Irrevocable vs. Revocable Trusts

We are often asked the difference between Irrevocable Trusts and Revocable Trusts. They are both part of the estate planning toolbox but have entirely separate uses. In short, Revocable Living Trusts (RLT) are primarily used to bypass the probate process and do not protect assets from creditors.

There are a variety of Irrevocable Trusts. Here we will focus on Irrevocable Income-Only Trusts (IIOT), or Grantor’s Trusts, as they are the preferred method for protecting assets from Medicaid. Here are seven salient differences between the two Trusts.

Property Ownership

Assets transferred into an Irrevocable Asset Protection Trust no longer belong to the settlor; rather, the assets are owned by the Trust. This does not exclude one from living in “their” house or driving “their” car simply because it’s now formally owned by the Trust, it merely means you don’t own it, not that you cannot still benefit from it.

Similar to renting or leasing, you may still use the assets as you see fit, but you may also buy, sell, and live off the income they provide. A properly formed and funded Trust fund provides the best possible protection of assets from creditor claims because you don’t own the asset. Thus, creditors may not attach a judgment to the asset any more than they may seize your neighbor’s home. The assets quite literally change owners.

This is vitally different from an RLT wherein the grantor maintains ownership.

Modification

An Irrevocable Trust agreement is significantly more difficult to modify or revoke, even with a court order. This limitation is what enables the sought-after asset protection. However, you can have a Trust established that will still enable you to amend the designated beneficiaries without affecting the benefits you desire.

Revocable Living Trusts, on the other hand, are structures that may be changed at the Grantor’s discretion at any time. This difference means the Trust’s assets are accessible, for both the grantor and the grantor’s creditors. The dictionary definition of ‘irrevocable’ scares people into thinking that the Trust may not be changed no matter what. This is not the case:

Strategic Medicaid Planning

With Irrevocable Trusts, a prime benefit of elder planning is enabling the elderly to qualify for Medicaid benefits should they require specialized long-term care, e.g. a nursing home. Through transferring assets into an Irrevocable Trust five years ahead of needing care, the settlor secures his beneficiary inheritance from claims. Again, this strategy is meaningless with regard to Revocable Trusts because Medicaid does not consider the holdings of such Trusts to be “exempt assets”.

Trustee Appointments

There is a common conception the trustee of your IIOT must be 3rd party, preferably one who is independent. These Trusts are also known as self-settling because of this feature. Note, that whoever is the trustee has a fiduciary duty to protect the assets and act in the best interests of the beneficiaries.

The trustee, regardless of who, is tasked with managing the assets in the Trust and is bound by the provisions you set forth. Note, that the “Income Only” portion of the IIOT means you may live off the income produced by the assets.

Taxes

As the Grantor does not own the assets in a Trust, the Trust is not included in your estate calculations when you pass away. Revocable Trusts, though, are designed to avoid probate and do not assist with minimizing taxes. This is because you still have full control over the assets and thus they are included in your death estate and Medicaid estate.

Protecting Assets

The assets in an Irrevocable Trust no longer belong to the settlor, they are thus considered to be owned by a “3rd party” and are generally protected from creditors, lawsuits, and the government, so long as the original transfers were not fraudulent. This structure affords an extra degree of protection from those seeking to seize your assets.

An Irrevocable Income Only Trust (IIOT) is our recommended structure for avoiding Medicaid’s asset and income test. Generally, the senior person in need of specialized care must exhaust their resources before qualifying for Medicaid provisions. These spend-down provisions can whittle away your life’s work and leave your heirs with nothing.

Let’s contrast this with a revocable structure. A revocable structure is subject to Medicaid clawbacks because the initial transfers were not exempt due to the assets still being under your control. Assets like these are still accessible for addressing outstanding debts and obligations.

Income Tax Return

Our Medicaid Asset Protection Trusts have their own tax identification number (TIN/EIN) and file a 1041 with the Internal Revenue Service. The Trust may then either pay the tax directly (atypical) or issue a K-1 to the Grantor/Beneficiaries for income that passes through to the recipients via a Schedule E.

RLTs, though, have no such discrepancy given they are disregarded entities for tax purposes. The Grantor files everything on their 1040 because they personally own the assets that are "held" in the Trust.

Reviewing the differences between irrevocable and revocable structures makes clear the former is for protecting assets whereas the latter is meant to bypass probate. The assets are protected from estate taxes because they are outside the death estate at the time of passing, from creditors, including Medicaid, because you do not own them. This benefit comes with certain restrictions, such as only being able to live off the asset’s income, but is often well worth the trade-off.

Conversely, the Revocable Living Trust simplifies the transferring of assets to beneficiaries through avoiding the probate process but provides no other protections. Laws change and are more complex than we can represent here. For these reasons, we recommend consulting with an expert before embarking upon significant estate planning decisions.