How Can a Trust Protect My Children’s Inheritance?

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Will a Trust Protect My Children’s Inheritance?

One of the main reasons to do Estate Planning is to provide loved ones with protection from claims of future creditors and divorcing spouses or lawsuits. If you leave your property to your child as an outright distribution, the property will not be protected. What you need to do to protect your children’s inheritance is create a trust.

A living trust is a common estate planning tool for transferring assets at death to children and other loved ones. One of the primary reasons trusts are used is to avoid the necessity of having assets tied up in Probate Court (a common misconception is that a Will avoids probate – it does not). Another reason might be to minimize the amount of estate taxes owed upon death, although under current tax laws, estate tax is reserved for the very wealthy. However, one of the most important benefits of a trust is the ability to protect your assets from your children and from their creditors.

A common estate plan might provide that upon your death (or upon the death of the last to die of you and your spouse), your assets will be distributed outright to your children. While that has the benefit of being simple, there can be risks with such a plan:

  • The child may be immature or irresponsible with finances. In many cases, a child who receives a sizable inheritance will view it as a windfall. Rather than save the money for the future, he or she may not be able to resist the temptation of spending it on items or services that he or she ordinarily would not have purchased, such as expensive cars, luxury items, and lavish vacations.
  • The child may have creditors. If a child owes money to a creditor (whether as a result of a loan, a civil judgment, or otherwise), and defaults on that debt, that child’s assets are subject to being seized or attached by his or her creditors. To the extent a child receives an inheritance outright, it becomes fair game to his or her creditors.
  • The child may get divorced. In a divorce, a couple’s marital assets are typically divided equally between the former spouses. While inheritance is considered a “separate” asset under most states’ laws, and not marital property, it can easily be reclassified as marital property if the child commingles it with other marital property. An example of this would be using that money to help purchase a marital home, or depositing it into a joint bank account.

A properly drafted trust can reduce those risks or protect your children’s inheritance by limiting or delaying the distribution of assets to your children and putting control of distribution decisions in the hands of a qualified trustee. In most cases, a trust will give the trustee some degree of discretion concerning distributions of income or principal to the trust’s beneficiaries.

There is a longstanding concept in trust law known as “spendthrift” protection. These are provisions which provide that the Trustee will have sole control to make distributions from the Trust without interference from others. The spendthrift clause prevents a third party (i .e., a creditor or “predator”) from being able to compel the Trustee into making distributions of trust property for the benefit of the third party.

Under the spendthrift rules of most states, a person is free to leave assets in trust for another person, with specific language in the trust specifying who, besides a trust beneficiary, can have access to the trust assets. If the trust includes a “spendthrift” clause that specifically states that trust income and principal is not to be available for payment to a trust beneficiary’s creditors, then as a general rule the trust would be immune from attack by a beneficiary’s creditor. This sweeping protection would apply regardless of the amount or nature of a beneficiary’s liabilities, and would include protection of the trust assets if the child were to go through a divorce.

However, the extent of protection offered by a trust with a spendthrift clause will depend upon state law. Under some states, certain creditors are still allowed access to a trust. This could include a beneficiary’s obligations for alimony or child support, or payments to creditors who have provided certain “necessities of life” to the beneficiary.