Do living trusts protect assets from creditors?

While there are several good reasons to consider a revocable living trust for your estate plan—avoiding probate, for example—keeping your assets safe from creditors is not one of them.

To understand why, it's helpful to discuss what a revocable trust is and what it does, as well as how it differs from an irrevocable living trust—a legal instrument that actually may help you protect assets from creditors.

Aside from an irrevocable trust, there are other ways to keep creditors away from your stuff, so if you're concerned with asset protection, read on.

What is a revocable trust?

A revocable trust, sometimes called a living trust, holds the assets of a trust creator (called a “grantor," “settlor," or “trustor") during his or her lifetime. The trustor is named as trustee.

Upon the grantor's death, the “successor trustee," who had been chosen by the trustor, facilitates the distribution of assets to the trustor's chosen beneficiaries according to the provisions of the trust documents. All of this happens outside the probate process.

Indeed, many people turn to trusts to avoid probate, the court-supervised process of distributing a decedent's estate, which can become costly and time-consuming.

Generally trust documents do not become part of the public record, which means your affairs stay private, as opposed to what happens with a last will and testament, which goes on file for anyone to search.

Another benefit of a living trust is that the successor trustee can step in to handle the affairs of the trustor should the trustor become incapacitated, which, again, would happen without getting a court involved.

Two important notes about a revocable living trust, however: (1) The trustor is still legally considered the owner of the assets within the trust; and (2) the terms of the trust can be changed or the trust canceled by the trustor at any time.

These characteristics make the assets within the trust susceptible to collection by creditors because the trustor, as far as the law is concerned, still owns and has full control over the assets. As a result, a creditor could go after the trust, seek its termination, and gain access to assets within it.

So, to be absolutely clear: A revocable living trust does not protect assets from creditors.

What is an irrevocable trust?

An irrevocable trust, on the other hand, may protect assets from creditors. In fact, you may see the term “asset protection trust" used to describe such a trust.

What's the difference? With an irrevocable trust, the assets that fund the trust become the property of the trust, and the terms of the trust direct that the trustor no longer controls the assets. Also, an irrevocable trust's terms cannot be changed, and the trust cannot be canceled without the approval of the grantor and the beneficiaries, or a court order. 

Because the assets within the trust are no longer the property of the trustor, a creditor cannot come after them to satisfy debts of the trustor.

Still, it is crucial to know your state law regarding irrevocable trusts to understand exactly how well your assets are protected from creditors. Keep in mind that a court is within its power to find a transfer of assets to a trust to be fraudulent if it is done with the intent to defraud creditors. Not only could such a finding expose the trust assets to liability, but also it could mean heavy legal penalties for the trustor.

Asset protection strategies

If you are concerned with asset protection, there are several different ways to accomplish this, aside from putting your property into a trust that you will no longer have control over.

Depending on your state law, certain assets may already be protected from creditors, so you may choose to put your money into such assets. Many states, for instance, have a “homestead exemption" for the main home of an individual, which cannot be touched in bankruptcy. Most retirement accounts and pension plan funds are also usually off-limits.

Liability insurance is one of the most common ways to protect against potential lawsuits and creditors. Another option may be to create a separate business entity, such as a limited liability company (LLC) or corporation to shield personal assets from liability.

Make no mistake: The right kind of asset protection can make a big difference in how much your creditors could collect from you, so if you have any concerns about whether you're going about things correctly, you should contact an experienced professional for guidance.