NOVEMBER 25, 2013 VOLUME 20 NUMBER 45
This conversation comes up a lot with our estate planning clients. “So, you’re leaving your entire estate equally to your three kids,” we say to our client. “Do you want to leave it outright or would you consider putting it in a trust for them?” The two most common responses:
- “No, my kids are all OK. They can manage money and would be insulted if their inheritance was left in trust.”
- “No. If they can’t manage their inheritance then I can’t help them. I don’t want to try to control things after I’m gone.”
Then we explain that creating a trust is actually a good thing for the kids — but it’s usually hard to convince clients. So let’s try it here, and then we can just hand them this newsletter.
Why consider a trust for your child’s inheritance? It may be a real benefit to them, protecting their inheritance from their creditors, spouses — even estate taxes. Let’s look at each of those concepts briefly.
One common concern we hear: “we love and trust our daughter, but though we like her husband he doesn’t really have any money sense.” There’s good news for that client: even though Arizona is a community property state, inheritances start out as separate property. In other words, the money you leave to your daughter is not immediately available to her husband, even in a community property state.
But wait. It’s really easy for your daughter to turn that separate property into community or joint property. All she has to do is add it to her joint banking account, or add her husband to the account title. Once it has become joint property, it is difficult to return it to separate property status. If your son-in-law or daughter-in-law is a “spendthrift,” that can expose your estate to loss after your death.
By creating a trust for your child’s inheritance, you make it easier to keep the property separate from spouses, and more likely to pass to your grandchildren on your child’s death. Sadly, divorce is very common: you can help keep the inheritance from being considered as part of the property to be divided if your daughter does divorce.
Let’s consider creditors. “Our son is a doctor,” you say, “and he has plenty of money.” Ah, but professionals are vulnerable to future malpractice lawsuits, and anyone can have even a substantial estate drained by an auto accident or medical crisis. Creating a trust for your son can help protect the inheritance from lawsuits, creditors, and bankruptcy.
How about taxes? If your daughter is a successful professional, she might well have a taxable estate on her death. That could be true even though she is not particularly close to that figure today. If estate taxes do kick in, they start at a very high 40%. And though we tend to ignore state estate tax considerations in Arizona (we don’t have a state estate tax at all), other states do impose taxes, even on much smaller estates. You may have settled in Arizona for good, but your children may move several times before picking their final residence — and that may subject them to a state estate tax.
If you leave your daughter’s inheritance in trust, you can fairly easily arrange to keep it out of her “estate” for tax purposes. Even though she is worth, say, $3 million, and you are only going to leave her another $500,000, the math is compelling: by the time she dies, that $500,000 could mean $200,000 or more in additional tax liability to her estate.
So there are good reasons to leave an inheritance in trust, even though all your children are responsible and your estate is modest. But aren’t there some serious downsides? Doesn’t it mean a lot of additional costs and imposition of a bunch of difficult rules? Not really.
Depending on your family circumstances, you might even name your son trustee of his own trust. Or make your son trustee of the trust for your daughter, and make her trustee of his trust. Or make your daughter (you know, the one with her CPA who works for the bank) trustee for all the kids’ trusts. In other words, creating a trust does not mean you have to incur professional trustee fees — though it might actually make sense to name a non-family trustee. We can talk about those options.
The trusts for your children will have to file tax returns each year. That will in fact mean a small additional cost. But the total amount of income tax paid need not increase — it should be fairly easy to assure that each trust’s income is taxed to its beneficiary, rather than paying taxes at the (often much higher) trust rates. We can talk about those issues, as well.
What about your son’s access to the money? Do you think he might want to use his inheritance to pay off his mortgage, or to allow him to put more away for retirement, or to send your grandkids to college? You can give him the power to demand money from the trust, or give the trustee direction to follow those kinds of requests. Let’s talk about how much control you want to give each of your children over the trust while they are alive. And on their death, you can even give your children the power to name which of their children (or spouses, or charities, or whomever you want to permit) will receive the remaining trust’s assets. This concept, incidentally, is sometimes described as a “dynasty” trust — which makes it sound like a very fancy, expensive idea only for rich people.
Cost? Setting up a trust for each of your children will likely increase the cost of your estate planning — but by a pretty small number, in most cases. We do this a lot, and so we already have a library of provisions and ideas to draw on. We almost always charge flat fees for our estate planning work, so we can tell you upfront how much additional cost such provisions will add to our fees — and we predict that you will be at least mildly surprised at how little cost it adds.
Oh, and these principles apply even (perhaps especially) if you are leaving your estate to grandchildren, nieces and nephews, or anyone other than your children. The illustrations we use are not intended to limit the point by gender, either — whenever we say “son” you can substitute “daughter” and the point is still valid.