Wise use of an irrevocable trust can be a powerful way to protect assets as one gets older. One use is to avoid the need to spend down assets in order to qualify for certain benefits, such as veterans benefits and Medicaid.
But why use a trust? Why not just give the money away?
If a client is trying to protect assets and still qualify for government benefits, one strategy is to gift away excess funds to someone outside the household, typically children or other family members. The client then applies for veterans benefits, or in the case of Medicaid, waits five years before applying for benefits.
That strategy poses a number of significant risks. The person to whom it is gifted could die, become divorced, spend the money, invest the money in an unwise way, lose the money to creditors, and so on.
Even if the person making the gift were healthy when the gift was made, a health crisis could bring about the need for nursing facility care during the five years following the gift. If the gifted funds have been lost or spent, there could be no way to cure the gift. Without Medicaid benefits, there may be no way to pay for care.
An irrevocable trust has a number of advantages over an outright gift.
Control
Simply having the funds in a trust provides a superior amount of control over an outright gift.
In addition, the person who creates and funds an irrevocable trust (called the “grantor”) can make a number of important decisions about how the funds are held, managed, and disbursed. The grantor can name trustees, and decide whether to have a single trustee, followed by successor trustees, or co-trustees. The grantor can name beneficiaries and retain the right to change beneficiaries through a power of appointment in the grantor’s will.
A trust protector can be named, with the power to approve or disapprove distributions during the grantor’s lifetime. The grantor can decide whether there will be one trust or a number of trusts, and can stipulate what assets will be used to fund each trust.
Income
The grantor can decide to receive income from the trust, even if there is no access to principal. Having income makes grantors feel as if the money is still theirs in some way, thereby easing some concerns about establishing an irrevocable trust in the first place.
Income can also help the client make it through a five-year look-back period by providing a means to help pay for care.
Protection from loss
By far one of the biggest concerns about gifting away funds is that the recipient (or “beneficiary”) will lose it in some way. With the right drafting, though, the funds placed into an irrevocable trust will not be available to be lost in a beneficiary’s divorce or bankruptcy proceeding.
Using a trust avoids the risk that a beneficiary will die and that the funds will be distributed to the beneficiary’s heirs.
Spendthrift language can help prevent the money from going to a beneficiary’s creditors, or from being squandered by a beneficiary who cannot handle money due to bad decision-making, gambling problems, addictions, or other reasons.
Tax advantages
An irrevocable trust offers some tax advantages over an outright gift, primarily in the area of capital gains tax. If the trust is structured as a grantor-type trust, then appreciated assets, such as a stock portfolio, can receive a favorable step-up in basis upon the death of the grantor. If such an asset were merely gifted, the recipient would have the same basis as the donor, and in many cases owe much more in capital gains tax.
Using a grantor-type trust provides a similar tax advantage for a homeowner’s principal residence. The estate can take advantage of the grantor’s capital gains tax exclusion under 26 U.S.C. § 121, which would not be available to heirs if the residence were gifted during the lifetime of the owner.
Weighing the options
Whether to create an irrevocable trust in any particular situation requires a careful assessment of the client’s objectives, assets, income, health and care needs, family dynamics, and other considerations. It can work well in the right circumstances, but it’s always best to consult with experienced legal counsel to make an informed decision.
