Trust Your Heirs Not to Squander Your Estate

The Fiscal Times

Did you hear what Bill Gates and Warren Buffett are doing with their estates when they die? Giving most of it away. And they've convinced many other billionaires to do the same thing through a movement called the Giving Pledge. They want to do good for the world -- and, as Buffett has famously said in the past, "I want to give my kids just enough so that they would feel that they could do anything, but not so much that they would feel like doing nothing." 

Buffett isn't alone in his concern about the impact of wealth on kids. Nearly 60 percent of parents believe their children are not well prepared to handle a financial inheritance, according to a study by U.S. trust. Few heirs become debauched Jay Gatsbys, throwing nightly drunken parties in the Hamptons, or souls troubled by gambling or substance abuse. And yet, there's a good reason for concern. 

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Experts say that much of family wealth is lost when it’s passed from the first to the second generation, and it’s nearly all wiped away by the third generation. Some of that may owe to most estates not being that large and the bulk of money going to purchasing a home or providing education. But often the reason is that heirs are unprepared to deal with sudden wealth. 

"Older people today were once young themselves," says psychologist and registered investment adviser Phil DeMuth. "They think back and realize they didn't have a clue about money and how to handle it." Youth is unlikely to be any more resilient to divorce, unexpected problems with creditors, bad investment plans -- "all the things that can separate you from your money." 

The answer, according to experts, is a trust that can help preserve wealth and allow it to still grow while still providing a benefit to heirs. A trust is a legal mechanism to hold assets on behalf of beneficiaries and transfer the wealth in a specific manner over a pre-determined time. 

Related: How Young Millionaires Are Different than Their Parents 

Because the assets are technically owned by the trust until transferred to the beneficiary, the structure provides protection from more than just careless habits. A divorce cannot involve the trust because it is not property of the beneficiaries. Similarly, the money is beyond the reach of a debt collector. 

A trustee or trustees—often family members--administer the plan, regularly reporting financial results to the beneficiaries, filing taxes, and retaining professional financial and legal help. "I think it makes a lot of sense to pick two trustees--one that would be [an administrative trustee] for the children and one that would be a fiduciary for the money and have them meet to discuss how to invest," says Benjamin Brandt, a financial consultant in Bismark, ND. If you think the job would be too onerous for family members, you can appoint a professional trustee or institution to handle the job. 

Balance control and benefit
The trick in creating a trust is to balance fund conservation with incentives for children to develop into fully developed adults. "What [our clients] don't want is what some people call 'trust fund kids' that are not working and are just living off a trust and not being productive," says Chris Kerckhoff, president of St. Louis-based Plancorp. 

Depending on the particular circumstances of the family, there are different structures that might work. A traditional one provides income generated by the trust but splits transfer of the principle in three parts spread out over a 10- or 15-year period throughout the kids' 20s and 30s. A basic rule of thumb is that principle is available for health, education, maintenance, and support, "but not for Johnny wants to go buy a Ferrari," Kerckhoff says. 

Occasionally, parents will want to reach from beyond the grave and micromanage their children's lives. There may be good reasons. "I have a client whose son is a drug addict," says Heidi Bitterman, an associate attorney at The Law Offices of Donald P. Schweitzer in Pasadena, Calif. "She pretty much knows that whatever money is doled out is going to drugs." In that case, the trustee cannot disburse money unless the child can pass two drug tests. 

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However, there are legal limitations on the restrictions parents can place on their children. They cannot limit things like facial hair or piercings or require them to enter certain professions. 

Tax planning
In cases when adult children have already comfortably established themselves financially, it’s more fiscally prudent to leave the money directly to grandchildren. Doing so can limit estate taxes and insure that more money remains in the family. For example, if each generation has $4 million to pass on separately, they’ll remain under the $5.25 million estate tax threshold. Be sure to discuss the impact that income taxes will have on both the trust and your heirs as well. 

No surprises
Communication is crucial. "Make sure that the family members understand why the generation that currently has the bulk of the wealth is making the decisions it is," says Kerckhoff. Younger generations may or may not agree with the reasons, but it is important that they know what will happen in advance. It can make sense to have children attend trust meetings starting in their teens so they can learn more about how to intelligently manage money. 

Finally, remember that you can change a trust and may need to over time. Assets have to be explicitly added and don't automatically pass to the trust. A change in life circumstances may need modifications.

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