Estate Planning Considerations – Part 2 of 3

Posted on

Estate Plan In my last newsletter, I brought up the potential problems of leaving a large amount of wealth to your heirs. Many people who suddenly acquire wealth do not keep it very long if they have not learned how to manage it ahead of time. Some of them end up in a worst financial position several years later. This is not the kind of legacy we want to leave to our children.One possible solution is to leave some or all of our wealth to your children in trust. There are several different types of trust that can be used. This week I want to talk about a couple of them.

Dynasty Trust

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. Your wealth remains in the trust protected from estate taxes, the consequences of divorce, creditors and uncontrolled spending. The income it generates remains in the family for generations.

With a dynasty trust, your children never take ownership of the assets. This is an important principle that allows the assets to avoid the 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 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. The law typically states that the duration of the trust is limited to the lives of the beneficiaries plus 21 years. Seventeen states have since acted to modify or eliminate perpetuity laws permitting the trust to continue for very long times and in some cases – forever. You don’t have to live in one of seventeen states to set up a dynasty trust that will avoid the perpetuities law. However, the trust has to be established in one of these states and abide by that state’s laws.

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. Unfortunately, you never know what will occur during the lifetime of your heirs. You don’t want to leave wealth to your children thinking there will be plenty of money for your grandchildren’s education only to have them lose it to a lawsuit or through a divorce.

You set up the trust and provide guidance in the trust document for how the trust will operate and set the rules for distributions. The beneficiaries will be your descendants. You could specify the number of generations you want to cover or leave it open ended for as long as there are dependents. Any balance remaining can be passed to designated charities.

The trustee handles the operations of the trust and should not be a beneficiary. A professional fiduciary such as a bank or trust company should be selected to serve. The distributions will be governed by the terms of the trust. Generally, you will specify a certain percentage and allow for additional distributions for health, education, and support of your beneficiaries.

When considering a dynasty trust you should give careful thought about the length of time you envision the trust to last. There are important drafting considerations for the dynasty trust so you will need to use an estate planning attorney that is familiar with this type of document. The trust will need to qualify under the parameters permitted by the Rule against Perpetuities that allow trusts beyond a specific duration. You also want the trust to be structured in a way that avoids the transfer taxes beyond the initial amounts. Complex tax questions, including the application of GSTT require the participation of professionals skilled in this type of trust law.

A dynasty trust may be the single most powerful way to create a legacy that reaches generations in the future. If this is your goal, a dynasty trust could become central to your overall estate planning strategy.

Incentive Trust

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.

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 abstain 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.

You might find it helpful to think of an incentive trust as a conditional inheritance for your beneficiaries. You want to leave a proportion of your wealth to a grandchild. However, you don’t want the grandchild to use this money to live on and avoid pursuing a professional career or a college education. The incentive trust permits you to specify that the funds are only to be dispersed once the grandchild reaches the objective you established.

Incentive trusts can be as restrictive as you want them to be, as long as the restrictions imposed are not illegal – for example, you could not specify that your grandchild must divorce his/her current spouse to receive an inheritance.

A common restriction relates to the beneficiary’s age. Many people do not want a child to receive income or principal from the trust until he or she reaches a more mature age. Trust distributions are postponed until the child reaches age 25, 30, or whatever they decide. Hopefully by staggering distribution of funds over time, the child will learn how to manage money responsibly. At the very least, this strategy eliminates the possibility of your child blowing his or her inheritance all at once.

There are several drawbacks to this type of trust. Your beneficiary may resent the control you are trying to exert over their lives. It could also cause resentment towards other beneficiaries that don’t have requirements or whose requirements are easier to obtain in their opinion. Health issues could arise making the achievement of your benchmarks impossible. You also don’t want to punish your heirs for choosing to be stay-at-home parents.

The key to a successful incentive trust is good communication. It is extremely helpful to 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.

The dynasty trust and incentive trust are just two of the strategies we can use to develop an effective estate plan. Next week we will look at other types of trusts you can use to pass on your legacy.

Rick’s Insights

  • Laws exist in most states that prevent a trust from lasting in perpetuity.
  • Any trust that passes wealth down the blood line past your children is referred to as a generation skipping trust.
  • The most common “incentive” provision found in trusts is the age requirement that must be met before assets are dispersed.

Continue reading: Part 1, Part 3

Will Your Money Last Through Retirement?

No one wants to run out of money. But without goals and a solid plan,
how can you know for sure whether you’re on the right track?

Will I be able to maintain my current lifestyle?

What will my monthly income be in retirement?

Can I protect my hard-earned savings and still
have the income I want?

Rodgers & Associates answers questions like these every day.

Get Personalized Answers
2025 Lititz Pike, Lancaster, PA 17601
Phone: 717-560-3800, Toll-Free: 888-876-3437