Wealth Transfer Guardrails for Heirs

Like many people, your goal may be to pass on some of your wealth to loved ones. But if you're worried about how heirs may use their inheritance, you should know there are ways to guide their spending even after you're gone.

You have multiple options for directing how an heir inherits wealth, such as setting conditions in your will for receiving an inheritance or purchasing an annuity with scheduled payouts. However, for those hoping to set stricter inheritance stipulations, trusts are a popular solution.

Using trusts to control wealth transfer

Trusts are legal arrangements that help ensure your assets will be managed according to your wishes during or after your lifetime. Every trust has three key stakeholders:

• Grantor: An individual who establishes the trust
• Beneficiary: Someone who receives assets from the trust
• Trustee: An institution or individual responsible for managing the trust's assets

There are many types of trusts, each with their own uses and benefits, from donating to charities to minimizing estate taxes. However, two types of trust provisions—spendthrift and education trust clauses—are worth considering if your wealth transfer goals include establishing guardrails that may help prevent misuse of an inheritance.

What is a spendthrift trust?

One way to establish inheritance stipulations is to include a spendthrift clause within a trust. Commonly known as a spendthrift trust, this provision authorizes a trustee to control when a beneficiary receives asset distributions based on the terms outlined in the trust document.

There are many reasons a grantor may choose to include a spendthrift clause for one or more of their intended heirs. Here are some common circumstances that might warrant using this kind of clause:

• Frivolous spending habits
• History of poor financial decisions
• Susceptibility to fraud or deception
• Excessive debt accumulation
• A financially abusive spouse or partner
• Addiction—for example, substances or gambling
• Financial inexperience

How a spendthrift trust works

When a trust has a spendthrift clause in place, the assets will remain in the trust, and the trustee is responsible for managing and disbursing them based on the schedule and parameters established in the trust document. Through the trust, the grantor can determine how much a beneficiary should receive, as well as the frequency and method of payment.

Tammie Yarter, vice president of the Fiduciary Services Group at First Citizens, advises her clients to specify amounts in percentages rather than fixed sums. For example, you might specify that you want 1% of the trust's assets paid to your beneficiary on the first day of every month. "A percentage is better because $2,000 today is not going be what $2,000 is 10 years down the road," she explains.

While a spendthrift clause is designed to help control spending, beneficiaries may still be able to access more of their inheritance under specified circumstances or at the discretion of the appointed trustee.

The role of a trustee in a spendthrift trust

When you establish a trust, you'll name a trustee to manage and distribute the assets according to the detailed terms you set. You may choose anyone you want to be the trustee, but keep in mind that the person you choose will have a high level of responsibility, so appointing someone trustworthy is essential.

You may also choose to allow the trustee to make administrative decisions on their own. For example, if your heir were to experience health issues and require an expensive treatment, the trustee could have the ability to distribute additional assets to help fund their care.

Whether you specify that a trustee carries out the trust's rules explicitly or loosely is a critical decision. If you give the trustee the ability to interpret the trust's rules loosely, you're essentially appointing them as a financial caretaker to the intended beneficiary. To help minimize conflict, consider appointing an institutional trustee who may either act independently or as a co-trustee.

"Many of our clients feel like they can serve as the trustee effectively without help," says Michael R. Deming, senior vice president and director of the High Net Worth Wealth Planning Group at First Citizens. "But if there's any complexity in the estate—and there usually is—it's a very good idea to engage the support of an institutional expert."

Most people don't have the fiduciary expertise needed to act effectively as a sole estate trustee. An institutional trustee may add a lot of value—both with overall estate management strategies and the daily details.

Spendthrift trust pros and cons

Establishing a spendthrift provision may offer several benefits. For grantors, incremental asset distributions may help ensure their heirs will be supported throughout their lifetimes. In some cases, this type of trust provision may also help to preserve assets for heirs with negligent spending habits.

However, there are some potential drawbacks to consider when deciding if a spendthrift trust suits your situation. A trust may be complex to set up, and a spendthrift provision may involve ongoing maintenance costs. Likewise, it may be hard to change or revoke depending on how it's set up, and it may limit the heir's flexibility. It's also important to know that beneficiaries may contest trust provisions.

In addition, a spendthrift trust might not be appropriate for all beneficiaries. For example, a beneficiary with a mental or physical disability may need more assistance managing an inheritance, and in this case, a special needs trust may be more helpful. This kind of trust goes further than a spendthrift clause because a trustee manages the trust's assets for the beneficiary, even paying for expenses directly. Also, assets held in a special needs trust won't compromise a beneficiary's ability to qualify for needs-based government benefits.

Consulting with an estate planning attorney may help you sift through the advantages and disadvantages of setting up a spendthrift trust, as well as exploring other options as appropriate.

FAQ: Spendthrift trusts

Spendthrift trusts have complex rules and requirements. Here are answers to some of the most common questions that arise as people consider a spendthrift trust.

• Is a spendthrift trust revocable? Whether a spendthrift trust is revocable or irrevocable is determined by the terms specified by the grantor within the trust document. Typically, spendthrift trusts are irrevocable.
• Are spendthrift trusts taxable? Original assets inside irrevocable trusts are generally excluded from estate taxes, but any gains earned by those assets are taxable.
• Can a spendthrift trust take effect immediately? Testamentary spendthrift trusts are set up to go into effect upon the grantor's death. However, some states allow living spendthrift trusts, which may disburse assets while you're still alive.
• What if the beneficiary dies before the assets are fully distributed? Generally, when a spendthrift trust beneficiary dies, trust assets are subject to the provisions outlined in the trust itself. But it's a nuanced process that varies from state to state. The best strategy is to seek the advice of a wealth consultant.

How an education trust works

An education trust—which is a trust that includes an education spending provision—can be a smart way to help pay for escalating college expenses. Education trusts may be set up for a single child or grandchild, multiple family members, or a group of individuals. Many people establish education trusts for someone they're not related to but with whom they share a close relationship, like a godchild.

Sometimes, inheritance stipulations are specified in an education spending provision. For example, the grantor could stipulate that the funds may only be distributed if the beneficiary maintains a certain minimum GPA.

Education trust pros and cons

An education trust is intended to guide your loved ones toward spending their inheritance on educational expenses. But before you make a final decision, it's helpful to consider the potential drawbacks of adding an education spending provision to a trust.

As with any type of trust, education trusts may be complex and expensive. There's also a loss of asset control, which may be a significant drawback. Once funds are transferred to the trust, your beneficiaries won't be able to use their inheritance on any urgent non-education expenses, such as medical bills.

Education trusts versus 529 plans

Both education trusts and 529 plans enable you to set aside money to help pay for someone's education, and both offer tax-deferred growth, tax-free withdrawals and gift tax advantages. However, there are important differences between the two.

For example, unlike a trust, a 529 plan is relatively easy to set up, but it doesn't protect assets from creditors. It also gives you less control over how the money is spent and offers more limited investment choices than an education trust. And while both offer gift tax advantages, an education spending provision within an irrevocable trust may also help you minimize estate taxes.

To help determine which approach may be right for you, consider speaking with a financial professional who has insight into your entire financial situation.

FAQ: Education trusts

When it comes to education trusts, people often ask what happens to unused assets and about the timing of any distributions.

• What happens if a beneficiary doesn't use all of the trust's assets for their education? In the trust document, you may specify how unused or remaining assets should be distributed.
• Can an education trust take effect while I'm still alive? Yes. You may set up an education spending provision within a living trust that will take effect immediately. You may even choose to serve as the trustee or co-trustee in this case. This option may affect gift and estate tax liability, so it's wise to consult a tax specialist before proceeding.

The bottom line

Crafting a wealth transfer plan is an important part of the financial legacy you leave behind. If you're considering guardrails for your beneficiaries, the spendthrift and education trust provisions are options to consider.

Due to the complexities involved in the process, enlisting the support of a wealth consultant who understands your goals and has access to a team of financial consultants—including estate settlement professionals and fiduciary officers—may be invaluable.