Trusts fall into two main categories: revocable trusts and irrevocable trusts. Each has its own purpose suitable to a particular situation. It’s worth learning some of the differences and also understanding them in terms of how you handle IRAs if you have a trust.
Trusts have a truly ancient history in the law. They were developed in the Middle Ages to enable someone to manage property while the owner was away in the Crusades.
While trusts now have many variations, the concept is the same: A trust is created when a person, called the grantor, signs a legal document spelling out the terms of the trust. The grantor transfers property to the trust; the trust holds legal title to the property. The property is managed by a trustee (who may be the grantor in some situations) for the benefit of a beneficiary (who may also be the grantor).
If the terms of the trust can be changed—or the property reclaimed by the grantor—then the trust is revocable (it can be revoked). Revocable trusts are also referred to as “living trusts.” They may also be referred to as inter vivos trusts, meaning that they are set up during the grantor’s lifetime.
Once the grantor dies, the trust becomes irrevocable. Irrevocability also occurs if the grantor also manages it and becomes incapacitated (one example: suffers from Alzheimer’s).
Revocable trusts are often used as an estate-planning tool to transfer property outside of the often costly, lengthy and public court-supervised probate process. Like a will, the trust specifies who inherits the property when the grantor dies.
However, it’s not advisable or always possible to put all the grantor’s assets into a revocable trust. For example, it may not be wise to make an IRA payable to the trust because this could prevent the ultimate beneficiaries of the IRA (the trust beneficiaries) from being able to spread distributions from the IRA over their life expectancies. (Although you can designate a trust as the beneficiary of your IRA, you cannot put your IRA in a trust while you are living.)
For income tax purposes, revocable trusts usually are treated as grantor trusts. All of the income, gains, tax credits and other tax items are reported on the grantor’s personal tax return as if he or she owned the property directly. In most cases, no fiduciary return (Form 1041) for the trust is needed.
A trust is irrevocable if the person setting up a trust cannot change his or her mind and recoup property or alter the terms in the legal document. The person setting up the trust cannot be the sole trustee of an irrevocable trust. It can be inter vivos (set up during the grantor’s life) or testamentary (come into effect under the terms of a grantor’s will).
The trust must file an annual federal income tax return, Form 1041, listing income and expenses and showing income paid to the trust beneficiary on Schedule K-1 of Form 1041. The trust is taxed on income retained by the trust; the beneficiary reports the income received from the trust on his or her personal return.
Some Important Uses for Irrevocable Trusts
Irrevocable trusts have many important uses, such as tax savings and asset protection. Here are some of them:
- Charitable remainder trusts. The grantor continues to enjoy income during his or her life (or for a term of years), with the property then passing to a charity.
- Life insurance trusts. They buy and own life insurance on the grantor’s death, keeping proceeds out of the grantor’s estate (and saving estate taxes).
- Generation-skipping transfer trusts. Also called dynasty trusts, they are used to transfer property from a grandparent to grandchild (skipping the child’s generation) in order to save estate taxes.
- Minor’s trusts. These are created to manage property for the benefit of a child. Usually property is distributed once the child reaches an age specified in the trust.
- Spendthrift trusts. Where there is concern that the beneficiary may be unable to handle money wisely, a trust can be used to manage the property and disburse funds to the beneficiary, who is not permitted to give away any interest in the trust.
- Medicaid trusts. These are trusts created so that property is preserved for the family of an elderly person who needs Medicaid to pay for long-term care. The trusts must be established more than five years before applying for Medicaid in order to achieve the intended results.
- Supplemental needs trusts. If a beneficiary with a disability is receiving government benefits, these trusts (also called special needs trusts) can be used to provide the “extras” (e.g., birthday parties) without causing the loss of government benefits.
Before You Establish a Trust
Trusts may be used to achieve many important personal and financial objectives, but they’re not do-it-yourself documents. It is best to consult with an attorney who can draft the documents reflecting the aims for a particular situation.