It's estimated that $11.6 trillion of wealth will be transferred to baby boomers from their parents. A big question for parents of baby boomers and younger children is what is the best way to leave this wealth to their children? Too often, a child uses up a significant inheritance within a couple years, and then creates debt for themselves because they became accustomed to increased spending.
While transferring wealth to their children isn’t a goal for everyone -- a study by U.S. Trust showed that 49 percent of baby boomers did not plan to leave an inheritance for their children -- for those who do plan to leave wealth to their children, the question is how to do so responsibly.
There are several ways to pass on wealth to your children. The three basic ways are outright, in an annuity, or in a trust. We’ll discuss each of these ways to transfer wealth and highlight four reasons to consider using a trust instead of leaving the money outright or through an annuity.
Leaving Money Outright
If you leave money to your child outright, they can do whatever they want with it. The money is also available for your child's creditors. This creditor could be an old business partner, a person your child injures when driving, or an ex-spouse.
Leaving Money in an Annuity
You can also direct in your will or revocable living trust to have the money that will pass to your child be used to purchase an annuity for them, which will then provide an income stream to your child for life. This helps protect your child from spending too much money at one time (assuming they can’t get credit to buy more things), but the annuity payments are still an available resource for a creditor to try to collect.
Leaving Money in Trust
Another option is to leave money to your child in a trust. A trust involves three people: the grantor, who is the person that creates the trust; the trustee, who is the person in charge of administering the trust; and the beneficiary, who is probably your child that will receive money from the trust. You get to write the rules for why and when your child, as the beneficiary, receives money from the trust. These trust rules could specify that your child receives (i) a set amount of money periodically (monthly, quarterly, yearly), (ii) whatever is needed for basic living expenses or other set needs (commonly health, education, maintenance, and support), or (iii) money for doing certain things to incentivize certain behaviors (such as graduating from college, working full time, volunteering, buying a house, or starting a business).
When you leave money to your child in trust, you can also create rules that help prevent the money from going to creditors by using certain provisions known as spendthrift clauses. Setting up a trust with these protections cannot be done with the same levels of protection by your child.
With the framework of the three options for leaving money to your child, here are four reasons why you should think twice before leaving the money outright to your child or even in an annuity.
Reason 1: Creditors
When your child receives money outright or in an annuity, the money can be reached by your child’s creditors. Most parents don’t like the idea of an ex-son-in-law potentially getting part of the money they left their daughter. By placing the money in a trust for your child, you can help protect the money from creditors and ensure that the money lasts longer and goes to your child for the purposes that you want.
Reason 2: Sudden Wealth Leaves Suddenly
A recent national study by Ohio State University showed that one in five people spend all the money they receive in an inheritance within two years. After these few years, the person is used to spending more money and continues to even after the money runs out, which results in debts that leave 34.9 percent of people with either the same amount of wealth as before the inheritance or less.
IRA administrators estimate that between 70 to 80 percent of people who inherit IRA accounts cash them out in the first year. This gives up the huge advantage of the tax deferred savings and accumulation that can take place within an IRA. Plus, by having a huge spike in income in one year, the person is likely to pay more in taxes than if they cashed out the IRA over several years. By having a trust, and selecting a trustee that can manage how much money your child receives, you can ensure the money doesn’t get spent too quickly and on frivolous things.
Reason 3: Lack of Advice for Managing Money
Your child probably isn’t used to managing as much money as they will inherit. They probably don’t have the advisors and people in place to invest the money. They may easily be pulled into investing a significant portion of the money they receive into a friend’s business, which may result in nothing more than extra spending money for that friend. By using a trust, you can put a trustee in place that will know how to manage the money and have a duty to invest the money prudently.
Reason 4: New Friends
A person who suddenly has a good bit more money may quickly make more "friends." You don’t want your money to be spent on these “friends,” but on helping your child have a more meaningful and greater life. Again, by having the money in a trust, it creates a layer between this wealth and any new "friend" who wants to get their hands on it.
How you leave your money to your child, or whoever else, is up to you. As you think about how your wealth might be used when you’re not here, think about how you can make sure it's used in a way that you're happy about. These are issues that the attorneys at Horenstein Law Group frequently counsel people about and we invite you to give us a call when you’re ready to take the next step in determining how your wealth will pass and last for the next generation.