level of control over your assets, a revocable trust may be the right choice for you. Setting up a revocable living trust will cost more than a will, but, for a typical physician, it will likely be worth it in the end, especially if you can avoid probate. It can be done yourself by using online resources for as little as $100 but will probably cost $1,500-$3,000 for an estate planning attorney to ensure it is done correctly.
Most doctors should form a revocable living trust at some point in their life. It doesn't need to be done immediately after residency, but as you accumulate assets without a designated beneficiary, you'll want to establish one as part of your estate plan. Other than a will, which is needed as soon as you have children (even if you're dirt poor), and designating appropriate beneficiaries on retirement and life insurance accounts, setting up a revocable living trust is the next most important estate planning step to take.
If you have a large estate and are looking for asset protection, especially if you're going to run up against the federal estate tax exemption limit of $12.06 million ($24.12 million if married) [in 2022], an irrevocable trust may be the best way to go. However, most people and many white coat investors will not have to worry about estate taxes.
The best way to determine which is the right choice for you is by speaking to an estate planning attorney. A knowledgeable attorney can advise you on the best course of action and help you form a plan to reach your financial goals.
Have more questions about estate planning or protecting your assets? Hire a WCI-vetted professional to help you sort it out.
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