Protecting Your Child’s Inheritance from Spouses and Divorce
About 40 to 50 percent of all marriages in the United States end in divorce. Regardless of how you feel about your child’s spouse, you must face the possibility that they could become your child’s ex-spouse. Should that day come, the money you leave to your child could be subject to a division of marital assets. But with careful estate planning, your child’s inheritance can be kept safely out of the hands of their spouse or former spouse.
Separating Inheritance Money from Marital Money
During marriage, the lines between what each partner owns can blur. Generally, whatever is acquired during the marriage by either partner becomes marital property that is subject to division in the event of a divorce, but there are exceptions.
One exception is a bank account that is kept separate during the marriage. Inheritance money that you leave to your child or monetary gifts that you give to your child during your lifetime can theoretically go into a separate account. However, in practice, it can be difficult for spouses to avoid commingling bank accounts. Even something as simple as depositing marital money into the account or using it to pay bills during the marriage could make the account marital property.
A better way to keep your child’s gift or inheritance separate from their spouse’s money is to hold it for them in a trust account. It is not just wealthy parents who leave money to their children in a trust. A trust is a flexible and powerful estate planning tool that allows parents of any means to exercise greater control over the money and property that they pass down.
Trust Management and Third-Party Trustees
Holding your child’s inheritance in trust involves doing the following:
- You place money and property in a trust
- You name a trust beneficiary (i.e., your child)
- You name a trustee (somebody to manage trust distributions)
- You leave written instructions that specify how the money and property are to be used (trust instrument)
While it is possible to name your child as both the beneficiary and the trustee of the trust, absent additional restrictions, this structure negates the point of establishing a trust for the purpose of preventing spousal commingling. Similar to how commingling can occur with a separate bank account, if your child uses money in the trust for marital expenses and then gets divorced, the court could consider the trust funds to be marital property.
To avoid commingling, you can name a third-party trustee to manage the money on behalf of your child. This takes control of the trust out of your child’s hands and places it in the hands of a third-party who can use their discretion in interpreting the trust’s instructions for how the trust funds are to be used.
Instead of distributing money from the trust directly to the beneficiary (which raises the possibility of commingling and trust division in a divorce proceeding), the trustee can pay third parties on the beneficiary’s behalf. For example, if the beneficiary needs a new vehicle, the trustee can pay the car dealership directly. Or, for larger purchases such as a home, the trustee could loan the money to the beneficiary. The house would be used as collateral to secure the debt to the trust and protect it from asset division.
Child and Trustee as Co-Trustees
Giving a single third-party trustee sole discretion over trust fund distributions affords maximum protection against asset commingling, but it provides your child with limited flexibility over how they can spend their inheritance. If you prefer to give them more options but still protect the funds you leave to them in the event of a divorce, you can name a third party to serve as co-trustee with your child. However, other restrictions may be appropriate for creditor protection and tax purposes.
When setting up a trust, there are several types of trustees that you can choose from, each with a different set of responsibilities and obligations. For example, you might name your child as an investment trustee, giving them the authority to invest money held in the trust. In this capacity, your child is acting on behalf of the trust (not in a personal capacity), so the trust money is not commingled with marital assets. At the same time, with good investments, they are effectively growing their own wealth. You can then have a co-trustee handle distributions for your child’s benefit.
Naming co-trustees has other benefits as well. In the event of a divorce or creditor issues, the child can resign as trustee, leaving the other trustee with sole discretion. You can also set up the trust in such a way that an independent co-trustee can make distributions to your child for any purpose, but your child is limited to distributions for health, education, maintenance, or support (i.e., a HEMS provision or ascertainable standard that is a safe harbor under federal law). While this does not provide the maximum creditor protection (because any distributions made to the child could be susceptible to creditors), amounts remaining in the trust may still be protected. In addition, special consideration must be given to the beneficiary’s ability to remove and replace another co-trustee.
Covering All Angles
To create a bulletproof trust strategy to keep your child’s inheritance out of their spouse’s hands, you must take a wide view of everything that could happen. That includes a possibility that you would probably prefer not to think about: your child passing away.
Should your child either predecease you or pass away before receiving the full benefit of the trust that you establish for them, the trust may, by default, be inherited by their spouse unless you have planned for this event. You can keep this from happening by naming a contingent (backup) beneficiary to your child. This could be your grandchildren, your child’s sibling, a charity, or any other party that you specify as next in line as the trust beneficiary.
In addition, be careful when giving a testamentary power of appointment to your child. This power would allow your child to direct trust property (or their share of trust property) to another individual upon their death, and that person could be their spouse. As the creator of the trust, though, you can limit who the trust property can go to, such as your child’s children or other descendants only.
Take Control of Your Legacy: Talk to a Trust and Estate Planning Attorney
Part of being a parent is protecting your children from their own lack of foresight. If your child is newly married or in a marriage that is headed in the wrong direction, you can take steps to keep your hard-earned money from falling into their spouse’s hands, where it may not benefit your family, by creating a trust.
Flexibility is one of the most powerful features of a trust. There are many types of trusts to choose from, and they can be customized with any number of provisions to ensure your final wishes are fulfilled.
Remember that an estate plan can—and should—be revisited. You can include restrictions in the trust now and remove them later as circumstances change. You can also decide to do away with the trust altogether. Whatever plans you have for your money and property, make the most of them by getting help from Adam Demetri, Esq. Contact us to set up an appointment.