What is an irrevocable trust and how does it work?

A trust you can’t change, except under certain legal circumstances.

Elissa

Elissa Suh

Published June 20, 2019

KEY TAKEAWAYS

  • The grantor (also called a trustmaker or settlor) cannot change an irrevocable trust

  • Legal conditions must be met to make a change

  • Irrevocable trusts have benefits that a revocable living trust does not

  • You can protect your assets and qualify for Medicaid benefits

As an alternative to a will, you might place your assets into a trust, a legal entity with rules as to how your belongings and property are distributed to your heirs. The grantor, or trustmaker, can change the terms of the trust, like who the beneficiaries are and what assets are distributed. An irrevocable trust is one that can’t be revoked — meaning it cannot be changed, modified or cancelled, except under certain circumstances.

Deciding to open an irrevocable trust as part of your estate planning can be a gamble. Let’s say you are having financial difficulties and want to sell some real estate that you placed into a trust. If the trust is irrevocable, then you would not be allowed to sell those assets because the trust would own them.

While the prospect of not being able to make changes is daunting, irrevocable trusts come with advantages. They can help you overcome the income requirement for Medicaid and offer tax benefits. However, in order to make use of these tax advantages, you’ll need to have a very large estate. For this reason, it’s helpful for very wealthy individuals.

In this article:

How an irrevocable trust works

Once you’ve opened a trust you’ll designate a trustee and beneficiary. The trustee is the person who manages the trust. He or she can be one of the beneficiaries, or heirs, but not the grantor. Beneficiaries, can be family, friends, or entities like businesses and non-profit organizations, but again not the grantor.

When you transfer your assets into an irrevocable trust, you relinquish control of them. The trust is now the owner of the assets, which you’ll retitle or register in the trust’s name. The assets are no longer yours, and have no bearing on your wealth, the value of your estate, or your tax liability.

In fact, the trust is governed by its trust document and even has its own tax identification number. The trustee is responsible for paying taxes owed by the irrevocable trust (with trust funds). We’ll discuss the tax advantages more in depth later.

Once the grantor passes away, the trust assets will be distributed to the beneficiaries. One of the advantages of a trust is that you stipulate the terms for how the beneficiaries receive their assets. For example, you might forbid them from withdrawing funds until they reach a certain age.

Irrevocable trusts also offer asset protection from future creditors and lawsuits. You cannot be asked or forced to give up assets in the trust in the event that you’re sued. They’re also shielded from recovery for long-term care expenses. But if there are current creditors with a claim to assets, moving them to a trust won’t protect you. The move would be considered a fraudulent transfer.

Revocable vs irrevocable

On the other hand, a revocable trust on the other hand lets you freely make changes to it up until death. While you do name your assets into the trust, you still retain ownership rights over them for income tax and estate tax purposes.

FeatureRevocable trustIrrevocable trust
Remove or retitle assetsNoYes
Rename beneficiariesYesNo
Protection from creditorsNoYes
Tax shelter (estate tax, capital gains tax)NoYes
ConfidentialYesYes

Making changes to an irrevocable trust

You can only alter an irrevocable trust under law. Typically you need the permission of all beneficiaries in order to make a change.

Revoking an irrevocable trust might be easier in some states than others. Missouri, for example, offers flexibility: you can make changes if the trust assets aren’t enough to justify the cost of administering the trust, allowing the grantor to reform the trust to conform to his or her intentions.

Other states like Virginia and New Hampshire allow changes to an irrevocable trust by decanting. This is the process of creating a new trust with updated terms, then transferring (or decanting) the old trust assets into the new one. Roughly half of the states permit decanting, and some of them even let you do so without notifying the beneficiaries.

Spendthrift clause

In some states, like California and Montana, you can’t terminate the trust even with consent if the trust has a spendthrift provision in place, where a trustee disburses the assets over time, so the heirs don’t spend everything at once. States also have different requirements regarding beneficiaries who are minors and may not be able to consent.

Types of irrevocable trust

There are two main types of irrevocable trusts — trusts created while the grantor is alive (a living trust), and trusts that are created upon death.

If you write a will that instructs your assets to be placed into a trust when you die, this would be an example of a testamentary trust. It is by nature irrevocable, since the grantor won’t be able to make any changes because they're no longer alive.

All other trusts created while you’re alive are called living trusts or inter vivos trusts. Some common examples of irrevocable living trusts are:

Irrevocable life insurance trust (ILIT)

Life insurance proceeds, also known as the death benefit, are typically a tax-free lump sum, but may be subject to the estate tax in certain circumstances. Mainly this would happen if the life insurance beneficiaries are dead, causing the death benefit to become part of the estate, or the deceased owned the policy or the ability to make changes to it. If the estate is large enough, a tax will be levied against it, but an irrevocable life insurance trust can help you avoid it. It will buy the life insurance policy and pay the premiums. The trust will be the owner of the policy; you only need to fund the trust.

Read our in-depth guide to irrevocable life insurance trusts (ILITs).

Special-needs trust

Also known as a supplemental needs trust, a special-needs trust is specifically intended for disabled beneficiaries. This allows for them to be able to receive government benefits, like supplemental security income (SSI) or Medicaid, which come with income-eligibility restrictions. If you’re disabled, you must have low income and limited number of resources or assets in order to qualify for these benefits.

Specific language must be used in order for the trust to be considered as a special needs trust, like a statement that the trust is meant to provide extra care, not basic support. You may want to consult with an attorney, especially if you want to fund the trust with the beneficiary’s money (like proceeds from a settlement), which needs to follow some tricky federal and state laws.

Other types of living irrevocable trusts

  • Charitable trusts let you transfer your assets to a charitable organization and receive a tax deduction.
  • Irrevocable gift trust (IGT) allow you to “gift” the trust in the present for tax purposes.
  • Grantor-retained annuity trust (GRAT) could leave your heirs paying no taxes.
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Irrevocable trusts and Medicaid

When it comes to Medicaid, there are two ways that irrevocable trusts can help. To qualify for a nursing home or assisted living from Medicaid, you must meet a few requirements. Each state sets a limit on income levels as well as resources, or assets, and which are applicable.

Read this state-by-state guide to Medicaid for more details, or contact your local Medicaid agency.

For example, to qualify for Medi-Cal, California’s state Medicaid program, you must meet an income limit and your assets must be under $2,000 to $4,200 (depending on how many people own it) and certain resources (like the house your spouse lives in and small burial and life insurance policies) do not count.

If you find that you have too many resources, you can “spend down” your assets by placing them into an irrevocable trust. However, if you do this shortly before you apply for Medicaid you’ll be penalized, so it is important to start your long-term care planning in advance.

In certain circumstances, the state will try to recoup or recover Medicaid expenses after the grantor’s death in what’s called Medicaid estate recovery. Irrevocable trusts assets are protected from Medicaid estate recovery. Required by the law, this might happen if the grantor was 55 years of age or older and received nursing home care through Medicaid.

How are irrevocable trusts taxed?

Some of the common taxes affected by an irrevocable trust are:

Estate tax

When you die the executor will assess the size (or worth) of your estate. Larger estates will have to pay an estate tax — a federal estate tax and possible state estate tax will diminish how much money your heirs ultimately receive. Only an irrevocable trust can help lower the total value of the grantor’s estate so that it is below the exemption limit and free of the hefty federal estate tax charge. This is one of its key advantages over a revocable trust.

As of 2019, the estate tax exemption is $11.4 million. If the estate greater than $11.4 million, it will be subject to the 40% federal estate tax on the amount above the limit. (For example, if your estate is $12.4 million, then you would pay federal estate tax only on $1 million.)

This is mostly useful for the very wealthy, whose assets and wealth are above this amount. However, this limit will lapse in 2025, unless it is renewed by Congress. In 2018, the exclusion amount was $11.18 million; in 2017, it was $5.49 million.

Capital gains tax

When you realize a profit on an investment you experience a capital gain, which is often accompanied by a tax. If you sell assets in a revocable trust, you will have to report any capital gain on your income tax return and pay any applicable taxes. You can avoid paying the capital gains tax with an irrevocable trust; the trust sells the assets and pays any taxes.

Tax deductions

If you’re funding a charitable trust, you can receive tax deductions while you are still alive when you transfer the assets into the trust. If the assets are not transferred into the trust until after your death, then the estate will receive the deduction.

Should you get an irrevocable trust?

Irrevocable trusts are difficult to change. Reasons you might benefit from an irrevocable trust are:

  • You’re very wealthy and want to reduce your taxable estate
  • If you have a disabled dependent
  • You have are likely to be sued and need asset protection

But if you generally just want to protect your assets or have something in place to distribute your property in case you become incapacitated, a revocable trust might still meet your needs. A living revocable trust will still ensure your assets are passed down properly and that your heirs don’t spend the money at once, if that’s a concern.

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