Blog

What's the Difference: Revocable vs Irrevocable Trust - Prudent Investors

Written by Jared Ong | Apr 18, 2022 6:01:49 PM

There’s nothing better than a fresh chocolate chip cookie straight from the oven.  Soft, not crispy, with the chocolate in that perfect gooey texture. There’s that perfect window of time before the cookies cool off and go into the cookie jar for the grandchildren.  If grandma’s nice, she’ll let you sneak a couple before dinner, but usually they’re kept safe so as not to spoil dinner. But, what do cookies have to do with revocable vs irrevocable trusts?

Trusts are actually kind of like cookie jars. They serve a similar purpose in providing protection from outside hands by making assets only accessible to those individuals who are designated as beneficiaries by the trust.  Like grandma, who decides how many cookies everyone should get from the jar, a trustee decides how much money or property beneficiaries are to receive from the trust based on the trust’s terms.

Revocable vs Irrevocable Trust

There are actually a lot of different types of trusts, but they generally come in two forms: revocable and irrevocable. At a glance the difference between a revocable vs. irrevocable is simple. A revocable trust allows the trustee to control their assets at any point in time, while an irrevocable trust essentially moves the assets out of the estate’s control. 

Revocable Trust

Revocable trusts, which may also be known as living trusts or family trusts, are a way to keep control of your assets while you’re still alive. This is because you have the power to revoke or change who benefits from the trust.  

Normally a revocable trust is set up so that you, the grantor (i.e. the individual funding the trust), is also the trustee (i.e., the person administering the trust) and beneficiary. Because you’re the trustee, changes can be made at any point in time to the trust or the trust’s beneficiaries.  

From the government’s perspective, because you still have power to change who can receive the assets, you still own the assets, and therefore any income received from the trust is taxed to you.  At death, the trust is still considered part of your estate for estate tax purposes, but your revocable trust becomes irrevocable since revocability ceases at your passing.

Because revocable trusts become irrevocable at the grantor’s death, they are used to help protect assets from probate. Probate is the legal process of settling a deceased’s estates. It is when final taxes are collected, wills are reviewed for validity, and inheritances are distributed. This process is public, can take a long time, and be costly.  In fact, in California, probate fees can cost as much as:

4% for the first $100,000

3% for the next $100,000

2% for the next $800,000

1% on the next $9,000,000

0.5% on the next $15,000,000

A way to look at revocable trusts using our cookie jar example is that cookies are assets and the jar is the trust.  Grandma makes a bunch of cookies and then puts them in a jar. A revocable trust would be if grandma decides to keep the right to choose who receives a cookie from the jar.  She could eat the cookies herself or decide to give them to her grandchildren.  Either way, she still owns the cookies.  However, if she passes away, she no longer has power to change who gets the cookies (i.e. the trust is now irrevocable). Because the cookies are already put into the jar, the government won’t be involved during probate and also will not decide who gets the cookies.

So who gets to decide who gets the cookies?  That would be a successor trustee – a person chosen by grandma to distribute the cookies after her passing according to terms previously dictated (i.e., a trust).

Irrevocable Trust

So what would be the purpose of creating an irrevocable trust prior to death?  Irrevocable trusts are used when the person creating the trust wants to relinquish all rights to the property or asset, including the ability to choose who the beneficiaries might be.  Creating this type of trust moves assets out of the individual’s estate and shifts the taxation to the irrevocable trust and/or beneficiary. 

To go back to our grandma scenario, it’s as if she put the cookies in the jar and said that only her grandchildren could take the cookies. Additionally, she assigns someone else, like a trusted uncle or professional trustee, to administer the cookies in the jar.  Because grandma has completely disowned ownership and revocability, it’s removed from her estate. 

One of the advantages of moving assets out of the estate is it protects the assets from creditors.  Additionally, depending on how the trust is set up, taxation of income from the trust might be passed on to a beneficiary who is in a much lower tax bracket.  

A common scenario in estate planning for using an irrevocable trust is to allow a surviving spouse to receive income for a trust, but not be able to change the beneficiaries of the trust who are biological children or loved ones.  This is done to protect against undue influence or to prevent the trustor’s progeny from being disinherited.

Another scenario where irrevocable trusts are common is with special needs trusts. These trusts are used to allow a person with special needs to qualify for government benefits, such as social security disability insurance or Medicare. Irrevocable trusts are especially beneficial from a tax perspective because the beneficiaries more often than not are in a low tax bracket due to their disability.  You can learn more about the benefits of establishing a special needs trust and supplemental coverage considerations in our guide, How to Prepare Your Child’s Special Needs Trust Before You Go. 

When beginning the estate planning process, consider the pros and cons of a revocable vs irrevocable trust.  They both have their specific purposes.  If you want the ability to choose who gets the cookies while you live, look into a revocable trust.  If you’d like to remove the cookies from your estate while you’re alive, look into an irrevocable trust. Either way, both trusts will have the advantage of avoiding probate and allow you to dictate how your assets should be distributed even after you’ve passed.