When it comes to trusts, a variety of options exist. Two of the most common are revocable living trusts and irrevocable trusts. As with most anything in life, both have their pros and cons. Irrevocable trusts can be particularly problematic, however, due to their lack of flexibility and potential tax issues. If you set one up and its associated taxes aren’t properly managed, you could find your irrevocable trust doing you more harm than good.
While irrevocable trusts can reduce estate taxes, income and capital-gains taxes can be costly.
Many years ago, the U.S. income tax code taxed irrevocable-trust income at a far lower rate than personal income. As a result, the wealthy would often create irrevocable trusts to hold their money as a way to reduce their income taxes. In response to this trend, the IRS created “grantor trust rules” that made irrevocable-trust income taxable at the individual trust maker’s tax rate under certain circumstances. These grantor trust rules effectively reduced the income-tax benefit of parking money in an irrevocable trust.
Today, income generated from an irrevocable trust is generally taxed at a higher rate than a trust maker’s personal income-tax rate — which can be a big deterrent.
Workarounds exist, however. For example, even though the tax rates have changed, the grantor trust rules remain the same. These days, a common way to overcome the income-tax burden of an irrevocable trust is to make it a “grantor trust,” which causes the trust income to be taxed at the trust maker’s income-tax rate instead of the trust’s.
Another approach is to grant certain restricted powers of appointment to beneficiaries. This can reduce the income-tax burden of using an irrevocable trust and reduce or eliminate its capital-gains-tax burden.
Irrevocable trusts can go a long way in protecting your assets, but only if they’re set up and managed correctly.
If you think an irrevocable trust might be useful in your estate-planning process or you’re the beneficiary of an irrevocable trust, it’s important to work with a professional who has in-depth knowledge of how these trusts work and is on top of of the latest tax laws so that your money continues to work for you rather than against you. If you’re already working with a financial advisor, he or she could recommend an estate-planning attorney who can help navigate your irrevocable trust. Ultimately, you want what you’re leaving behind or what’s being granted to you to be a benefit, not a burden — so connect with someone who can help make that happen.