They can achieve many important personal and financial objectives, but their relationship to IRAs is complex
- Trusts fall into two main categories: revocable trusts and irrevocable trusts.
- Revocable trusts can be altered by the person establishing them, the grantor.
- Irrevocable trusts cannot be altered by the grantor.
- IRAs cannot be placed in a trust while the account-owner is alive.
- Placing IRAs in a trust can complicate distributions for those inheriting them.
Trusts have a truly ancient history: In Western society, they date back to the Middle Ages. They were established to enable someone to manage property while its owner was away, fighting in the Crusades.
Although the instrument has developed since then, their purpose and underlying concept are the same: to safeguard wealth by establishing a vehicle to contain assets and a person to be responsible for them.
A trust is created when a person, called the grantor, signs a legal document spelling out the terms of the trust. The grantor transfers property to the trust; the trust holds legal title to the property. The property is managed by a trustee (who may be the grantor in some situations) for the benefit of a beneficiary (who may also be the grantor).
Trusts come in many varieties, but they can be divided into two basic categories: revocable and irrevocable. It’s worth learning some of the differences and also understanding how they function with IRAs.
If the terms of the trust can be changed—or the property reclaimed by the grantor—then the trust is revocable. That is, it can be revoked or discontinued. Revocable trusts are also referred to as “living trusts” or, to use the Latin, inter vivos trusts, meaning that they are set up and operate during the grantor’s lifetime.
Once the grantor dies, the trust becomes irrevocable. Irrevocability also occurs if the grantor is managing the trust, but becomes permanently incapacitated: suffers a stroke, develops Alzheimer’s Disease—anything that prevents his ability to function.
Revocable trusts are often used as an estate-planning tool. Like a will, the trust specifies who inherits the property when the grantor dies. However, transferring property into a trust means you avoid to the often costly, lengthy and public court-supervised probate process that a will is subject to.
It is not advisable or always possible to put all the grantor’s assets into a revocable trust. Although you can designate a trust as the beneficiary of your IRA, you cannot put your IRA in a trust while you are living. For example, it may not be wise to make an IRA payable to the trust because this could prevent the ultimate beneficiaries of the IRA from being able to spread distributions over their life expectancies after they inherit it.
Important: Although revocable trusts avoid probate, they are still considered part of a deceased person’s estate.
For income tax purposes, revocable trusts usually are treated as grantor trusts. That means that all of the income, gains, tax credits and other tax items are reported on the grantor’s personal tax return as if he or she owned the property directly. In other words, the trust is not treated as a separate entity, as it is if it’s irrevocable.
A trust is irrevocable if the person setting up a trust cannot change his or her mind and recoup property or alter its terms. It can be inter vivos (set up during the grantor’s life) or testamentary (come into effect under the terms of a grantor’s will). However, if the former, the person setting up the trust cannot be its sole trustee.
Unlike the revocable trust, the irrevocable trust must file an annual federal income tax return, Form 1041, listing income and expenses and showing income paid to the trust beneficiary on Schedule K-1 of Form 1041. The trust is taxed on income retained by the trust; the beneficiary reports the income received from the trust on his or her personal return.
IRAs can be placed in irrevocable trusts. However, the designated beneficiary on the IRA documents trumps any beneficiary designated by the trust.
Uses for Irrevocable Trusts
Irrevocable trusts have many important uses, such as tax savings and asset protection. Here are some of them:
- Charitable remainder trusts. The grantor continues to enjoy income during his or her life (or for a term of years), with the property then passing to a charity.
- Life insurance trusts. They buy and own life insurance on the grantor’s death, keeping proceeds out of the grantor’s estate (and saving estate taxes).
- Generation-skipping transfer trusts. Also called dynasty trusts, they are used to transfer property from a grandparent to grandchild (skipping the child’s generation) in order to save estate taxes.
- Minor’s trusts. These are created to manage property for the benefit of a child. Usually, the property is distributed once the child reaches an age specified in the trust.
- Spendthrift trusts. Where there is a concern that the beneficiary may be unable to handle money wisely, a trust can be used to manage the property and disburse funds to the beneficiary, who is not permitted to give away any interest in the trust.
- Medicaid trusts. These are trusts created so that property is preserved for the family of an elderly person who needs Medicaid to pay for long-term care. The trusts must be established more than five years before applying for Medicaid in order to achieve the intended results.
- Supplemental needs trusts. If a beneficiary with a disability is receiving government benefits, these trusts (also called special needs trusts) can be used to provide “extras” without causing the loss of those benefits.
Before You Establish a Trust
Trusts may be used to achieve many important personal and financial objectives, but they’re not do-it-yourself documents. They need to be worded precisely and specifically, to avoid challenges and be in line with applicable federal and state laws. It is best to consult with an attorney who specializes in trust and estate work.