At its core, estate planning consists of the steps you take during your lifetime to ensure your assets are transferred according to your wishes. The ultimate goal, of course, is to protect your assets, so they will grow and be distributed appropriately when you’re gone, whether you want to pass your wealth to a family member, distribute it among your children, or make a gift to a charitable organization.
When it comes to balancing matters of your estate, the tax planning and compliance considerations are vast, which is why your estate planning efforts should include a team of professional advisors. If your estate is complex, you may benefit from having someone manage your assets for you. And, regardless of size, you’ll need a knowledgeable, specialized attorney and tax professional to help you navigate the ins and outs of estate planning, such as the setup and maintenance of revocable and irrevocable trusts and related tax laws and compliance considerations.
Many individuals and families can benefit from establishing some type of trust. Deciding which type of trust is right for you and your beneficiaries should start with an assessment of your goals and concerns, as well as an understanding of the differences between revocable and irrevocable trusts.
What are revocable trusts, and how do they help in estate planning?
A revocable trust is a living trust, meaning the trust’s creator (the grantor) is permitted to change the terms of the trust, such as altering the instructions for handling assets or adding or removing assets from the trust, during their lifetime. Revocable trusts also allow the grantor the ability to revoke the trust entirely.
A grantor can use a revocable trust in conjunction with an estate planning package that includes other legal documents, such as a pour-over will, financial power of attorney, and health care directive and proxy, to help ensure their wishes for certain assets are carried out in the event they are incapacitated. In this case, the trustee can step in to manage the assets in the trust. Once the grantor passes away, their revocable trusts become irrevocable, which means these trusts also help grantors keep their beneficiaries away from the often lengthy and expensive probate process.
The primary disadvantages to revocable trusts are that they provide no tax benefits or creditor protection. For tax purposes, these trusts are considered grantor trusts, which means they are disregarded entities for tax purposes. Disregarded entities do not pay their own taxes or file a separate tax return. Most federal and state income tax benefits, including exemptions, only come into play if the grantor is willing to waive their right to modify the trust, which is where irrevocable trusts come in.
What are irrevocable trusts, and when are they beneficial in estate planning?
Irrevocable trusts can be incorporated into your income, gift, and estate planning strategy to help you save on taxes. An irrevocable trust is not a living trust, so the grantor is not permitted to revoke or make changes to the terms of the trust after it has been created without the consent of the trust’s beneficiaries.
By giving assets to an irrevocable trust, you’re essentially giving up your legal right to the assets in the trust, which removes the assets from your estate and helps you reduce your estate taxes. The grantor may appoint a trusted family member, friend, or third party as trustee to oversee the administrative functions, such as handling the assets according to the trust’s terms and taking care of tax filings and fees.
Placing assets in an irrevocable trust can help you divests ownership interest without giving your beneficiaries early access to their inheritance. Irrevocable trusts can also restrict creditors, including Medicaid and nursing homes, from accessing the assets in your trust. Any assets titled in your own name are subject to creditors, including former spouses and taxing authorities. But by giving them to an irrevocable trust, in many instances, the assets are protected from creditors either completely or by providing legal hurdles that can make creditors shy away from taking pennies on the dollar in a settlement involving significant legal fees and resources.
For tax purposes, irrevocable trusts may be treated as grantor trusts, simple non-grantor trusts, or complex non-grantor trusts.
- If the irrevocable trust is a grantor trust, it will be treated as a disregarded entity for tax purposes, and the grantor will be responsible for filing and paying associated taxes with their personal return.
- If the irrevocable trust is a complex non-grantor trust, it is considered a separate entity. These trusts must pay taxes on income received at a tax rate that is typically much higher than the individual income tax rate; however, they are permitted to deduct their expenses. Complex trusts retain some of their income, distribute all or some of the principal to the beneficiaries, and distribute some funds to charitable organizations. A complex trust is allowed a $100 exemption.
- If the irrevocable trust is a simple trust, it makes annual distributions of income earned on the assets to the beneficiaries, does not distribute the trust’s principal, and does not make distributions to charitable organizations. A simple trust is allowed a $300 exemption. It is possible to convert a simple trust to a complex trust.
How do you know which type of trust is best suited for your estate plan?
Start by asking yourself a few questions to evaluate what goals are most important to you. Do you prefer to retain control over your assets during your lifetime? Is it more important to you to ensure your assets will be protected should you become incapacitated? If so, a revocable trust may be the right choice. Is your primary concern to reduce future estate taxes or prevent creditors from coming after or seizing your assets? In this case, an irrevocable trust would likely better serve your purposes.
Estate planning is situation-specific. With a knowledgeable, professional advisory team on your side, you can ensure that you and your family are making the right choices based on your circumstances. LGA’s Individual Tax Team helps clients understand their options when creating tax-efficient trust and estate plans that meet their goals and needs.
I work with attorneys to interpret estate and trust documents to help ensure our clients maintain compliant reporting and that their assets will be distributed to the proper beneficiaries. If you’re ready to reevaluate your estate plan, a trust, or your gifting strategy, contact me today.
by Marci Cohen
Marci Cohen is a Partner at LGA with over 30 years of experience providing individual and entity tax planning and compliance services. She holds a certificate in trust and estate planning. Marci’s focus is on high-net-worth individuals and families with complex reporting and planning needs, as well as their associated trusts, estates, and entities. With her collaborative and diligent tax planning approach, Marci ensures her clients can achieve their personal financial goals.