How a Revocable Living Trust Works
A trust is a legal entity that’s specifically created to hold an individual’s or a family’s assets and property. A living trust is an empty vessel until the trustmaker transfers ownership of those assets and property into the name of the trust and its trustee. This process is referred to as “funding” the trust. Unlike an irrevocable trust, the trustmaker reserves the right to undo or modify a revocable trust, thus the term “revocable.” They can reclaim assets they’ve placed into it, divert the trust’s income to themselves or another beneficiary, change beneficiaries, sell the assets, or place more assets into the trust. The trustee retains final control. A revocable living trust doesn’t have its own taxpayer identification number, unlike an irrevocable trust. A revocable trust and its trustmaker share the same Social Security number. The trust’s income and deductions are reported on the trustmaker’s personal Form 1040 tax return, just as though they continued to hold ownership of the assets personally. The probate court says that they have indeed relinquished ownership, however. They’ve given the assets to the trust, even though they can take them back. The trust’s assets would not pass through probate for this reason, assuming that the trustmaker hasn’t taken them back as of their date of death. The successor trustee can therefore settle the trust outside of probate court, without supervision.
Example of Revocable Living Trust
A revocable living trust covers three phases of the trustmaker’s life: their lifetime, their possible incapacitation, and what happens after their death.
Phase 1: The Trustmaker Is Alive and Well
When a revocable living trust is formed, the trust’s documents should include specific provisions allowing the trustmaker to invest and spend the trust assets for their benefit during their lifetime. These documents explain how the trustmaker’s assets will be distributed after their death. The trustmaker can go about business as usual with the assets that have been transferred or funded into the trust’s ownership, assuming no one else has been appointed to act as trustee.
Phase 2: The Trustmaker Becomes Incapacitated
The trust agreement should also specify what happens if the trustmaker becomes mentally incapacitated and can no longer manage their own affairs and those of the trust. The trust documents should name a “successor trustee,” someone who will step in if and when the trustmaker is determined to be mentally incompetent. The successor trustee can then manage the trustmaker’s finances and the assets that have been placed into the trust.
Phase 3: The Trustmaker’s Death
A revocable trust automatically becomes irrevocable (i.e. unchangeable) when the trustmaker dies, because the trustmaker is no longer available to make changes to it. The named successor trustee steps in now as well, paying the trustmaker’s final bills, debts, and taxes just as they would if the trustmaker had become incapacitated. They would then settle the trust, distributing the remaining assets to the trust’s beneficiaries according to instructions included in the trust’s formation documents.
Revocable Trust vs. Irrevocable Trust
All living trusts are either revocable or irrevocable. The primary difference between a revocable and irrevocable trust is whether or not the grantor can change the trust over time. Another major distinction is that the grantor still technically owns the assets in a revocable trust and can act as a trustee. The grantor must step aside and appoint someone else to serve as trustee of an irrevocable trust. Both types of living trusts protect the privacy of the property and beneficiaries. The distribution of assets is a private family matter and not aired out publicly in probate court. Unlike an irrevocable trust, assets placed in a revocable trust don’t avoid estate taxes, because the trustmaker and the trust share the same Social Security number. The trustmaker can reclaim the assets held within the trust anytime they like, so the IRS takes the position that they haven’t relinquished ownership as they would with assets placed in an irrevocable trust. The probate court says that they have indeed relinquished ownership, however. They’ve given the assets to the trust, even though they can take them back. The trust’s assets would not pass through probate for this reason, assuming that the trustmaker hasn’t taken them back as of their date of death. The successor trustee can therefore settle the trust outside of probate court, without supervision.
