Revocable Trusts 101: How They Work

Clients who seek to disperse their worldly assets in a complex or specific manner will often use living trusts as the vehicle of choice. These versatile instruments can provide users with a wealth of benefits and protections that ensure their financial wishes and needs are met efficiently while they are living and after they die.

Here’s what a revocable trust is and how it works and may benefit you.

Key Takeaways

• A revocable trust is a legal entity that can own, buy, sell, hold, and manage assets according to a specific set of instructions.
• It can be changed anytime or even revoked by the grantor who set it up.
• The other parties involved in a revocable trust are the trustee who oversees the management of the assets in the trust and the beneficiary or beneficiaries for whom the assets are managed.
• When the trust owner dies, the assets are exempt from probate, and information about their dispersion is not made public. However, they are still subject to federal and state estate taxes.
• Different types of revocable trusts are designed to serve different purposes. Two examples are the qualified terminable interest property (QTIP) trust and the incentive trust.

What Are Revocable Trusts?

A trust, by definition, is a legal instrument created by a lawyer. A trust resembles a corporation in that it is a separate entity that can own, buy, sell, hold, and manage property according to a specific set of instructions.

Some trusts have their own tax ID numbers and can be taxed as a separate entity or structured as a pass-through instrument that passes all taxable income generated by the assets in the trust through to the grantor. This is usually the case for revocable trusts, as the tax rates for trusts are among the highest in the tax code.

There are typically three parties who are involved in a trust:

• The grantor is the person who creates the trust (by paying a lawyer to draft it) and then funds it by depositing cash or assets into the trust account. Tangible property is simply retitled in the name of the trust.
• The trustee is appointed by the grantor to oversee the management of the assets in the trust and follow any instructions that the grantor has written in the trust.
• The beneficiary is the recipient for whom the assets are managed.

The grantor, trustee, and beneficiary (or at least the primary beneficiary) can all be the same person in many cases.

All trusts are either revocable or irrevocable. The former type allows the grantor to change the instructions in the trust, take assets out of the trust, and terminate it. Irrevocable trusts are called such because assets that are placed inside them cannot be removed by anyone for any reason. The instructions that are written into them can likewise not be changed. Most revocable trusts are known as revocable living trusts because they are created while the grantor is still living.

Pros and Cons of Revocable Trusts

Revocable trusts can allow grantors to disperse assets in ways that would be extremely difficult to do with a will. All assets that are deposited into revocable trusts are unconditionally exempt from the probate process, which can greatly simplify and accelerate the estate planning process.

Furthermore, all activities relating to trusts and their dispersion of assets to beneficiaries are strictly confidential and are not published in the public records of probate courts.

One disadvantage is that the assets in a revocable trust aren’t shielded from creditors to the degree that they are in an irrevocable trust. So if the grantor is on the losing end of a lawsuit, trust assets may be ordered liquidated to satisfy a judgment. Also, after the owner dies, the trust assets are subject to federal and state estate taxes. In addition, some trusts can cost thousands of dollars to create if they are complex or if they deal with complicated intangible assets.

Pros

• A revocable trust may be altered or revoked at any time by the grantor.

• Assets are exempt from the probate process, which can simplify estate planning.

• Activities relating to a trust and the dispersion of assets are strictly confidential.

Cons

• If a grantor is sued, trust assets can be used to satisfy a judgment.

• Once the owner dies, trust assets are subject to estate taxes.

• Trusts that are complex or that deal with intangible assets may be costly to set up.

Types of Revocable Trusts

There are several types of revocable trusts that are designed to meet specific objectives. They include:

Qualified Terminable Interest Property (QTIP) Trust: This type of trust is generally used when the grantor has divorced and remarried. The grantor will name the current spouse as the primary beneficiary, and they will get to use the property (such as a house) inside the trust as long as they live. The property will then be distributed to the grantor’s children from the previous marriage upon the death of the second spouse.

Incentive Trust: This type of trust can reward beneficiaries with monetary or other incentives if they meet certain criteria that are laid out by the grantor. This could include getting an education, marrying a certain type of person, or accomplishing other objectives.

There are also other types of revocable trusts that are designed to reduce estate taxes for wealthy grantors, protect land from lawsuits, and facilitate the Medicaid spend-down strategy.

What Is a Major Benefit of a Revocable Trust?

There are two major benefits:

1. As the owner of the trust, you get the benefits of the trust assets during your lifetime—trust income and the right to use trust assets.
2. After your death, the trust assets are distributed in the way that you have spelled out through the terms of the trust.

What Assets Should Not Be Placed in a Revocable Trust?

For a variety of reasons, retirement accounts, Health Savings Accounts, life insurance policies, and Uniform Transfers to Minors Act (UTMA) and Uniform Gifts to Minors Act (UGMA) accounts that are set up to benefit a minor should not (or cannot) be put into a revocable trust.

If you transfer a retirement account into a trust, for example, it will count as a withdrawal, which is a taxable event. Instead, you can name the trust as the beneficiary of the retirement account so the funds will transfer upon your death, and you can spell out in the trust document how the funds should be divided among your beneficiaries. Consult an estate planning attorney for assistance in creating a revocable trust and the assets that are best put into it.

Which Is Better, a Revocable or an Irrevocable Trust?

It depends on your situation and your goals in creating a trust.

Revocable trusts are easier to set up and can be modified at any time by the owner, or grantor. While the trust assets won’t go through probate, they are still subject to federal and state estate taxes.

Irrevocable trusts are harder to create and very difficult to modify, but the trust assets are not subject to estate taxes upon the owner’s death. In addition, assets in an irrevocable trust are protected from creditors, so people in professions that may be at risk of lawsuits (e.g., doctors or lawyers) might want to create one to protect their property.

The Bottom Line

Revocable trusts can accomplish many objectives and provide many benefits for both grantors and beneficiaries. They can be used to reduce income and estate taxes and avoid probate. Their cost can vary according to their complexity and the number of them that are used.

For more information on revocable trusts and how they can benefit you, visit the Financial Planning Association website.