Gifts With Strings Attached
Paul Merriman wanted to leave money to his grandson. But while the 55-year-old Seattle investment adviser liked the idea of one day freeing 5-year-old Aaron from financial insecurity, he was also afraid of spoiling the boy. So Merriman set up a trust with a tax-free gift of $10,000 that his grandson can't touch until the ripe age of 65. Each year after that, Aaron will be able to withdraw 7% of his inheritance, with the remainder going to a charity of his choice when he dies. "It's not going to make him rich," Merriman says of the trust, which will nonetheless reach $4.9 million in 60 years if it compounds at 10% a year. "If he wants to be rich, he can do that on his own."
Thanks to a booming economy and a soaring stock market, a large number of Americans are now in a position to leave a sizable inheritance. But many fear their heirs may not be able to handle big windfalls. "A great many people never imagined having this kind of money," says Mary Hickok, trust counsel at Wilmington Trust in Wilmington, Del. "Now they are frightened to leave it outright to their children." So, instead of handing stock or cash over directly, many are tying the money up in a trust, a legal entity that holds and manages assets for heirs.
Although some trusts contain few, if any, restrictions on how and when money can be used, many have requirements that reflect a benefactor's values or a child's economic or health needs. "You can write in any set of rules you want," Hickok says.
With the help of a good lawyer, for example, parents afraid of assets being frittered away can safeguard their child's nest egg for retirement by preventing payouts before age 60--or even later. If your child would rather watch TV than look for a job, a trust that links the payout to the amount he or she earns might create an incentive to work. And to encourage entrepreneurialism, some trusts allow beneficiaries to withdraw or borrow against a portion of their inheritances to set up businesses, says Joanne Johnson, a trust and estate lawyer at J.P. Morgan's Private Bank in New York. If you're concerned the money will be wasted on a scam, you can require accountants or attorneys to approve a business plan.
You also can cut the odds of subsidizing a drug, alcohol, or gambling habit. Jeffrey Condon, a Santa Monica (Calif.) trust and estate lawyer and co-author with his father, Gerald Condon, of Beyond the Grave: The Right Way and the Wrong Way of Leaving Money to Your Children (and Others) (Harper Business, $15), recommends hiring a professional trustee, such as a bank, to oversee the funds and write checks to creditors, including landlords and doctors. Some advisers suggest appointing a sympathetic but discerning friend or relative to assess the heir's needs and vet all but routine payouts. Those who want to play hardball can make payments contingent upon rehabilitation, Johnson says.
WINDFALLS. Although no rules say so, there are some things parents will never be able to control via a trust. A mother who hates her son-in-law cannot make her daughter's trust payments contingent upon a divorce. Similarly, parents cannot block withdrawals if an heir marries someone of a particular religious, racial, or ethnic background. "The courts have routinely thrown those limitations out," Hickok says.
When drafting a trust, the choice of a trustee is vital. "If you don't have someone who will discharge the responsibilities of the trust with the utmost integrity and objectivity, you are going to have some problems," says Johnson. A professional, such as a trust company officer, can provide both objectivity and investment advice. The downside, though, are annual fees that frequently amount to 1% of the trust's assets. (Fees are often waived when non-professionals, such as friends or relatives, serve as trustees.) That is on top of the cost of establishing the trust, which can run from $2,500 to $12,000, depending upon where you live and the complexity involved.
The next step is to draft the trust's terms. That means deciding when the money can be released. Often, trusts pay heirs interest on their investments annually, while distributing the principal in stages. A common arrangement gives beneficiaries a third of their share at age 30, another third at 35, and the rest at 40, when the trust terminates. The theory behind staggering payouts is that heirs get practice in handling windfalls. Accordingly, if someone blows a first installment on, say, a failed restaurant, he or she might be more conservative with the remainder, Hickok adds.
THINK TWICE. You don't have to give everything away within a set timetable. Johnson says some people give their children most of their inheritances in their 30s and 40s. But to preserve some assets for old age, they require some money to remain in the trust for the heirs' lifetimes. Many are also establishing "generation-skipping trusts," which allow married couples to put away as much as $2 million for grandchildren and subsequent generations, although they allow children to be named as beneficiaries as well. For single people, the threshold is $1 million. The government exempts these sums from the 55% generation-skipping tax normally levied upon gifts to grandchildren. (That tax is separate from the estate taxes that kick in on gifts of more than $650,000 per person, or $1.3 million for couples.) Because generation-skipping trusts are able to grow tax-free for generations, those who establish them should think twice before allowing their children to withdraw every penny.
When setting up a trust, consider how flexible you want it to be. If you want your progeny to have access to money whenever they need it, you might consider letting the trustee approve withdrawals. Alternately, some trusts spell out how and when money can and cannot be used--no ifs, ands, or buts--say, exclusively on college or a home.
Some choose a middle ground by allowing a trustee to deviate from the rules if someone makes a special request for money for "education, support, maintenance, or health." These are part of broad standards the Internal Revenue Service established to give trustees guidance.
Trust and estate lawyers say they advise clients not to be too rigid. "If you draft a trust to be flexible, it can be responsive to the evolving circumstances of your children," says Johnson. For example, if you deem that the trust cut off heirs who remain unemployed, you could punish stay-at-home parents and those who become too disabled to work. One solution is to give the trustee room to make exceptions, Hickok says.
NEST EGG. It's also a good idea to allow your progeny to keep their money in the trust longer than required. Because trusts with so-called "spendthrift" clauses are protected against creditors, they can shield a nest egg from divorce, bankruptcy, malpractice, and other legal claims.
Finally, keep in mind that no matter how many rules you put in a trust, you have no guarantees that things will go according to plan. For example, if you establish a minor's trust for a child under age 21, that child has the right to withdraw some--if not all--of the money during a 30-to 90-day period once he or she reaches adulthood, regardless of the trust's restrictions.
For those willing to contend with extra paperwork, a so-called Crummey Trust offers some protection against raiding. Crummey provisions require that an adult heir or a guardian of a minor child receive notification after each contribution is made. That sum can then be withdrawn during a 30-to 90-day window. But money given beforehand remains off-limits until the trust's terms permit.
Whatever type of trust you settle on, be aware that most cannot be changed once established. So before you sign off, make sure the trust reflects your heirs' needs and your values. Then ask yourself whether the trust is flexible enough to allow for the unforeseen. No matter how well you know your heirs, you can't possibly predict the future.