An irrevocable trust is a legal arrangement in which a person — called the grantor — permanently transfers ownership and control of assets into a trust. Unlike a revocable trust an irrevocable trust generally cannot be changed, amended, or canceled once it has been created and funded. In exchange for giving up control of the assets the grantor gains significant benefits including asset protection, Medicaid planning advantages, and potential estate tax benefits.
How an irrevocable trust works
When you create an irrevocable trust you transfer ownership of assets — such as your home, investments, or cash — into the trust. At that point those assets no longer legally belong to you. They are owned by the trust and managed by a trustee — typically someone other than yourself — for the benefit of your named beneficiaries.
Because you no longer legally own the assets they are generally not counted toward Medicaid eligibility and may be protected from creditors and estate taxes depending on the type of trust and how it is structured.
Irrevocable trust vs revocable trust
The fundamental difference between an irrevocable trust and a revocable trust is control:
- A revocable trust allows you to maintain full control of the assets, change the terms at any time, and cancel the trust entirely. However because you retain control the assets are still considered part of your estate for Medicaid and tax purposes.
- An irrevocable trust requires you to give up control of the assets permanently. In exchange the assets are generally protected from Medicaid spend-down requirements, creditors, and in some cases estate taxes.
The right choice depends on your goals. If maintaining control is most important a revocable trust may be more appropriate. If asset protection and Medicaid planning are priorities an irrevocable trust may be the better choice.
Types of irrevocable trusts
There are many types of irrevocable trusts each designed to serve a specific purpose:
- Irrevocable Medicaid asset protection trust — designed specifically to protect assets from Medicaid spend-down requirements. Assets transferred into this trust more than five years before applying for Medicaid are generally not counted toward eligibility. The grantor typically retains the right to income generated by the trust but gives up access to the principal.
- Irrevocable life insurance trust — ILIT — holds a life insurance policy outside of the grantor’s taxable estate. When the grantor dies the death benefit is paid to the trust and distributed to beneficiaries free of estate tax.
- Special needs trust — holds assets for the benefit of a person with a disability without disqualifying them from government benefits such as Medicaid and SSI
- Charitable remainder trust — provides income to the grantor or other beneficiaries for a period of time after which the remaining assets pass to a designated charity
- Charitable lead trust — provides income to a charity for a period of time after which the remaining assets pass to the grantor’s beneficiaries
- Qualified personal residence trust — QPRT — allows a grantor to transfer their home into a trust at a reduced gift tax value while retaining the right to live in the home for a specified period
- Spendthrift trust — protects a beneficiary’s inheritance from their own creditors or poor financial decisions by restricting their ability to access or assign their interest in the trust
The Medicaid look-back period and irrevocable trusts
One of the most common reasons people create an irrevocable trust is for Medicaid planning. When assets are transferred into an irrevocable Medicaid asset protection trust the transfer is subject to Medicaid’s five year look-back period. This means that assets transferred into the trust within five years of applying for Medicaid may still be counted toward eligibility and could trigger a penalty period.
However assets transferred into the trust more than five years before applying for Medicaid are generally protected. This is why early planning is so important — the sooner an irrevocable trust is created and funded the sooner the five year clock starts running.
Asset protection benefits
Because assets in an irrevocable trust are no longer owned by the grantor they are generally protected from the grantor’s creditors. This can be valuable for people in professions with high liability exposure such as physicians or business owners as well as for people who want to protect assets from potential future long term care costs.
The level of asset protection provided by an irrevocable trust varies depending on the type of trust the state where it is created and how it is structured. Working with an experienced attorney is essential to ensure the trust provides the intended protection.
Estate tax benefits
For people with large estates an irrevocable trust can help reduce estate taxes by removing assets from the taxable estate. Because the assets in an irrevocable trust are no longer owned by the grantor they are generally not included in the grantor’s taxable estate at death which can reduce or eliminate estate tax liability.
The federal estate tax exemption is quite high — over $12 million per individual as of recent years — meaning that federal estate tax is a concern for relatively few people. However some states have their own estate taxes with lower exemption amounts. An estate planning attorney can help determine whether estate tax planning is relevant to your situation.
What the grantor gives up
Creating an irrevocable trust requires giving up significant rights and control. Depending on the type of trust the grantor may give up:
- The right to take back the assets
- The right to change the beneficiaries
- The right to change the trustee
- The right to access the principal of the trust
- The right to use trust assets for personal benefit in most cases
Some irrevocable trusts allow the grantor to retain certain limited rights such as the right to income generated by the trust assets or the right to live in a home held by the trust. However any retained rights may affect the asset protection and tax benefits the trust provides.
Who should be the trustee
Because the grantor of an irrevocable trust generally cannot serve as their own trustee choosing the right trustee is a critical decision. The trustee must manage the trust assets prudently, follow the terms of the trust document, act in the best interests of the beneficiaries, and maintain proper records and tax filings.
Options for trustee of an irrevocable trust include:
- A trusted family member or friend who is financially responsible and understands the purpose and terms of the trust
- A professional trustee such as a bank or trust company that provides trustee services for a fee
- An attorney or accountant who is familiar with trust administration
Tax considerations
Irrevocable trusts have their own tax identification numbers and generally file their own tax returns. Income generated by trust assets may be taxed at trust income tax rates which are often higher than individual rates. The specific tax treatment depends on the type of trust and how it is structured.
For Medicaid asset protection trusts that allow the grantor to retain income rights the income is typically reported on the grantor’s personal tax return rather than a separate trust return.
Working with a tax professional who is familiar with trust taxation is important when creating and administering an irrevocable trust.
How to create an irrevocable trust
Creating an irrevocable trust is a significant legal and financial decision that should be made with the guidance of an experienced estate planning or elder law attorney. The process involves:
- Consulting with an attorney to determine whether an irrevocable trust is appropriate for your goals and situation
- Working with the attorney to draft a trust document that meets your objectives and complies with your state’s laws
- Signing the trust document before a notary
- Funding the trust by transferring assets into it — this step is essential and must be done correctly to achieve the intended benefits
- Updating beneficiary designations and other documents as needed to coordinate with the trust
Key terms to know
- Irrevocable trust — a trust that generally cannot be changed or canceled once created
- Grantor — the person who creates and funds the trust
- Trustee — the person or organization that manages the trust assets
- Beneficiary — the person or organization that receives benefits from the trust
- Irrevocable Medicaid asset protection trust — an irrevocable trust designed to protect assets from Medicaid spend-down requirements
- Look-back period — the five year period during which Medicaid reviews asset transfers when determining long term care eligibility
- Spendthrift trust — a trust that protects a beneficiary’s inheritance from creditors and poor financial decisions
- Qualified personal residence trust — QPRT — an irrevocable trust used to transfer a home at a reduced gift tax value
Sources
- American Bar Association — Public Resources
- National Academy of Elder Law Attorneys — naela.org
- USA.gov — Estate Planning
- Internal Revenue Service — irs.gov
This article is for general informational purposes only and does not constitute legal or financial advice. Trust laws vary by state and are subject to change. Consult a licensed attorney for guidance specific to your situation.