As you get older and start planning for the future, you may start to think about who should inherit your belongings when you die. But what if the family member or loved one you want to pass an inheritance to isn't so good at managing their finances? If you're afraid that a future heir will squander away the money you diligently saved for them, you might consider opening a spendthrift trust.
This type of trust protects a financially irresponsible beneficiary by limiting their access to the trust funds. With a spendthrift trust, you include a provision in the trust agreement that dictates how much and even when a beneficiary receives any payments from the trust. A trustee will be responsible for making these distributions and managing the trust according to your terms, making a spendthrift trust ideal if you have a financially risky beneficiary.
Spendthrift trusts can offer asset protection from a beneficiary’s creditor and limit how much the beneficiary receives.
A spendthrift trust operates like a normal trust, but includes a spendthrift clause or spendthrift provision.
The trustee is responsible for managing the trust funds and the distribution of trust assets.
How a spendthrift trust works
A trust is a separate legal entity that holds different types of assets for the intended benefit and use of trust beneficiaries. With a spendthrift trust, the grantor or settlor limits how much and how often the trust beneficiary receives money from the trust and under what circumstances in their trust agreement.
If you open a spendthrift trust, instead of bequeathing a lump sum to your beneficiary, you can have trust distributions happen incrementally, as monthly or quarterly payments, or even have the beneficiary only receive trust income. A spendthrift trust can also provide asset protection, which means trust property (while it’s still in the trust) cannot be used to satisfy creditors in case the beneficiary is sued.
To make sure the spendthrift clause is drafted in proper legal terms, you can seek the legal advice of a professional like an estate planning lawyer.
The trustee of a spendthrift trust is especially important because they are like a gatekeeper or middleman between the beneficiary and the trust property. They are obligated to follow the terms of the trust agreement, but you can also give them more discretionary powers. If you open a trust during your lifetime (a living trust or inter vivos trust), then you can act as trustee. Just be sure to name a successor trustee to take over when you pass away who can continue managing the trust.
The benefit of establishing the spendthrift trust while you're alive is that the assets are not subject to probate. If you have a spendthrift trust created upon your death through instructions in the will, then your beneficiaries must wait until the probate process is completed before they can receive any of the assets.
Revocable vs irrevocable spendthrift trust
A spendthrift trust can be revocable or irrevocable in nature. A revocable trust is one that can be changed or modified by the grantor. On the other hand, an irrevocable spendthrift trust cannot be changed. Irrevocable trusts come with additional benefits and tax advantages for the grantor.
Example of a spendthrift trust
Let's say you want to leave $1 million worth of assets for your child who is in college, but aren't quite confident in their ability to manage their finances. You fund the trust and designate them as the trust beneficiary, specifying that they should receive a monthly $1,000 distribution from the trust on the first of every month, which increases annually on their birthday.
Additionally, you allow the trustee to make discretionary payments to your child only in the case of a medical emergency and hardship, and to disburse all remaining trust funds when when the child turns 40.
Look at how the spendthrift trust could work in following situations:
They overspend their monthly allowance for the week but need money for vacation: The trustee will not distribute funds until next month.
They run out of money, but need to pay for surgery: The trustee can give them money because it falls in accordance with the trust agreement.
They fall into credit card debt and face debt collection: The trust property is protected from creditor claims.
They are in car accident and the other driver sues: Assets in the trust are protected in the event of a lawsuit.
They buy a house but default on mortgage payments: The lender cannot come after the remaining trust funds that haven't been distributed yet.