Revocable vs Irrevocable Trusts — CFP Exam Comparison

A revocable living trust is created during the grantor's lifetime and can be amended or revoked by the grantor at any time, as long as they are mentally competent. The grantor typically serves as the initial trustee, managing the trust assets for their own benefit.

The primary benefit of a revocable trust is probate avoidance. Assets held in the trust pass directly to the beneficiaries named in the trust document upon the grantor's death, bypassing the probate process. This can save time and money, and provide greater privacy compared to a will.

However, because the grantor retains control and ownership of the assets, revocable trusts offer no asset protection from creditors and provide no estate tax benefits. The assets are considered part of the grantor's estate for estate tax purposes.

An irrevocable trust, as the name suggests, cannot be easily amended or revoked once it is established. The grantor permanently transfers assets into the trust, relinquishing control. This transfer is generally considered a completed gift.

A key advantage of irrevocable trusts is potential estate tax reduction. Because the assets are removed from the grantor's estate, they are not subject to estate taxes upon the grantor's death. Irrevocable trusts can also offer significant asset protection from creditors, depending on state law and the specific terms of the trust.

However, the loss of control is a significant drawback. Once assets are transferred, the grantor generally cannot access them or change the beneficiaries without potentially adverse tax consequences. Careful planning is essential before establishing an irrevocable trust.

Revocable Trusts: The grantor is treated as the owner of the trust for income tax purposes. All income generated by the trust is reported on the grantor's individual income tax return (Form 1040). The trust assets are included in the grantor's gross estate for estate tax purposes (Form 706), and transfers to the trust are not considered taxable gifts.

Irrevocable Trusts: The income tax treatment depends on the type of irrevocable trust. Some trusts are grantor trusts (income taxed to grantor), while others are non-grantor trusts (income taxed to the trust or beneficiaries). Assets are generally excluded from the grantor's gross estate for estate tax purposes, provided the grantor retained no prohibited powers or interests. Transfers to the trust are considered gifts and may be subject to gift tax (Form 709), potentially utilizing the annual gift tax exclusion or lifetime gift tax exemption.

Revocable trusts offer virtually no asset protection. Because the grantor retains control and access to the assets, creditors can typically reach the trust assets to satisfy the grantor's debts.

Irrevocable trusts, on the other hand, can provide significant asset protection, especially if the grantor is not a beneficiary. The degree of protection depends on state law, the terms of the trust, and whether the transfer was made with the intent to defraud creditors. Spendthrift clauses, which prevent beneficiaries from assigning their interests, can further enhance asset protection.

Several types of irrevocable trusts are commonly used in estate planning: Irrevocable Life Insurance Trust (ILIT): Holds life insurance policies to remove the death benefit from the estate. Grantor Retained Annuity Trust (GRAT): The grantor receives a fixed annuity payment for a specified term; any appreciation above the IRS-determined interest rate passes to the beneficiaries tax-free. Grantor Retained Unitrust (GRUT): Similar to a GRAT, but the payment is a fixed percentage of the trust's value, revalued annually.

Qualified Personal Residence Trust (QPRT): Transfers a personal residence to the trust while allowing the grantor to live there for a specified term. Charitable Remainder Annuity Trust (CRAT): Provides a fixed annuity to the grantor or other beneficiary for life, with the remainder going to charity. Charitable Remainder Unitrust (CRUT): Similar to a CRAT, but the payment is a fixed percentage of the trust's value, revalued annually, with the remainder going to charity.

An A-B trust, also known as a credit shelter trust or bypass trust, was traditionally used to minimize estate taxes for married couples. Upon the first spouse's death, assets equal to the applicable exclusion amount (federal estate tax exemption) are placed into the B trust (credit shelter trust), while the remaining assets pass to the A trust (marital trust).

The B trust is structured so that it does not qualify for the marital deduction, but it utilizes the deceased spouse's estate tax exemption. The surviving spouse can receive income from the B trust and may have limited access to the principal. Upon the surviving spouse's death, the assets in the B trust pass to the beneficiaries without being included in the surviving spouse's estate. While less common due to the increased estate tax exemption amounts, A-B trusts can still be useful in certain situations, especially in states with separate estate taxes.

The generation-skipping transfer tax (GSTT) is a tax on transfers of property to skip persons (e.g., grandchildren, great-grandchildren, or unrelated individuals more than 37.5 years younger than the transferor). Trusts can be subject to GSTT if they benefit skip persons.

Both revocable and irrevocable trusts can be designed to minimize GSTT. Grantors can allocate their GSTT exemption to transfers to trusts that benefit skip persons, sheltering the transfers from GSTT. Careful planning is crucial to avoid unintended GSTT consequences.

Here's a table summarizing the key differences: