Revocable vs. Irrevocable Trust – What’s the Difference?

Sometimes you need to look past the trust's name to see if it is truly revocable or irrevocable.
Sometimes you need to look past a trust’s name to see if it is truly revocable or irrevocable.

At first, the difference between a revocable trust and an irrevocable trust may appear very simple. One would think that, as the names imply, a revocable trust is one that can be terminated or amended, while an irrevocable trust is one that cannot be changed.  However, as often happens with the law, things aren’t always what they seem as reported in the article “What’s the difference between a revocable and irrevocable trust” from Market Watch. 

Sometimes you have to look beyond the name of the trust to determine if it is truly revocable or irrevocable.

A revocable trust, often referred to as a revocable living trust, is one that can be changed or terminated by the person who created the trust, whom we shall refer to as a trust maker. A revocable living trust is often used as a substitute for a Will because, like a Will, it can be amended by the trust maker depending on the circumstances, and it can help avoid probate if the trust maker’s property is titled in the name of the trust (or the trust is named as a beneficiary on the trust maker’s accounts and other assets).

But, a revocable trust becomes an irrevocable trust on the trust maker’s death. Also, the trust maker’s incapacity during life may result in a revocable trust becoming irrevocable. This can be confusing because the trust may keep the same name (for example, the John Doe Revocable Living Trust), but, if John Doe is deceased, the revocable living trust is really an irrevocable trust.

A revocable trust is considered almost an alter ego of the trust maker. As a result, a revocable trust does not provide creditor protection. From a tax standpoint, a revocable trust belongs to the trust maker and is included in the trust maker’s estate when calculating the estate tax.

As for an irrevocable trust, one would generally think that it is a trust that cannot be changed. But this impression, too, may be deceptive. A trust maker, beneficiary, or an independent person may be given powers to make certain changes to an irrevocable trust. Those changes may include the removal and replacement of a trustee and the ability to change or add beneficiaries.

An irrevocable trust is considered to be totally separate from the trust maker. It is usually constructed to avoid having the assets of the trust included the trust maker’s estate for estate tax purposes. An irrevocable trust can offer the beneficiary creditor and divorce protection, as well as prudent management of trust assets if the beneficiary is not good with financial matters. That’s why many parents create irrevocable trusts for their children when making gifts instead of making gifts to their children directly.

In addition to the trust maker giving the power in limited circumstances to change certain provisions of an irrevocable trust, an irrevocable trust may be “reformed” by a court, if it can be shown that the trust’s purposes can no longer be carried out.

And many states have passed laws allowing an irrevocable trust to be “decanted” – meaning that the assets of the original trust may be poured like wine into a new trust that includes provisions that are better suited to the current situation. These laws for the most part include safeguards to make sure that this is not a unilateral decision on the part of the trustee or the trust maker and the decanting is permitted only if it is in the best interests of the beneficiaries.

Of course, a trust maker may always prohibit reformation or decanting when creating an irrevocable trust, but, if the trust is to last for generations, it may make sense to allow limited ways for the irrevocable trust to adapt to changing circumstances.

So the next time you come across a reference to a revocable or irrevocable trust, look beyond the name to determine whether the trust is really revocable or irrevocable.

Reference: Market Watch (Oct. 8, 2021) “What’s the difference between a revocable and irrevocable trust”

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Make Tax-Free Gifts to Your Children

There are several ways to make tax-free gifts to your loved ones.
There are several ways to make tax-free gifts to your children and other family members.

Do not let constant political and financial speculation prevent you from making tax-free gifts to your children or other family members. These can take the form of  what’s called “annual exclusion” gifts, or the payment of a child’s or grandchild’s medical expenses, or paying for their education.

Making Tax-Free Annual Exclusion Gifts

Annual exclusion gifts are transfers of money or property in an amount or value that does not exceed the annual gift tax exclusion. In 2021, the annual gift tax exclusion is $15,000 per recipient. Therefore, this year you can give up to $15,000 per person to as many individuals as you choose without having to report the gifts to the IRS. In other words, the IRS does not consider gifts that are equal to or less than the annual exclusion amount to be taxable gifts at all. You may need to file a gift tax return if your gifts either exceed or do not qualify for the annual exclusion amount. Your estate planning attorney or accountant can guide you.

Married couples can take double advantage of the annual exclusion and make tax-free gifts of $30,000 in 2021.

Making Tax-Free Gifts That Qualify for the Medical Exclusion

 A payment that qualifies for the medical exclusion is another type of tax-free gift you can make. Payments qualify for this exclusion if they are made on behalf of an individual to a person or an institution that provided medical care or medical insurance to the individual. In general, medical expenses that qualify for this exclusion are the same ones that are deductible for federal income tax purposes. Therefore, in 2021, you can pay the cost of your grandchild’s emergency appendectomy and, in the same year, give your grandchild an additional $15,000 without having to file any gift tax returns.

To qualify for the medical exclusion, a payment must meet two critical requirements.

  • You must make payment directly to the person or institution that provided the medical care or medical insurance. If you give the money to the individual who received the medical care or insurance benefit, even with explicit instructions that it be used to pay for the medical care, your payment will be considered a gift to the individual and not payment of a qualified medical expense.
  • The amount paid must not have been reimbursed by the individual’s insurance company. Any reimbursed amount is not eligible for the unlimited medical exclusion from the gift tax, and that amount will be treated as having been made on the date the individual received the reimbursement.

Making Tax-Free Gifts That Qualify for the Educational Exclusion

A payment that qualifies for the educational exclusion is another type of tax-free gift. For example, in 2021, in addition to paying for your grandchild’s emergency appendectomy and giving them $15,000 (see above), you can pay their college tuition costs without having to file any gift tax returns or pay any gift tax.

To qualify for the educational exclusion, a payment must meet two critical requirements.

  • You must make payment directly to the institution providing the education rather than to the individual receiving the education.
  • Your payment must be for tuition only, not for books, supplies, room and board, or other types of education-related expenses.

If your payment fails to meet either of these requirements, it will be considered a gift to the individual.

Giving gifts can be an effective way to provide financial assistance to your family members. An estate planning attorney can help with any questions you may have on how to make tax-free gifts of money or property to your family.

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Five IRA Rollover Mistakes to Avoid

Making a mistake when rolling your 401(k) to an IRA could result in unexpected taxes and possible penalties.
Making a mistake when rolling your 401(k) to an IRA could result in unexpected taxes and possible penalties.

Recent changes in the job market have led to an increase in IRA rollovers, but at the same time, people are making more mistakes when transferring their employer related retirement accounts to an IRA, reports The Wall Street Journal in a recent article, “The Biggest Mistake People Make With IRA Rollovers.” These IRA rollover mistakes may result in additional taxes and penalties.

Done properly, rolling funds from a 401(k) to a traditional IRA offers you more flexibility and control. A company retirement plan may limit you to a half-dozen or so investment choices; but, depending on the IRA custodian, the IRA owner may choose investment options ranging from stocks and bonds to mutual funds, exchange-traded funds, certificates of deposits or annuities.

However, if you are considering rolling over an employer related retirement plan to an IRA, make sure to avoid these common IRA rollover mistakes:

Mistake #1:  Taking a lump-sum distribution of the 401(k) funds instead of moving the funds directly to an IRA custodian. The clock starts ticking when you do what’s called an “indirect rollover.” Miss the 60-day deadline and the amount is considered a distribution, included as gross income and taxable. If you’re younger than 59½, you might also get hit with a 10% early withdrawal penalty.

There is an exception: if you are an employee with highly appreciated stock of the company that you are leaving in your 401(k), it’s considered a “Net Unrealized Appreciation,” or NUA. In this case, you may take the lump-sum distribution and pay taxes at the ordinary income-tax rate, but only on the cost basis, or the adjusted original value, of the stock. The difference between the cost basis and the current market value is the NUA, and you can defer the tax on the difference until you sell the stock.

Mistake #2:  Not realizing when you do an indirect rollover, your workplace plan administrator will usually withhold 20% of your account and send it to the IRS as pre-payment of federal income tax on the distribution. This will happen even if your plan is to immediately transfer the money into an IRA. If too much tax was withheld, you’ll get a refund from the IRS.

Mistake #3:  Rolling over funds from a 401(k) to an IRA before taking a Required Minimum Distribution or RMD. If you’re required to take an RMD for the year that you are receiving the distribution (age 72 and over), neglecting this will result in an excess contribution, which could be subject to a 6% penalty.

Mistake #4:   Rolling funds from a 401(k) to a Roth IRA and neglecting to pay taxes immediately. If you move money from a 401(k) to a Roth IRA, it’s a conversion and taxes are due when you make the transfer. However, if you have some after-tax dollars left in the 401(k), you can make a tax-free distribution of those funds to a Roth IRA.

Mistake #5:  Not knowing the limits when moving funds from one IRA to another, if you do a 60-day rollover. The general rule is this: you are allowed to do only one distribution from an IRA to another IRA within a 12-month period. Make more than one distribution and it’s considered taxable income. Tack on a 10% penalty, if you’re under 59½.

Reference: The Wall Street Journal (Oct. 1, 2021) “The Biggest Mistake People Make With IRA Rollovers”

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