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Is a Testamentary, Dynasty, Incentive or Spendthrift Trust Right for Your Family?

The mechanics of estate planning are easy enough, but the big picture of how to disperse your assets requires a lot of thought and soul searching. How should you leave a sizable estate to children and/or grand­children in a way that is prudent and won’t ultimately cause them harm? Studies have shown that when new wealth is created in a family, there is a 90% proba­bility that it will all be gone by the third gener­ation. This is not the kind of legacy you want to leave for your family.

Should the estate be left to children outright or in a trust? Some parents want to ensure that their heirs are leading productive lives before they get a share of the estate. A sound estate-planning practice could be to establish a testa­mentary trust through your will for each child. The trust may prevent the child from becoming a spend­thrift and protect the assets in a divorce. A prudent trust distri­b­ution scenario might start paying income at age 25, and then allows access to principal in three install­ments at 35, 40, and 45.

Other Trusts

Dynasty Trusts

A dynasty trust is sometimes known as a generation-skipping trust (GST), although I want to make a distinction. I think of a GST when the goal is to leave money to your grand­children. A dynasty trust is used to provide income and support for your children and to pass those same benefits on to future gener­a­tions of your family. A key feature of this type of trust is the term. The trust is intended to last as long as you have descen­dants. The laws of many states do not allow trusts to last in perpe­tuity.

A signif­icant benefit of this trust is the ability to protect the assets from creditors, bankruptcies, lawsuits and divorce. Your heirs may be very respon­sible and marry respon­sible spouses. With a dynasty trust, your children never take ownership of the assets. This is an important principle that allows the assets to avoid estate taxes. Your children will be respon­sible for paying income taxes on the distri­b­u­tions they receive. Any income earned within the trust that is not distributed will be subject to income taxes paid by the trust itself.

A dynasty trust may be the single most powerful way to create a legacy that reaches gener­a­tions in the future.

Incentive Trusts

An incentive trust is designed to encourage or discourage certain behaviors by using distri­b­u­tions of trust income or principal as an incentive. This type of trust sets fixed condi­tions for access to trust funds as opposed to a typical discre­tionary trust that often leaves such decisions up to the trustee. You might find it helpful to think of an incentive trust as a condi­tional inher­i­tance for your benefi­ciaries.

A typical use for an incentive trust might encourage a benefi­ciary to complete a degree or pursue the training necessary to enter a profession. The trust could also be set up to discourage certain behavior such as abstaining from substance abuse. The trust may award the benefi­ciary an amount of money from the trust upon gradu­ating from college. Another incentive could be to have the trust pay a dollar of income from the trust for every dollar the benefi­ciary earns.

The key to a successful incentive trust is good commu­ni­cation. Discuss your inten­tions with your heirs and the trustee to assure your objec­tives are clear. You don’t want your incen­tives to backfire. An incentive trust can be an effective estate planning tool to encourage education, philan­thropy, a strong work ethic and to develop sound financial management skills.

Spendthrift Trust

A spend­thrift trust restricts the amount of money that may be spent by the benefi­ciary. The trustee has the sole authority to make distri­b­u­tions from the trust either to the benefi­ciary directly or to make payments on behalf of the benefi­ciary. The trustee must follow the terms of the trust. Typically, these terms are defined as the health, education, and mainte­nance of the benefi­ciary. You can leave the defin­i­tions broad to give your trustee some discretion or keep the terms strict.
This type of trust is often used when the parent is concerned about a child’s ability to handle financial affairs. A child who is living in constant financial turmoil is a good candidate for this type of trust.

The trust is written in a way that the benefi­ciary cannot antic­ipate or encumber their interest in the trust. It is written this way so that the benefi­ciary cannot borrow against the trust. The income they receive from the trust can also not be counted on, which means the benefi­ciary can’t use it to qualify for a loan. Generally, the trust contains specific language stating the Trustees will not be liable for, or subject to, the debts, contracts, oblig­a­tions, liabil­ities, or torts of any benefi­ciary.

There is no one size fits all solution when planning your estate. Each situation is unique. Trusts can be an important part of your estate plan when leaving assets to benefi­ciaries. However, the best strategy includes educating your children about money and wealth and how to handle it. This is the ultimate safeguard against potential problems. Don’t think that you can just pass the money on and hope that in doing so you also pass on your values. Your children need to under­stand that they are your legacy, not your money and posses­sions. For your legacy to flourish, you must get your children involved, work with them to create something and contribute something to your community for the benefit of others.

Rick’s Insights:

  • A testa­mentary trust might pay income to your heir until age 25, and then distribute principal in three install­ments at ages 35, 40, and 45.
  • An incentive trust uses distri­b­u­tions of trust income or principal as an incentive to encourage or discourage certain behaviors.
  • A spend­thrift trust is often used when the parent is concerned about a child’s ability to handle financial affairs.