(U.S. News & World Report) - Estate planning is a crucial part of any holistic financial plan, and financial advisors often work with estate planning attorneys for guidance in this area. But while attorneys are great, and necessary, for crafting the legal documents used in estate planning, they don't always see the big picture.
An attorney may focus only on how the estate plan will impact your client's overall estate, without giving consideration to how the plan will affect your client while she is still alive. It's important for you, as your client's advisor, to understand the elements of estate planning, so you can guide your client to the best option for her present and her future.
Here's a guide for financial advisors to understand the difference between revocable and irrevocable trusts, plus how to advise clients on this important element of their estate plan.
What Are Trusts?
One common element in estate planning is a trust. "Many people believe that trusts are only for the very wealthy. But in reality, most families can benefit from some type of trust," says Lindsay Graves, elder law attorney and founding partner of The Graves Law Firm. "The key is deciding which type of trust is right for you, which is based on identifying your goals and concerns."
There are two varieties of trusts: revocable and irrevocable. The main difference between a revocable trust and irrevocable trust is all in the name: One can be revoked or amended by the trust's creator (called the grantor) while the other cannot. With an irrevocable trust, the grantor cannot make changes without the consent of the beneficiaries.
This distinction leads to several benefits and drawbacks for each type of trust.
What Is a Revocable Trust?
A revocable trust is another name for a living trust, or a trust that can be changed by the grantor at any time. The grantor can alter the instructions for how assets are handled or add or remove assets from the trust entirely. She could even terminate the trust. Once the grantor dies, the trust becomes irrevocable.
"Revocable trusts are normally done to pass your estate to your children without going through probate," says Patrick Simasko, elder law attorney and wealth preservation specialist at Simasko Law. "If your estate is going to children, you pick someone through your trust to watch over the inheritance until they are mature enough." He typically picks age 25 for this transition.
What Is an Irrevocable Trust?
An irrevocable trust cannot be amended once established. After the grantor sets up the trust and determines what assets should go within it, he or she cannot change the terms or terminate the trust without the permission of the trust's beneficiaries. The grantor has essentially given up any legal right to the assets in the trust by giving the assets to the trust. Because of this, irrevocable trusts are often used to remove assets from a person's estate, helping to reduce estate taxes.
"By appointing a trusted family member or friend as your trustee, irrevocable trusts can restrict creditors, including nursing homes and Medicaid, from accessing the assets in your trust," Graves says.
Historically, clients in high-risk professions would use an irrevocable trust, so creditors couldn't claim them. "Now, with people living longer, we use irrevocable trusts to divest your estate, so that you can get approved for Medicaid and/or veteran benefits," Simasko says. Since both of these benefits are asset-based, families may need to divest their ownership interest in certain assets, but do so without giving their children access to their inheritance early.
The Benefits and Drawbacks of a Revocable Trust
There are several benefits to a revocable trust, including these:
- A revocable trust safeguards the grantor's wishes. "The main benefit of a revocable trust is the protection that it provides by ensuring that the grantor's wishes are implemented if incapacitated," says Kalimah Z. White, wealth strategist and senior trust advisor at TD Wealth Private Client Group.
- A revocable trust avoids probate. "Probate is a lengthy, costly and public process that allows a platform for any unhappy relatives to argue over who gets what, which is why we often prefer to avoid it," Graves says.
- A revocable trust can hold qualified assets. Revocable trusts can hold certain assets that would not be suitable for an irrevocable trust, such as qualified accounts like IRAs, 401(k)s and 403(b)s, Graves says.
But revocable trusts aren't without their drawbacks, most notably being that there are no tax benefits or creditor protection. The law requires the grantor to "give up" the right to modify a trust to take advantage of most federal and state income tax benefits, including exemptions. Since the grantor of a revocable trust retains this right to modify the trust agreement, the law does not allow the grantor to hop in and out of a trust to reduce taxes or protect assets.
The Benefits and Drawbacks of an Irrevocable Trust
The ability to save on taxes through various income or estate and gift planning strategies becomes one of the main benefits of an irrevocable trust, experts say.
The benefits to an irrevocable trust include these:
- Irrevocable trusts carry tax benefits. "The IRS provides many exemptions to certain tax laws. For example, retaining assets in a trust for generations, so they're never subject to estate tax, requires an irrevocable trust for the technique to work properly," White says.
- Irrevocable trusts contain creditor protection. "Assets titled in your own name are subject to creditors, including ex-spouses and taxing authorities," White says. "Assets titled in the name of an irrevocable trust, in many instances, are protected from the reach of creditors or, at minimum, provide hurdles for the creditor that may prompt settling the claim for pennies on the dollar."
While saving on taxes and creditor protection can be great benefits for your clients, advisors can't forget that many people do not enjoy losing control over their assets, White adds. Your clients may not like the idea of "locking up" their funds and only being able to access them at the discretion of a trustee or third party.
"Some clients find it disadvantageous to be a beneficiary of an irrevocable trust and at the mercy of a trustee for access to trust assets, especially in situations where parents or grandparents established the trust," White says.
That said, she points out that nowadays, irrevocable trusts are less irrevocable. "There are several ways to modify a trust to increase the client's control over the trust assets and a client's ability to retain a beneficial interest in a trust, while at the same time providing creditor protection and substantial tax savings potentially," she says.
You can work with an estate attorney to help you increase your client's control of their trust's assets.
Choosing Between a Revocable Versus Irrevocable Trust
Given that there are benefits and drawbacks to both, it can be hard to know which type of trust is right for your client. Expert advice: Start by determining your client's goals.
"If the client's main goal is to plan for incapacity, they may only need a revocable trust, which always should include a pour-over will, financial power of attorney and health care directive and proxy to complete the estate planning package," she says. If the grantor becomes incapacitated, the trustee can step in to manage the assets in the trust.
"Alternatively, if the main goal is creditor protection and/or tax savings, a client can only accomplish such goals with an irrevocable trust," White says. Clients will also opt for an irrevocable trust when they want to remove assets from their estate.
Before choosing between a revocable and irrevocable trust, however, be sure your client understands what she'd be giving up by using one over the other. If she wants to retain control over the assets with a revocable trust, she must also be aware that she won't get the tax benefits or creditor protection that she would with an irrevocable trust. On the other hand, getting tax benefits and creditor protection through an irrevocable trust comes at the expense of control over the assets.
The key aspects to evaluate when choosing between a revocable and irrevocable trust include:
- Degree of control. Does your client want to retain control over the assets while she is still alive, or is she comfortable relinquishing control?
- Concerns about incapacitation. Is your client worried she may become incapacitated and be unable to manage her own assets during her lifetime?
- Tax shelter. Does your client want to reduce future estate taxes by removing assets from her estate?
- Creditor protection. Is your client concerned that creditors may try to seize her assets?
If maintaining control and navigating incapacitation are her primary concerns, a revocable trust is probably best. But if she's more concerned about taxes or creditors, and is willing to relinquish control of her assets, an irrevocable trust is probably the right choice.
The key to remember is these are merely tools in the toolbox, Simasko says. "You need the right tool for the right job."
By Coryanne Hicks
Copyright 2021 U.S. News & World Report
