As a part of your estate plan, you must decide how you will distribute your inheritance. There are three main options: a direct inheritance, a sprinkling trust and a lifetime protective trust. There are benefits and risks to each option. However, if your primary goal is to preserve your inheritance for the beneficiary's use, a lifetime protective trust is usually the best option. A lifetime protective trust is designed to protect the inheritance from involuntary third-party transfers and the beneficiary's bad financial decision-making.
Many people do not realize that there is much more to estate planning than just deciding who will receive your inheritance. You also have the power to choose how and when your estate will be distributed to your chosen beneficiaries. There are three main options regarding the timing of the distribution of your inheritance:
- Directly to beneficiaries at your passing.
- A percentage at three ages (a “sprinkling trust”).
- A lifetime protective trust.
Each option has benefits and risks. However, if your primary goal is to preserve your estate for your beneficiary's use, a lifetime protective trust is most likely the best choice. This structure can prevent a distribution from being made at a bad time in the beneficiary's life (i.e., when their marriage is failing or the court has entered a judgment against them) and preserve the inheritance for their use. Both a direct inheritance and sprinkling trust leave the inheritance vulnerable to creditors.
Which option you choose will be dependent on your family situation and planning goals. One of Legacy Plan's experienced Network Attorneys can help you decide what is right for your unique situation. Below is more information about each distribution method and its advantages and disadvantages.
What is a direct inheritance?
A direct inheritance is when the beneficiary receives the property outright and unconditionally. The beneficiary gets their entire inheritance during the administration of the estate. They have full ownership and control over the assets and can spend the funds in any way that they choose.
What are the benefits of a direct inheritance?
Leaving a direct inheritance is the simplest choice. You can easily leave a direct inheritance through a basic will. There is no need to create a trust. Because it is so straightforward, it is how the majority of Americans distribute their inheritance.
What are the disadvantages of a direct inheritance?
Although it is the most common way to distribute an inheritance, there are many risks of leaving a direct inheritance. The biggest disadvantage is that you leave open the possibility that your inheritance will be quickly wasted through either the beneficiary's bad decision-making or an involuntary transfer to a third party.
The beneficiary gets full access to the funds and can use them in whatever ways they please. The inheritance you worked so hard to save could be quickly spent because of the beneficiary's poor money management skills or immaturity. Sometimes individuals who come into possession of a relatively large sum of money will suddenly consider themselves “rich” and quickly spend the fund on a few expensive memories. For some people, their rash and impulsive spending could leave them in debt and in an even worse position than they were at before receiving the inheritance.
Additionally, there are significant risks of leaving a direct inheritance if your beneficiary struggles with substance abuse. If you place money directly into their hands with no restrictions, it may fund their destructive behavior. People with addictions cannot control certain impulses, and distributing your inheritance to a beneficiary with substance abuse may only enable their addiction.
Even if your beneficiaries are financially responsible, there are risks of leaving a direct inheritance. If you distribute your inheritance directly, there is a possibility that it will be involuntarily transferred to a third-party creditor. For example, if they go through a divorce after receiving the funds, part of the inheritance could end up in the hands of your beneficiary's ex-spouse – an outcome that most individuals would not prefer.
Furthermore, a direct inheritance is not protected from lawsuits. If the court enters a judgment against you, you could be forced to use your inheritance to pay the judgment. While those in occupations with a high risk of lawsuits – such as doctors, real estate professionals, accountants and lawyers – are the most in danger of facing a lawsuit, anyone can be sued. If your beneficiary tries to protect their inheritance after being sued, it will most likely be struck down as a fraudulent conveyance.
What is a sprinkling trust?
A sprinkling trust distributes the inheritance to the beneficiary at set ages of your choosing (i.e., a third of the inheritance is given at ages 30, 35 and 40). The trustee must distribute the assets at the specified time regardless of the beneficiary's circumstances. After the funds are distributed, the beneficiary has complete control over the assets and can spend the funds however they choose.
What are the benefits of a sprinkling trust?
A sprinkling distribution pattern has many of the same risks as a direct inheritance. First, it is based on the assumption that the beneficiary is “old enough” to manage the funds without any assistance. However, this may or may not be true. Many people do not automatically gain money management skills and financial responsibility as they age.
More importantly, there is no asset protection from creditors. A creditor could require that the distribution be made to them. The inheritance can still be lost through a divorce, lawsuit or creditor.
Lifetime protective trusts
What is a lifetime protective trust?
A lifetime protective trust is a type of trust designed to protect your inheritance from involuntary third-party transfers and a beneficiary's poor money management. Your inheritance is held in a trust and managed by a trustee of your choosing.
The trustee has complete discretion in making distributions when the time is right. The trust will include an appropriate standard (selected by you) to guide the trustee in making distributions. For example, the lifetime protective trust could allow distributions for the beneficiary's education and maintenance in health and reasonable comfort. Likewise, the standard could be support in the beneficiary's accustomed manner of living. Distributions are not mandatory at any set age or stage in life.
The beneficiary can be given (but doesn't have to be) the right to look to the trust first for their support and maintenance. Some states will allow the beneficiary to be the trustee, but this may not be the best choice for every beneficiary.
What are the benefits of a lifetime protective trust?
There are several benefits of a lifetime protective trust. The most significant benefit is protection from involuntary third-party transfers. The trustee can avoid making distributions when the beneficiary is going through a divorce, lawsuit or bankruptcy. If your goal is to protect your estate for your beneficiary's use, a lifetime protective trust is probably the best option.
1. Protection from lawsuits
Property in a lifetime protective trust is safe from legal judgments. This benefit is especially relevant to beneficiaries who work in an occupation with a high risk of lawsuits, such as medical professionals, accounts, real estate professionals and lawyers. However, the United States is a highly litigious country, and anyone can end up getting sued.
2. Protection from bankruptcy
A bankruptcy creditor can only seize property that is owned and possessed by the individual. Property in a lifetime protective trust is shielded from the beneficiary's creditors because it is owned by the trust, not the beneficiary. The trustee would never distribute trust funds to the beneficiary while they are in bankruptcy proceedings.
3. Protection from divorce
Typically, in a divorce, all marital property is divided between the divorcing spouses. All property classified as separate is not subject to division. As a general rule, inherited property is considered separate property during a divorce. However, it can become marital property if it is commingled with marital property (i.e., the inherited property is placed in a joint bank account or used to buy a family vacation home). An inheritance is often commingled when there is an outright distribution.
While the inheritance remains in a lifetime protective trust, it is not subject to division. It is protected from ending up in the hands of your beneficiary's former spouse. If the beneficiary's marriage is failing, the trustee will ensure that no distributions are made from the trust.
In addition, to asset protection, a lifetime protective trust has various other benefits. It protects against the beneficiary's bad financial decision-making. You can rest assured that the beneficiary will not blow their inheritance on a few extravagant purchases or bad investments. Furthermore, any trust assets will pass outside of the beneficiary's estate, providing certain tax advantages at their death. Finally, if the beneficiary becomes incapacitated, the trustee will be able to provide immediate and continued support.
What are the disadvantages of a lifetime protective trust?
Despite all the advantages listed above, there are lifetime protection trusts do have some disadvantages. The impact of these disadvantages can be lessened if you take certain precautions.
1. Trustee failures
A lifetime protective trust places a lot of responsibility and faith in the trustee. There is a risk that the trustee could not live up to your standards. For example, the trustee could make distributions at the wrong time or in the wrong amount. Equally, the trustee could fail to make distributions you would have wanted them to. To help avoid these outcomes, it is critical to appoint a responsible and trustworthy trustee who is willing and able to carry out your wishes.
2. Beneficiary resentment
To achieve asset protection, a lifetime protective trust takes some control away from the beneficiary. Unlike a direct inheritance, the beneficiary does not have complete control and access to their inheritance. There is a trustee to act as a gatekeeper. This structure can lead to beneficiary resentment if they feel they have to “beg” for money. It is possible for disputes to arise between the trustee and the beneficiary regarding distributions.
There are two ways to help avoid this issue. First, under some circumstances, the beneficiary may also act as the trustee while maintaining asset protection benefits. This option is not available in all states. Secondly, you can communicate with your beneficiary before your death and explain the reasoning behind your estate planning decisions.
3. No asset protection after distribution
Once a distribution is made, it's subject to the same risks as a direct distribution pattern. After the trustee distributes the property, the beneficiary has complete ownership and control over the assets, and it can be reached by creditors. This disadvantage is irrelevant if the trustee does not make distributions during a bad time in the beneficiary's life.