The world of estate planning is full of complicated and rarely encountered terms, especially when it comes to living trusts. For those who haven’t encountered these terms before, many of them can be somewhat confusing.
This is especially true when you consider that the terminology that lawyers use isn’t necessarily the same terminology that the IRS uses when it categorizes trust for tax purposes. Let’s take a look at some common trust terms you might encounter and try to clarify them a bit.
One of the most important ways to differentiate between different kinds of trusts is revocability. A revocable trust is one that you can change. On the other hand, irrevocable trusts are those that, once you create them, are largely set in stone.
Living trusts are those you make that take effect while you are still alive, while testamentary trusts are those you create through the terms of your last will and testament. All revocable trusts are living trusts, meaning that all revocable trust will take effect while you are still alive, and you cannot create one through your last will and testament.
Simple or Complex
To add another layer of complexity to trusts, it’s often important to know whether the IRS considers your trust to be either simple or complex. Though it’s sometimes difficult to determine which is which, the difference between a simple and complex trust is how the trust distributes any income it generates.
In general, and though there are some significant exceptions, a simple trust must, and does, pay all of its income to the named beneficiary or beneficiaries. On the other hand, a complex trust is not required to distribute all of its income to beneficiaries.
Determining whether your living trust, testamentary, or revocable is simple or complex is not always an easy determination to make. Further, the type of trust you want to create will depend largely upon your individual circumstances. While many people, for example, create revocable living trusts because they have so many useful features, these trusts are not ideal for all needs. Some people might have to create a certain types of irrevocable trust if they wish to take advantage of tax exemptions or reduce their income tax exposure.
Regardless of your individual circumstances, talking to your estate planning attorney before you decide to make a living trust is essential. Not only will your attorney tell you what your trust can do and how it will be treated for tax purposes, but you can also get a better understanding of what role the trust can play in your life.