Advantages and Disadvantages of an Irrevocable Trust

If you're trying to get your assets in order, an irrevocable trust may be one option you've considered using to handle estate planning. You can use an irrevocable trust to transfer the ownership of your assets to established beneficiaries according to the terms and conditions you set, but the trick is that the trust can't be modified, amended or revoked once it's been created.

There are advantages and disadvantages of an irrevocable trust that are worth knowing about before you decide if it's right for you. 

How Do Irrevocable Trusts Work?

A trust is a complex legal document that can specify certain requirements for dispersing your assets to beneficiaries. As an estate planning tool, a trust can hold your assets for an extended time after your death. You can even bar beneficiaries from receiving your assets until they reach a certain age. An attorney is usually required to create one. 

An irrevocable trust is one way to transfer your assets after you die while also avoiding probate and estate tax. Probate is the legal process required to validate a will and pass ownership of assets to a living beneficiary. The written terms of an irrevocable trust agreement can't be modified or canceled after its creation except in rare circumstances. 

Once the trust is created, you must transfer your assets and property from your name to that of the beneficiary. This relinquishes your control over your assets and establishes the irrevocable trust as the owner.

With these rigid rules and restrictions in place, it can be nearly impossible to access your property or money if you face an unexpected financial hardship or decide you want to remove one of your beneficiaries. Irrevocable trusts aren't for everyone, but you can choose from a few options if you decide it's for you. 

Common Types of Irrevocable Trusts

Irrevocable Life Insurance Trust

This type of trust is funded using one or more life insurance policies. Some people use this trust to have additional control over how the death benefit of their life insurance policy is distributed instead of having its value included in estate taxes. It also gives you more control over how and when you want that money dispersed to beneficiaries. 

Testamentary Trust

If you write a will outlining that your assets should be placed in a trust after you die, a testamentary trust can be used to hold some or all of your assets. This can ensure your assets are handled professionally, and it reduces estate tax liability.

Grantor Retained Annuity Trust

A grantor retained annuity trust provides the grantor with an annual income once their assets are locked in the trust. As the grantor, you pay an initial tax when the trust is first established. After that, the yearly annuity payments usually come from the interest earned on the assets you've placed in the trust. This trust makes it possible for you to transfer assets to your heirs without worrying about a gift tax.  

Revocable vs. Irrevocable Trusts

Trusts can either be considered revocable or irrevocable. Revocable trusts are more common, and they can give you more control over your assets while you're still alive. With an irrevocable trust, the government no longer sees you as the owner of your assets; the trust is the owner.

The main difference between these two types of trusts is that you can still make changes to a revocable trust, which means your belongings count as part of your taxable estate. Revocable trusts also offer no real tax advantages, whereas assets transferred to an irrevocable trust don't count toward the value of your estate for tax purposes.

An irrevocable trust also offers asset protection against future lawsuits and creditors. This means that if you're sued and the document is structured correctly by an attorney, you can't be forced to relinquish your assets. 

Advantages and Disadvantages of an Irrevocable Trust

Now that you have a better idea of what an irrevocable trust is and the options available to you, take a look at some advantages and disadvantages of an irrevocable trust. 

Advantages

Tax Advantages

An irrevocable trust can be designed to remove certain assets from your taxable estate. This essentially freezes the worth of your assets as of the date they're transferred, which can be an advantage if you have assets that are likely to experience high values of appreciation. This is ideal if you have a large estate or complex wealth management needs.

In addition, the trust can be designed so that the grantor pays the income tax, which allows assets within the trust to continue accruing for future generations. 

Creditor Protection

In most instances, creditors can no longer seize your assets if you run into any problems repaying debt because you no longer control the assets that are held in the trust. 

Prevent Assets From Being Mishandled

Irrevocable trusts are nearly impossible to alter, which can work in your favor. By establishing set conditions regarding how your trust's assets are distributed, you can prevent your beneficiaries from mishandling or misusing anything. 

Disadvantages

Lack of Control

You no longer have direct control over your assets once they've been transferred to an irrevocable trust. If you have a spouse, you can create a separate trust for each of you, which helps you maintain some control. However, this strategy can be tricky and should only be done with the assistance of a skilled attorney.

Rigid Terms

Once the terms of an irrevocable trust are established, there isn't much room for change. Changes are permitted in rare circumstances, such as when the trust becomes outdated or unreasonably expensive to maintain. The beneficiaries or appointed trustees may then be able to modify the terms in court. 

Unforeseen Changes

The average person experiences many unforeseen changes in life, including finances, relationships, goals and priorities. If you establish an irrevocable trust based on your current lifestyle, the terms may not line up with future circumstances.

Additional Information To Know About Irrevocable Trusts

Can You Withdraw Money From an Irrevocable Trust?

The transfer of assets to an irrevocable trust is permanent, which means once they've been moved over, they usually can't be taken out again. On an as-needed basis, you may be able to withdraw funds to cover necessary expenses or to use for the benefit of the trust according to established terms.  

Who Pays Taxes on an Irrevocable Trust?

The grantor is in charge of paying taxes due based on the trust's income from its assets.

Do Irrevocable Trusts File Tax Returns?

Yes, the trustee typically files a Form 1041 on behalf of the trust. An irrevocable trust is considered an entity legally independent of its grantor for tax purposes, and trust income is taxable.