When thinking of ways to transfer wealth to children, techniques such as 529s, UTMAs and Roth IRAs are often discussed as common strategies. But what if a parent wants to limit or restrict the use of these funds based on the actions of their child? Or what if a parent wants to make a gift for the benefit of an adult child or children? If that is the case, then these planning techniques may not necessarily be a fit. Take for example, an UTMA account, where once the child attains the age of majority (18 or 21 depending on the state), they have immediate unfettered access to the account. Or a 529 account, where if the funds are not used for qualified educational expenses, there may be taxes and penalties involved. Instead, for many parents who have either maxed out these planning strategies or who have children that may not fit the mold for these planning strategies (think adult children), utilizing a trust could be a better option.
What is the best way to make substantial gifts, while maintaining some control?
One option is an incentive trust that motivates responsible behavior by the beneficiary. The trust can also encourage family values that are important to you. Instead of distributing a fixed percentage per year or lump sums at certain ages, an incentive trust sets conditions based on goals or accomplishments. The trust is meant to reflect the desires of the grantor, as well as the circumstances of the beneficiaries.
Key features of an incentive trust:
- Conditions: The trust contains specific goals that beneficiaries must meet to receive distributions. These conditions can vary widely and may include education, employment, or community engagement. Recovery from substance abuse, or avoidance of other harmful behaviors are also options to include.
- Trustee Discretion: The trustee has a degree of discretion to determine if the conditions have been met. This can help the trustee ensure the intentions of the trust conditions are followed, rather than face insincere efforts by the beneficiary that are inconsistent with the trust’s objectives. It is also important to choose a trustee that can make these tough decisions and has the ability to say “no” to a beneficiary that has not met the conditions of the trust.
- Long-Term Outlook: Incentive trusts can establish goals for a beneficiary over many years. A long-lived trust may also help meet other wealth transfer goals, such as asset protection from creditors or divorce.
- Flexibility: Most Grantors do not want to punish beneficiaries for circumstances that are beyond their control (i.e. disability, accident, sick child) and therefore the trust should create some flexibility for the trustee in these situations. Often you will see what is called a hardship provision where the trustee has the ability to make distributions to the beneficiaries even if the “conditions” are not met.
Potential drawbacks of an incentive trust:
- Overly Restrictive: If the terms are especially limiting, the beneficiary could become resentful. The trust might then end up influencing situations that it was meant to avoid.
- Ambiguous: Terms should balance the trustee’s discretion with adequate means for the beneficiary to feel like fair decisions are being made. A mechanism should exist for resolving disputes or material changes in circumstances.
- Income Tax: A trust that retains investment income (rather than distributing it to a beneficiary) may be subject to unfavorable tax rates. Potentially negative tax outcomes can be mitigated through coordinated tax planning and portfolio construction.
Families can use incentive trusts to achieve specific estate planning goals, as well as instill certain family values. But setting the right criteria and restrictions is not always easy, especially if multiple beneficiaries have diverse wants and needs. It’s important to develop any major gifting or wealth preservation tactics with your overall financial plan in mind. Our Wealth Management professionals can coordinate conversations with qualified estate attorneys and help you create a plan that aligns with your objectives and the needs of your beneficiaries.
