Are the assets in your revocable trust outside of the reach of your creditors? During your lifetime, the answer to that question is “No.”
Many clients mistakenly believe that by creating a revocable living trust, they protect their assets from the claims of divorcing spouses, predators and creditors. This isn’t the case. When you transfer assets from your name into your revocable trust, you are merely changing the form of ownership. Because you are the grantor of the trust, you are deemed to own it. You can freely change the terms of the trust whenever you want, and can control the disposition of the trust assets, so the assets of the trust are still considered yours.
Revocable trusts generally use your social security number as the tax identification number, so there’s no separate income tax return to file as long as you are alive. All of the income of the trust appears on your federal Form 1040 just as it always has.
Because assets inside of your trust remain yours legally, the trust does not shield you from liability.
This came to light recently when a client was involved in a tragic accident that involved killing a motorcyclist while driving her car. Because she was retired, she had cut expenses, limiting her automobile insurance coverage to 100/300/50, meaning that she had coverage of $100,000 bodily injury liability insurance per person, $300,000 total bodily injury liability insurance per accident, and $50,000 property damage liability per accident.
Moreover, she had dropped her umbrella insurance policy. Umbrella insurance is extra liability insurance that stacks on top of your home, auto and boat coverage. It is designed to help protect you from major claims and lawsuits. As a result, it helps protect your assets and your future. A $2 million umbrella policy, for example, will provide additional coverage above the limits of those policies. Generally speaking, you must increase your home, auto, and boat coverage to the maximum limits when purchasing an umbrella policy. For most people, umbrella policies are very affordable.
Our client’s auto insurance wasn’t adequate to cover the losses associated with the accident. This meant that her other assets, including those assets funded into her revocable trust, were at risk in the negligence lawsuits following the incident. The lesson to be learned is to carry adequate insurance, and if you have any degree of net worth, even if you are retired, it makes sense to carry an umbrella insurance policy.
When you die and leave continuing trusts for your spouse, children or beneficiaries, however, you can build those trusts to provide protections from creditors and predators. This is because your trust is no longer revocable. Once you pass away, your trust becomes irrevocable.
If you wish to protect the inheritance you leave your loved ones, then you may build a testamentary (after-death) trust inside of your trust. In order to offer the best protection, you would make the income and principal distributions discretionary as opposed to mandatory, and you would not name the beneficiary of the trust as the sole trustee. Distributions would have to be approved by an independent trustee to provide the maximum protections.
Assume, for example, that you leave assets in a testamentary trust for your daughter Brenda. You would like Brenda to control the investment and distribution decisions during her lifetime, so you name her as the trustee. You are concerned, however, because Brenda isn’t all that experienced handling money and has had problems with credit cards.
In this case, you may want to name a bank, financial firm, or trust company as Brenda’s co-trustee so that she has professional money management and some level of protection over any creditors that she may have. By making the trust distributions discretionary, if Brenda had any outstanding judgments the trustee can withhold distributions that the judgment creditor otherwise may be entitled to.
Whenever naming a bank, financial firm, or trust company as a co-trustee, you should consider allowing Brenda or someone else close to her the ability to remove and replace the corporate co-trustee. This way, Brenda isn’t married to any one particular financial institution.
By naming an independent trustee that can withhold trust distributions, Brenda would not have access to the trust funds during a creditor problem, but would also put her legal team in a better position to negotiate the debt with the creditor, perhaps settling for pennies on the dollar. Or, in a worst case scenario, Brenda may consider bankruptcy proceedings to discharge the debts. Once those debts are satisfied, then the trustee could resume distributions to Brenda or for her benefit.
If, however, you left the inheritance outright to Brenda, or if you named Brenda as the sole trustee of her testamentary trust, then her inheritance could be at risk.
I hope this gives you a better understanding of the differences as to the levels of asset protection between a revocable trust that benefits the grantor during his or her lifetime, as opposed to a testamentary trust that springs into effect upon that grantor’s death.