Irrevocable trusts are a special type of trust which cannot be modified, amended, or canceled, except under specific conditions. They contrast with revocable trusts, which can be changed or terminated by the grantor.
This means that once you, as the grantor, transfer your assets into an irrevocable trust, you relinquish all control and ownership over them. It also means that once you name the trustee and beneficiaries, and set the terms and conditions of the trust, it is fixed.
Irrevocable trusts have their benefits in the form of greater asset protection and tax efficiency. However, there are also some disadvantages of an irrevocable trust.
Trusts Defined
A trust usually consists of a few parts
- settlor
- trustee
- beneficiary
The settlor creates the trust.
The trustee manages the trust.
And the beneficiary benefits from the trust.
An irrevocable trust is called that because it can not be changed, in comparison with a revocable trust that may be amended easily. Depending on your circumstances will determine what is best for you, whether that is a revocable or irrevocable trust. However, there are four distinct disadvantages of an irrevocable trust.
Disadvantages of an Irrevocable Trust
- Inflexible
- Loss of Asset Control
- Tax Implications
- Complex
1. Irrevocable Trusts are Inflexible
Irrevocable trusts are specifically designed to be difficult to change. Typically, the consent of all the beneficiaries is required to change the trust.
There may also be certain laws and regulations which need to be followed to change the trust, depending on the jurisdiction and type of irrevocable trust.
The grantor should understand the severity and not assume that they would be able to change or revoke the trust.
With an irrevocable trust although it is made to avoid unnecessary estate taxation it comes with a price as the grantor then does not have any control over or rights to the trust.
When an irrevocable trust agreement is signed the trustee assumes complete control over the trust. Different from a revocable trust whereby the grantor still has complete control over the trust and is, therefore, able to amend any aspect or revoke it entirely, this is not the case with an irrevocable trust.
The rigid nature of irrevocable trusts can be a benefit when it comes to finding the right type of asset protection, but it has the drawback that the grantor and beneficiaries may not be able to adapt to changing situations.
2. Loss of Asset Control with Irrevocable Trusts
Once the grantor has transferred their assets into an irrevocable trust, they relinquish all ownership and control over them. The assets are then officially owned and controlled by the trust itself as a separate entity.
The fact that these assets no longer form part of the grantor’s personal estate can be beneficial in certain situations, but it also means that the grantor is unable to reclaim those assets if a personal financial crisis arises.
There is also the danger that the grantor’s relationship or feelings towards the designated beneficiaries changes, and they would prefer to remove them, but would be unable to do so.
For these reasons, the grantor should be certain about their circumstances before entering into an irrevocable trust agreement. However, this is not always possible because life is full of unexpected surprises.
3. Tax Implications for Gift, Income, and Estate Taxes with Irrevocable Trusts
Many choose irrevocable trusts because they often offer greater tax efficiency and are often used in part of a larger estate tax planning strategy. The fact that the assets are removed from the grantor’s personal estate means they no longer form part of their taxable income.
However, the taxable income earned by the trust must still be taxed separately from the grantor, and the tax rate may even be higher in some situations. Furthermore, there is added effort and fees involved in filing a separate tax return.
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4. Irrevocable Trusts are Complex Instruments
Irrevocable trusts are often much more complex than revocable trusts or other financial vehicles. They often contain complicated terms and provisions, that require a high level of expertise to understand.
These complex provisions are part of what makes them such highly secure financial vehicles but can be difficult for the layperson to navigate.
Downside of an Irrevocable Trust
Irrevocable trusts can be extremely useful as part of an estate or asset protection plan. However, like all financial vehicles, they also come with their drawbacks.
If the drawbacks affect you then it's likely that this type of trust is not the perfect fit. Each individuals circumstance will determine what is the most appropriate type of trust that should be used.
Are Irrevocable Trusts a Good Idea?
Entering into an Irrevocable Trust agreement is a good idea if you are looking to save on your tax burden, protect your assets and secure your estate and your future.
It is important to be aware of these disadvantages of irrevocable trusts and of the implications of entering into an trust agreement before you get started.
