Despite some misleading assertions to the contrary, trusts are not the solution for every estate plan. Trusts come with baggage and the person setting up the trust (herein the “parents”) must weigh the pros and cons to determine how best to structure the trust given the goals, the beneficiaries (herein the “children”), and the assets. Occasionally, the use of a trust for the child’s lifetime after parents’ death makes the most sense.

In simple terms, a “trust” results any time restrictions are placed on the use and/or control of assets.

By way of example, if a parent gives $100K to a child outright, there is no trust. If a parent gives $100K to a child and says the gift is to be controlled by Uncle Phil and only to be used for college – this would require a trust because the gift is restricted by both control and use.

The type of trust is defined by its terms. Trusts are separate legal entities that have their own tax ID numbers and have statutory reporting requirements. They are governed both by the governing document (e.g. last will and testament) as well as state law.

Smart trust terms

It’s important to note that there exists an inverse relationship for trusts between control and protection on the one side and beneficiary access on the other.

For example, a parent could set up a trust providing full access to a child anytime and in any amount. This type of trust would provide little to no protection or control.

Conversely, a trust could grant the child no access and no distributions. This would effectively protect the trust in all events but provide the child no access to funds.

Somewhere in between those extremes, smart trust terms are developed to balance those competing interests to best serve the goals, children and assets available.

It’s very common to set up a trust for a short period of time. For example, a parent might want to ensure minor children go to college and learn to manage money, so they set up a trust to hold the money until age 28 with distributions allowed before that time for college.

But why would the parent want to err on the side of more restrictions and keep the money in trust for lifetime? There are several situations where this makes sense.

To start, a lifetime trust requires adequate funding. So the parent really needs to be able to fund that trust sufficiently to offset trust costs. There is no magic number, but $750,000 is about the minimum. That’s steep for a lot of people but remember that a lifetime trust isn’t right for most, and that level of funding can be achieved with relatively inexpensive term life insurance.

Then, look to the beneficiaries. Some sets of beneficiaries functionally require a lifetime trust. Think of children who suffer from mental or physical disabilities, significant addiction or creditor issues, or those who are otherwise unable to manage their own affairs even after becoming an adult.

Key reasons to consider

But sometimes it also makes sense to keep a child’s inheritance in trust even when the beneficiary doesn’t have a functional requirement for a trust. Why then might a parent impose controls and restrictions if they are unnecessary? There are two key reasons.

First, trusts offer creditor protection. Outright distributions (not held in trust) are subject to creditor claims such as malpractice claims or injury claims (e.g. causing a car accident) but also potentially the separation of assets pursuant to a divorce. Trusts generally cannot be invaded by any creditor claims.

Second, trusts offer estate tax protection upon the child’s death. Rather than including the totality of the trust assets in the child’s estate to be taxed, a lifetime trust can eliminate any taxes associated with the child’s death to give more of the asset to the grandkids.

A lifetime trust for a child that has no functional need for the trust generally requires a higher level of funding. This is not required but helps better balance restrictions and access. For example, a lifetime trust for a child with $3 million of funding likely can reliably spin off an annual income to the child of a healthy $120K (4%) for the rest of the child’s life and completely avoid creditor claims.

There is no “right” way or reason to set up a lifetime trust. But there are considerations that should help guide the parent in setting up the trust. Talk to your attorney or advisor for more information.

Beau Ruff, a licensed attorney and certified financial planner, is the director of planning at Cornerstone Wealth Strategies, a full-service independent investment management and financial planning firm in Kennewick.