What exactly are testamentary trusts anyway?

In setting up your Will or Revocable Living Trust (RLT), one of the things you will need to decide is how to distribute your assets among your children.  You have two choices: leave your assets directly to your children, or put your assets in trust for your children.  We call these trusts for your children “testamentary” trusts because they are created after your death, by setting them up in a testamentary instrument (i.e. a Will or RLT).

If your children are minors, or are relatively young, we will always recommend setting up a testamentary trust for them.  Typically, these trusts are managed by your family or friends (i.e. the Trustee), and they are designed to hold your assets until such time as you determine that your children will be mature enough to manage their inheritance on their own.  While your assets are in trust, your Trustee will be responsible for investing and managing the assets for the benefit of your children, and the Trustee will have discretion to use the trust assets for your children’s health, education, maintenance, and support.  Then, when the children reach certain ages, the Trustee will distribute certain percentages of the trust directly to the children—perhaps 1/3 at age 25, 1/2 of what’s left at age 30, and the balance at age 35.

There are many benefits to setting up testamentary trusts for your children.  Two of the most significant benefits are:

  1. Management: The most obvious benefit is that while your children are young (and most likely not fully mature or responsible yet), your Trustee gets to make all of the decisions regarding the trust assets. Your Trustee gets to decide whether to keep or sell property, how to invest money, and how to spend the money for the benefit of your children.  Your children cannot demand that your Trustee give them money.
  2. Spendthrift: The trusts are set up as “spendthrift” trusts. This means that the trust assets are protected from your children who may be irresponsible with their money, or who may simply make poor decisions when it comes to money.  Trust assets are also protected from creditors of the children.  For example, if a child were to have a judgment against her for a car accident which she caused, the judgment creditor could not reach the assets in the trust to satisfy the judgment.  The spendthrift trust provides protection from many types of creditors, including a divorcing spouse, while the trust is in effect.  Note: when the trust eventually distributes to the child, the distribution is no longer protected (the remaining trust assets are still protected).

For many clients, these testamentary trusts are a great option.  Consider, however, the note in the spendthrift paragraph above—when the trust eventually distributes to the child, the distribution is no longer protected.  One estate planning technique we use is what we like to call “lifetime” trusts for children.  These are still testamentary trusts (because they are created after your death, by setting them up in a testamentary instrument), but with lifetime trusts, you do not require the Trustee to distribute the trust assets to your children at certain ages (i.e. 25, 30, and 35, as above).  There are no required distributions.  Instead, the Trustee is authorized to hold the Trust assets for the child’s lifetime and to use the assets for the benefit of the child, for the child’s health, education, maintenance, or support.

Why do this?  Why tie your assets up for your children’s entire lifetimes?  What if they need the money?  There are many reasons, but one of the main reasons is best described by example.  Above, we told you that a divorcing spouse is a creditor and that the spendthrift trust is protected from a divorcing spouse.  If the trust terminates when the child reaches the age of 35, however, and then if the child gets divorced after age 35, the child’s inheritance may not be protected from her divorcing spouse.  If your daughter deposits her inheritance in a joint checking account with her husband, for example, she may have inadvertently transmuted (converted) her separate property into marital property, which could cause it to be divided with the husband in her divorce.  By placing assets in the lifetime trust, your child never has the opportunity to transmute her inheritance into marital property.  We like to think of this as an alternative to your child signing a prenuptial agreement (although your child’s circumstances may warrant a prenup as well).  This same protection applies to most creditors, with the exception of “super creditors” such as the IRS and Medicaid.

Clients are often concerned that their children will think that they are trying to control them “from the grave” by setting up these lifetime trusts.  It may seem that way at first glance, but these trusts have many benefits that cannot be attained otherwise.  As a parent, you have several tools in your toolbox that you can use to protect your assets for your children.  However, once your children inherit from you directly (no trust), while they may still have some tools they could use to protect their inheritance, their toolbox is much smaller and less effective than yours.  It is much more difficult for your children to protect their inherited assets than for you to protect your assets for them, before they are inherited.

We have many options when setting up these lifetime trusts, and we always customize those options for our clients and our clients’ children.  For example, you may decide to allow your child to serve as her own Trustee once she reaches a certain age (such as 30).  Tennessee law provides that a trust can maintain its spendthrift status, even if the Trustee is the sole beneficiary of the trust.  This would give your child more control over the management and investment of the trust assets while maintaining the protection of the trust assets.

Finally, one of the most important benefits of a lifetime trust is that you can control what happens to your assets after the death of your children.  For example, you may want to set up a lifetime trust for your daughter, and then after her death, you may want to ensure that her children, not her husband, receive what’s left of her inheritance.  By setting up a lifetime trust, you can ensure that whatever is left in the trust when your daughter dies will pass to your grandchildren, ensuring that everything you have worked so hard for remains in the bloodline for generations to come.

Note: the same principals described here apply not just to trusts set up by a parent for a child, but are broadly applicable to any trust set up by someone for the benefit of someone else.

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