6. Irrevocable Trusts

Irrevocable trusts are in many regards vastly different than revocable trusts, a topic we discussed at length in a previous blog and podcast.

Recap: Revocable Trusts

A revocable trust can be a helpful estate planning tool because it provides flexibility and income to the living grantor. It is an estate planning option that manages the assets of the grantor and allows you to add, change, or remove assets, as well as make changes to the terms of the trust, at any time until your incapacity or death. Although ownership of assets is transferred to the trust, as trustee (or co-trustee with your spouse) you maintain complete control over them.

Primary Differences Between Revocable and Irrevocable Trusts

Irrevocable trusts have the inverse of many of a revocable trust’s critical features, including:

• Reduced control and flexibility: Once established, grantors cannot change an irrevocable trust, meaning they have no control over the held assets aside from what is outlined in the trust agreement. Changing an established irrevocable trust requires approval from trustees and beneficiaries, making it much harder to modify than a revocable trust.

• More robust asset protection: Once put into the trust and under the trustee’s care, assets held in an irrevocable trust are not considered part of the grantor’s estate. This offers protection for those assets in various circumstances, including legal action and taxation.

• Tax Benefits:

  • Appreciating Assets: This is especially beneficial for assets likely to grow in value over time, such as stock portfolios or a business. Any future appreciation will occur outside of the grantor's taxable estate.

  • Income Tax Savings: The income generated by the trust is taxed at the trust level, which may be a lower rate than the grantor's personal income tax bracket. This can allow trust assets to grow and compound more quickly over generations.

  • Generation-Skipping Transfer (GST) Tax Avoidance: Irrevocable trusts can be structured to avoid the GST tax, which applies to transfers of wealth to beneficiaries who are two or more generations younger than the grantor.

  • Flexibility with Grantor Contributions: Some irrevocable trusts can be designed so that the grantor pays the income tax on the trust's earnings. This allows the assets within the trust to continue to grow and appreciate for beneficiaries without reducing the principal value of the trust.

  • Medicaid planning benefits: Irrevocable trusts also offer a Medicaid planning benefit to some.

Some grantors prefer irrevocable trusts for these reasons, especially for tax and Medicaid planning purposes.

Common Types of Irrevocable Trusts

1. Asset Protection Trusts

2. Bypass Trusts

3. Charitable Remainder Trusts

4. Credit Shelter Trusts

5. Dynasty Trusts

6. Grantor Retained Annuity Trusts

7. Grantor Retained Income Trusts

8. Intentionally Defective Grantor Trusts

9. Irrevocable Life Insurance Trusts

10. Marital Trusts

11. Medicaid Asset Protection Trusts

12. Qualified Domestic Trusts

13. Special Needs Trusts

14. Testamentary Trusts

Drawbacks of Irrevocable Trusts

A drawback of many of these irrevocable trusts is that the grantor permanently gives up control and ownership of the assets placed within it. For instance:

• If the grantor experiences unforeseen financial hardship and needs the assets later in life, they have no legal right to reclaim them.

• The trust's rigid terms cannot be altered if family situations change, such as a beneficiary's divorce, addiction, or death.

• The grantor is completely dependent on the trustee to manage the assets fairly and responsibly. Poor decisions by the trustee can harm the beneficiaries and create family conflict.

• Unlike with a revocable trust, changes to an irrevocable trust are difficult and sometimes impossible without court intervention or the consent of all beneficiaries.

• An irrevocable trust's tax-saving purpose can be undermined if tax laws change after the trust is created.

• Setting up an irrevocable trust is a complex legal process that involves higher upfront legal and administrative fees than a revocable trust.

• The initial transfer of assets into the trust may be considered a gift and subject to gift taxes.

• Unlike assets passed through a will, assets transferred to an irrevocable trust may lose the valuable "step-up in basis" upon the grantor's death.

• Income earned by the trust is taxed separately and often at a higher rate than personal income.

• Transfers to an irrevocable trust are subject to a five-year look-back period for Medicaid eligibility.

• If assets are not legally re-titled into the trust's name, the trust is ineffective.

• Trusts can be invalidated by a court if they were improperly established or the grantor lacked capacity.

• The trust may be challenged if it can be shown that the grantor was coerced or manipulated.

• The trust can fail if the trustee mismanages assets, engages in self-dealing, or fails to fulfill fiduciary duties.

Medicaid Asset Protection Trusts

Importantly to many, a revocable trust offers no asset protection for Medicaid eligibility. A Medicaid Asset Protection Trust is an irrevocable trust specifically designed to shield assets.

What Is a Medicaid Asset Protection Trust?

A Medicaid Asset Protection Trust is exactly as it sounds—a trust designed to protect assets from being counted for Medicaid eligibility. This trust allows a person to qualify for long-term care benefits from Medicaid, while protecting assets from being depleted if long-term care is needed.

If investment assets are transferred to the trust, the former owner may not sell the investments but may continue to receive income generated from the investments. Qualified plans and IRA accounts cannot be transferred to a trust, so liquidation may be necessary.

As long as the trust is created and assets transferred five years before the donor applies for Medicaid, the trust’s existence will not impact Medicaid eligibility.

Common Mistakes and Considerations

Many people think they can avoid formal estate planning and still become eligible for Medicaid. The biggest mistake people make is transferring assets to children—typically the family residence. Problems can occur, such as losing protection if the child divorces or faces creditor issues.

When a Medicaid Asset Protection Trust protects the primary residence, the homeowner continues to live there just as they did before the trust was established.

Summarizing the Benefits

1. You can still benefit from the assets of a Medicaid Asset Protection Trust.

2. Your assets are safe from Medicaid and other long-term care creditors.

3. You can choose your beneficiaries.

4. Assets are protected from your beneficiaries’ creditors.

5. Protection from capital gains taxes.

Drawbacks of Medicaid Asset Protection Trusts

1. Timing is everything: Trusts must be created at least five years before applying for Medicaid.

2. Income from the trust is countable: Income generated may still affect eligibility.

3. Giving up control is non-negotiable: The trustee manages the trust; the grantor cannot.

4. Setting up the trust can be costly: It requires legal expertise and adherence to state and federal laws.

5. Potential effects on care: Medicaid may not cover all facilities, affecting care options.

The pros and cons discussed above are not exhaustive. Investing in a Medicaid Asset Protection Trust is a highly fact-specific process and may not be suitable for everyone.

Final Thoughts

Estate planning is not a one-size-fits-all process, and understanding the differences between revocable and irrevocable trusts is essential to making informed decisions about your financial future. While irrevocable trusts, including Medicaid Asset Protection Trusts, may seem complex, they can offer powerful benefits for asset protection, tax efficiency, and long-term care planning. However, they also require a willingness to relinquish control and careful consideration of timing and structure.

Working with an experienced estate planning attorney can help ensure that your trust is properly designed to meet your specific goals and to protect both your assets and your loved ones. By planning ahead, you can create a legacy that provides security, flexibility, and peace of mind for generations to come.