The Perils and Pitfalls of Do-It-Yourself Special Needs Planning
The risks of designing your own special needs plan, without the guidance of a professional, far outweigh the potential reward...Read more
You may be thinking about setting up a trust to protect your assets, save on estate taxes, or perhaps set aside money for a special needs family member.
Before you commit to a plan, make sure you understand the differences between the two basic types of trusts: the revocable (also called “living”) trust and the irrevocable trust. These differ in how they are structured and taxed, and each offers advantages and disadvantages depending on their purpose.
Both are tools for setting assets aside and distributing them according to specific wishes and instructions. They can protect one’s property, safeguard a family’s financial future, and provide tax-saving strategies.
As the name suggests, an irrevocable trust, once established, can’t be canceled or revoked. The person creating the trust, sometimes called the “grantor,” transfers assets into the trust and permanently gives up all claim to them. A trustee is appointed to carry out the instructions spelled out in the trust. No changes to the terms of the trust can be made without the consent of the trust’s beneficiaries.
In contrast, a living trust offers more flexibility. The grantor of a living trust still owns and controls the assets and can make changes at any time. A living trust also has a trustee, someone who would take over management of the trust if the owner is no longer capable of doing so.
Both types of trusts offer tax advantages, although these differ in key ways.
An irrevocable trust is considered a separate entity and must have its own tax returns filed annually under its tax ID number. Irrevocable trusts can incur additional costs if a certified public accountant is needed for tax preparation.
Because it is a trust and not an individual, the irrevocable trust can’t qualify for the various deductions and exemptions that individuals can claim on their returns.
Also, higher rates apply at lower income levels. For example, an irrevocable trust is subject to the highest federal tax rate of 37 percent if its income is at least $13,450 (in 2022), a much lower ceiling than for individuals.
Assets within a living trust are still considered the property of the trust owner. Any income earned from this trust is filed along with the owner’s other income.
Also, the assets of the trust belong to the owner’s estate, can bypass the probate process, and are taxed accordingly on the owner’s death.
For this reason, wealthy families may choose to transfer a portion of their assets into an irrevocable trust to keep the value of their estate below federal and state exemptions, to avoid estate taxes on property above those exemptions.
One key advantage of irrevocable trusts is that their assets are protected from lawsuits and creditors.
Special needs trusts are generally set up as irrevocable trusts, because the beneficiary with special needs likely cannot earn a living and thus needs that money for the rest of their life. Also, the beneficiary has access to this money without losing their eligibility for government benefits, such as Supplemental Security Income (SSI).
A living trust offers no protection from lawsuits or creditors, because it is still part of the owner’s property. This is an important consideration for families with children who have special needs.
A living trust is an option for someone who doesn’t need all these layers of protection but still wants to set up some provisions for the future.
They may want to set aside assets in the event that they become unable to manage their finances in the future, due to illness or old age, for example.
With a living trust, they control the property while they are competent, but a trustee can take over this function should the beneficiary lose this capacity.
If there are other considerations, such as estate tax planning, protection from creditors, or providing for a special needs family member, an irrevocable trust might be the better way to go. Find a qualified special needs planner in your area to obtain the best answers for your particular circumstances.
Keep in mind that this is general advice only and that specific situations may be treated differently than those described in this article. It is prudent to have an attorney’s advice on how your specific situation will be handled using different types of trusts.
Learn more about the landscape of trusts in the context of special needs planning in the following articles: