One of the fundamental reasons to plan your estate is to ensure that the wealth you’ve built up over your lifetime through property and assets can continue to support your family, especially your children, after you have passed on. However, from divorce to death to creditors, there are many circumstances that can cause your children to lose their inheritance and remove inherited wealth from your family.
Fortunately, there is a way you can ensure that divorce, stepchildren, or creditors cannot remove your family wealth from your family—a trust. In this article, we’ll delve into how inheritance is most commonly lost and how a trust can prevent these situations and protect your child’s inheritance.
How Your Children Can Lose Their Inheritance
Before we start discussing the best ways to leave money to a child, let’s dive into the most common ways family wealth can be taken out of a child’s inheritance:
- A child gets divorced and loses half of his/her inheritance when the marital property is divided.
- A child dies after inheriting family wealth and has a will that passes everything the child has to his/her spouse.
- A child is already in a second marriage and the in-law has children from a prior marriage.
- A child has financial problems and loses the family wealth to his/her creditors.
Many clients want their estate plan to protect their family wealth from a child’s creditors, spouse, or stepchildren, making proper estate planning essential for protecting the inheritance for children from creditors.
Why You Need to Protect Your Children’s Inheritance in Your Second Marriage
When talking to clients about preparing an estate plan, one issue that often comes up is how to protect the family assets from a new spouse if one dies and the survivor remarries. People often don’t think about this problem until it is too late. Normally, a couple’s documents clearly state that when the second of them dies, the assets go to the children.
But what if it happens after the first of the couple dies and the survivor later remarries? The survivor can change the will, invalidating the earlier one, to pass assets to the new spouse and take assets away from the children unless steps are taken in the planning process.
Finding the Best Way to Leave Money to a Child
The best and most secure way to protect your children’s inheritance is to use a trust. When set up correctly, a trust can protect wealth from creditors, divorce, spouses, and more to prevent assets and property from leaving your family line.
There are three specific provisions a trust needs to address to protect your child’s inheritance:
Provision 1 – When does the trust terminate?
The trust can only protect the inheritance if the inheritance stays in the trust. Many trusts have mandatory termination provisions when the child reaches a certain age. Sometimes the provisions spread the termination out over several ages—for example, a third at age 25, a third at age 30, and the last third at age 35. Once the inheritance comes out of the trust, all the protection the trust provided is gone.
To protect the inheritance, the trust should last for the child’s lifetime. There should be no mandatory distributions just because the child reaches a certain age.
Provision 2 – When do distributions of income come out of the trust?
Some trusts have provisions that mandate that the trust income must be distributed to the child in periodic installments. If the trust has an investment that earns 5%, then that income would have to be distributed out of the trust to the child. Often the payments of income are made monthly or quarterly.
To protect the inheritance, the trust should have no mandatory distributions of income. Only discretionary distributions, which are made by the trustee under certain criteria, should be allowed.
Provision 3 – Spendthrift Clause/Creditor Protection
A trust can contain a provision that prohibits a trustee from making any distribution to a child’s creditor. If a child owes a debt, even if the lender has a judgment against the child, this spendthrift provision prevents a creditor from forcing any of the child’s inheritance out of the trust to pay off the debt. These provisions often also prevent a child from “trading” his/her position as a beneficiary of the trust to pay off a debt.
Now that we have seen which provisions are important to protecting the inheritance for children with a trust, let’s see how they work in specific circumstances:
Situation 1: Protecting Inheritance from a Child’s Divorce
Inherited assets are not normally subject to a divorce as long as the child keeps the assets separate from the spouse. However, once the inherited assets are commingled with the spouse, they become marital assets subject to divorce.
By keeping the inheritance in the trust, it will be difficult for the spouse to argue that the inheritance was commingled and transformed into marital assets. Having discretionary distributions also makes the flow of cash uncertain and difficult to include in a divorce analysis.
Situation 2: Protecting Inheritance from a Child’s Spouse.
It would be great if your children only married wonderful people, but that is not always the case. By having a trustee and a co-trustee, a trust can protect your child’s inheritance from an unscrupulous spouse. The trustee is the child and the co-trustee is another family member or independent advisor who also has a voice in how the inheritance is managed and utilized.
Because a second co-trustee exists, there is always someone else serving to make sure the inheritance is used only for the child and the child’s descendants—not the spouse. This prevents the inheritance from being used by the spouse and his/her children from a prior marriage.
Situation 3: Protecting from a Child’s Creditors.
It is easy for a parent to protect the inheritance from a child’s creditors by using a trust. If the trust is drafted properly, Tennessee, like most other states, has specific laws that prevent a child’s creditors from reaching into a trust created by a parent (or anyone other than the child) for assets to pay a debt.
Even if the child declares personal bankruptcy, a properly designed trust can prevent the child’s creditors from reaching the inheritance.
Protect Your Children’s Inheritance with MHPS
Don’t leave your child’s inheritance at risk. We recommend always using a properly designed trust, the best way to leave money to a child, to pass family wealth onto your children and prevent it from being taken away.
If you are concerned about protecting your child’s inheritance, you will need to discuss your options with an experienced estate planning attorney. For decades, MHPS has been helping clients with family wealth preservation issues across Tennessee. Contact us today to schedule a free consultation.