Recently, I had the opportunity to speak with someone about inheritance issues concerning her father’s estate. Apparently, her father had inherited a lot of money and real estate from her grandparent’s estate. However, her father had remarried after Mom passed on, and everything other than a summer home went to the new spouse he had been with for only five years when he passed on. The summer home was placed in trust with the new spouse as trustee along with a sum of money to provide for the property upkeep for the next 90 years. However, all of the money for the upkeep of the house was now gone, the stepmother is not putting any of the other inherited money into the summer house (nor does she have an obligation to), and, big surprise, stepmom is getting married again. The daughter had come to grips with the fact that she was not going to inherit any money from her father, but the summer house is on the verge of falling into neglect since no money is available for its upkeep.
Question: Do you think this is what the daughter’s grandparents had in mind when they left everything to their son?
I often talk to clients about protecting inheritances across two generations instead of just one, and this can be for a variety of reasons. The main reasons are to protect against lawsuits, bankruptcy, a child’s spouse, or wasteful spending by the child. There are ways to protect not only protect assets and make sure they are available for the next generation but also to make sure that the remaining inheritance goes to the grandchildren as well instead of to a child’s spouse.
The Revocable Living Trust
The first step in protecting an inheritance is to make sure it is sheltered at the time of death and immediately thereafter through the use of a revocable living trust. Avoiding probate is generally a good thing because it avoids the expenses and delays of probate, but it also avoids the potential for a Will Contest for all of the assets in the trust. If a disgruntled family member does not like the plan you have created through a Last Will and Testament, then after you die the family member can go to an attorney who does Will contests, lay out the reasons why they feel the plan was wrong, and engage the attorney to contest the Will. Because it is in probate, there is a much, much greater chance that the attorney will be paid from the estate assets, even if they lose. On the other hand, if a family member does not like the plan you have created through a Revocable Living Trust, then after you die the family member can go to an attorney who does Will contests, lay out the reasons why they feel the plan was wrong, and ask the attorney about contesting the Trust. Because it is not in probate, the attorney will very likely ask for a $5,000-$15,000 retainer to get started because the case would be in regular civil court. The usual response from the disgruntled beneficiary is “whoa, whoa, whoa, you get paid when I get paid!” Unfortunately, attorneys are not paid by the government and they are in business to earn money. Because it is much more difficult to get attorney’s fees awarded in a trust contest compared to probate, attorneys will insist on money up front, and people who want something they are not entitled to will rarely put up their own money to try to get it. And so the revocable living trust is the safer way to lay out the initial plan. But what is next? The next step is to have the revocable living trust pay out the assets to Beneficiary Trusts for the next generation, typically the children, rather than sending the money directly to the children. This is because if the money goes directly to the children, it is not protected from lawsuits, bankruptcy or irresponsible spending, and if a married child does what most people do, they’ll simply put the money in a joint account with the spouse or buy a bigger house titled in both spouses’ names.
The Beneficiary Trust is an extremely useful tool to pass down but protect non-tax deferred assets for beneficiaries for their lifetime and then pass the inheritance along further to their descendants when they die. In the case of children, it is one Beneficiary Trust for each child, and the trustee usually ends up, eventually, being the siblings so they can protect each other’s trusts. So what about the Beneficiary Trusts makes them immune to lawsuits, bankruptcy, divorcing spouses, and irresponsible spending? By the time the assets pass from the revocable trust to the Beneficiary Trusts, the Beneficiary Trusts are irrevocable and all of the assets in the Beneficiary Trusts are handled in the complete discretion of the Trustees. In other words, it is the lack of control over the trust assets by the child than immunizes the trust from lawsuits against the child, bankruptcy proceedings for the child, a divorce of the child, and because the child has to get the trustee’s approval to take out money, irresponsible spending can be curtailed. Well, what prevents the trustee from never giving the child anything? First, while that is technically a possibility, you wouldn’t choose trustees who would do that. Second, it is typical in setting up Beneficiary Trusts for the children that they will end up being trustees for each other’s trusts, so if one child is never providing trust assets to support the child/beneficiary, then the same can be done to the stingy child with their own trust. And third, if things truly are out of hand, then there are provisions for replacing the trustee if it came down to that. Some of my clients do not like that their children would essentially be cut off from controlling their own inheritance, but in many cases it is a tradeoff they are willing to make in order to get the lawsuit, bankruptcy, divorce and spending protection the Beneficiary Trusts provide. And in the end, the remaining assets in each Beneficiary Trust will go to their descendants and not to the child’s spouse. That is for non-tax-deferred assets. What about tax-deferred, retirement accounts?
By far the best protective tool for tax-deferred assets is an IRA Trust, not only to protect inherited retirement account assets from lawsuits, bankruptcy, divorcing spouses and waste just like the Beneficiary Trust, but also to allow for the tax-deferred money, within certain limits, to remain tax-deferred and grow. Basically, the IRA Trust is a way to protect an Inherited IRA from those same four problems and issues but with some huge tax benefits to boot. While I could go into a whole article about the tax benefits of an IRA Trust, I actually have a whole book on the subject called (surprise) The IRA Trust that my office can provide. In setting up accounts to work the right way, we typically have spouses name each other as the primary beneficiary for all retirement and tax-deferred (and tax-free) accounts, but then instead of listing the children as the contingent beneficiaries we list each IRA Trust instead. Now the inherited retirement accounts must be handled through each child’s separate IRA Trust, and the mechanics are handled by the trustee of each IRA Trust. This avoids the probable problem of a beneficiary mishandling the inheritance and having to pay all of the taxes in one year, it provides protection against the four problems I mentioned, and it allows for the money that remains in the “Inherited IRA” owned by the trust to continue to grow tax-deferred through the years. And, again, in the end the remaining assets will go to the child’s children and not the child’s spouse. For those who know about Inherited IRAs, sometimes call “Beneficial IRAs,” they may have heard in the past that they were protected accounts anyway. So why deal with the IRA Trust when the child can simply set up their own Inherited IRA and get protection anyway. It is because that protection is not there. Up until recently, courts had been split on whether or not a simple Inherited IRA outside of an IRA Trust would be protected from bankruptcy and lawsuits. On June 12, 2014 in the case Clark v. Rameker, the U.S. Supreme Court determined that Inherited IRAs DO NOT have bankruptcy protection, and the very same reasoning that lead the court to determine this is also 99.99% likely to have them rule that the accounts are not protected from lawsuits either.
While there is more extensive planning involved to protect inheritances across two generations, it may very well be worth it depending on your goals. The right combination of a revocable living trust, Beneficiary Trusts, and IRA Trusts can secure an inheritance for much longer than a revocable trust (and certainly a Will) can do alone.