Introduction
A trust is a legal entity created by a document called a trust agreement. The agreement will spell out the trust’s purpose, who is in charge of managing the assets (known as the trustee), and who the trust is intended to benefit (known as the beneficiary). If you establish a trust during your lifetime, it’s known as a living trust. If your last will and testament creates a trust when you die, it’s called a testamentary trust.
While trusts can be formed for many purposes, one of the most common uses is an estate planning tool to replace a will (formally known as a last will and testament). Where a will directs how your assets should be transferred to heirs when you die, a trust actually takes ownership of your assets and can transfer assets to your heirs without going through probate.
Trusts also offer the added benefit of being able to direct how assets are used by your heirs, and it can shield the assets from misuse. For example, instead of gifting your children a lump-sum inheritance that may be carelessly squandered, a trust can withhold the principal value and only distribute investment income to the beneficiary. A trust can also withhold access to the principal until certain criteria are met, such as a child graduating from college. A trust can also dictate how the funds are used, such as for the purchase of the beneficiary’s first home.
What is a Revocable Trust?
A revocable trust allows the trust’s creator (known as the trustor or grantor) to retain ownership of the assets transferred to the trust. The grantor is allowed to freely access the assets, amend the trust agreement, and revoke or dissolve the trust if necessary. Often, the grantor will serve as the primary trustee and the primary beneficiary. In those cases, the trust agreement will appoint a successor trustee to manage the trust should the grantor die or become incapacitated, and a secondary beneficiary to receive the assets when the grantor dies.
Benefits of a Revocable Trust
The primary benefit of a revocable trust is its ability to avoid probate. Probate court can be costly and time-consuming process, prolonging the time your beneficiaries will have to wait to receive their inheritance, and eroding the ultimate value of their inheritance due to legal and appraisal costs. In terms of wasted time, most probate proceedings take a minimum of 4 – 6 months. If anyone contests your will, the process could take one or two years. In contrast, any of your assets transferred to the trust will transfer to your beneficiaries much quicker—sometimes in as little as a couple of weeks after your death.
Another common use of a revocable trust is to prepare for potential incapacitation. Should you ever become mentally or medically incapacitated, perhaps due to illness, a serious accident, or senility, a disability trustee can step in to manage your affairs for you. The disability trustee will not have no authority as long as you are alive and of sound mind, and should you regain your mental capacity, you can resume control as the primary trustee.
If you have minor or special-needs children, creating a trust for their benefit can be significantly easier than directly transferring assets to them. Most states require a court-supervised conservator or guardian administer funds owned by a minor or special-needs individual, which can turn into a major hassle. On the other hand, a trust is administered by the trustee of your choice, avoiding the need for a conservatorship or guardianship (financially—your minor children would still require a guardian to care for them).
As mentioned previously, a revocable trust allows you to do these things without sacrificing control or access to the assets in the trust. Should your financial situation ever change, it’s comforting to know that you can hit the reset button and make necessary changes to the trust.
What is an Irrevocable Trust?
In contrast, an irrevocable trust cannot be amended or revoked by the grantor. Once assets are transferred to the trust, they can only be accessed by the beneficiary according to the parameters in the trust document. You can form a living irrevocable trust during your lifetime, a testamentary irrevocable trust after your death, or, your living revocable trust will automatically irrevocable when you die.
Benefits of an Irrevocable Trust
The most common use for an irrevocable trust is to minimize your exposure to estate taxes. While assets transferred to a revocable trust will still count towards your final estate value, assets transferred to an irrevocable trust are completely removed from your estate. If you believe you may be at risk for estate taxes, lowering the value of your estate by transferring assets to an irrevocable trust could save you a significant amount of money in avoided taxes.
As a caveat, the money you transfer to an irrevocable trust is subject to gift taxes. Each year, individuals can gift $14,000 per person, and couples can give $28,000 per person. Anything above that would count towards your lifetime gift tax exemption, which is $5.49 million for individuals, and $11 million for married couples. That means an individual could transfer $14,000 a year to his trust, and a married couple could transfer $28,000 to their trust, without filing a gift tax return or affecting their lifetime gift tax exemption.
Transferring assets to an irrevocable trust have two additional tax benefits: avoiding capital gains taxes, and in the case of charitable trusts, increasing charitable contribution tax deductions. If done properly, transferring appreciated securities to a trust can bypass unrealized capital gains. If you make contributions to a charitable trust during your lifetime you can claim the tax deduction on that year’s income taxes; if you make contributions after your death, you can claim the deduction on your estate tax return.
Finally, assets in an irrevocable trust will not be considered for Medicaid planning. Normally you would be required to exhaust personal funds before the government will step in to help with the costs of a nursing home, but the government would not require you to access funds in your irrevocable trust. Having an irrevocable trust may allow you to maximize Medicaid benefits without depleting your children’s inheritance. Note, however, that some states require you to transfer the assets to the trust at least five years prior to your application for Medicaid. Any less, and the transferred assets may still be counted as part of your estate.
Can an Irrevocable Trust ever be Amended?
In some circumstances, an irrevocable trust can be amended with the permission of the trust’s beneficiary. This would entirely depend on provisions in the trust agreement.
Can a Living Trust Replace a Will?
Yes, a living trust can be used to replace a last will and testament. The creation costs of a living trust will be more than the cost of drafting a will, but bypassing probate with a trust can save a significant amount of time and money in the long run. Generally speaking, using a will is the preferable route for small estates (especially those under $100,000 that can skip probate with the small estate exemption), and a living trust makes sense for larger estates. That said, you may still want to include a pour-over will in your estate plan to catch any assets that you neglected to transfer to the trust.
Call our Arizona Estate Planning team at (480)467-4325 to discuss your case today.