You’ve spent your life accumulating assets. If you’ve done a particularly good job at saving and investing, you will probably have some left over when you eventually pass away.
I’m going to assume that you want a majority of the remaining assets to go to your children. If your children are financial wizards, this won’t be an issue – and no prep work is needed.
However, if they didn’t choose a financial career path – or even if they did – leaving a large sum of money to someone can be a life-changing event. And if they are not ready for it can cause more problems than it solves.
This is why lottery winners are broke within 5 years. Many times they’re even worse off than before they started. In this article, I will make some suggestions to ensure a smooth transfer of your wealth to the next generation.
When you are still early in the game, you usually have few assets. Your estate plan is generally used to ensure the care of your children through guardians, and uses a will to simply transfer everything you own to the surviving spouse. It then divides it equally among the children.
Now fast forward – your children are out of school, into their careers, and perhaps even married with children. You and your spouse have built up assets, are in your prime earning years, and contemplating retirement. This is when people tend to revisit their estate plan, with more complex objectives than before.
One of the biggest questions during this process is what to do with the wealth when both spouses pass away. Most people start out with the mindset of simply leaving their wealth outright to their heirs. This is rarely the best choice, however.
This could be due to the financial maturity level of the heirs, their current financial situation, relationships, or because of sudden money syndrome. Remember that estate planning is not used to simply pass on assets, but also about creating a legacy that passes along your family’s values.
Next, we explore in more detail the situations which call for more detailed estate planning, and what strategies you can use to protect your wealth and the well-being of your children/heirs.
Financial Maturity of Children
You may have the best children in the world, but when it comes to financial matters they may not be as mature as they need to be when handling a large inheritance. We all know that schools don’t teach children much in the way of financial education, and even parents who actively try to educate their children about finance might fall short due to lack on interest from the children.
If they have made poor financial decisions in the past, or you just don’t think they have the right outlook when it comes to money, there are ways to protect them during a wealth transfer. The simple solution is to give the inheritance to a trust, managed by a trustee which stays in existence for most of, if not all, of the child’s life.
The trustee can direct the trust to provide for the child as you instructed. This could be in the form of an annual payment, or periodic lump sum payouts spread out over the life of the child. This allows a child to learn as they go.
If they squandered part of the inheritance, hopefully they learn from it and will be better able to handle the next payout from the trust. Delaying and splitting payments also allows the child to “make their own way in the world,” providing a little help along the way but not squashing any ambition and independence. You can also set up separate trusts for each of your heirs with different rules depending on each child’s needs.
Spouses and Significant Others
With the divorce rate around 50%, odds are at some point you may have some concerns about your children’s partner choice. You may worry that your money will end up outside the family in the hands of a former spouse after a divorce. This is a very real possibility without some planning ahead.
Or maybe you just want to make sure that some of your wealth is allocated to your grandchildren, but don’t necessarily trust that your child and significant other will follow through on your wishes. Again, a trust can be set up to protect your wealth and direct it to whomever and however you see fit.
With a trust, you can set it up to be as protective as you want, for as long as you want and hand pick who will manage it for you. For example, if one of your children was recently married (especially if it’s to a spouse you don’t particularly trust) you can set up the trust to pay out after a certain period of time (after the marriage has stood the test of time).
An “illusory” trust may be a good option as well. This type of trust gives much of the control to the child beneficiary (maybe even naming them trustee). This will not provide much in the way of legal protection, but may provide a way to manage the assets and classify them as “non-marital” assets, keeping them separate in the event of a divorce.
The most obvious reason to not pass on assets directly is in the event of a mental disability or self-induced disability such as a drug, alcohol, or gambling addiction. A long-term trust is the best way to safeguard a child against, well, him or herself.
In this case, the selection of a trustee is of the most importance. While your first inclination would be to appoint a sibling as a trustee, make sure this person is ethically and financially set.
When family members are involved, there will inevitably be emotions involved to what should otherwise be an objective process. Therefore, an alternative might be a corporate trustee who has no emotional attachment. Better yet, a co-trustee situation might be the best option with a sibling serving alongside the corporate trustee.
Protection from Creditors
If any of your children have creditor issues, you must be creative in structuring your wealth transfer. It makes very little sense to transfer your wealth to your child only to have it taken right away by a creditor.
Likewise, it may not be a current creditor you are worried about. If your child is involved in a highly litigious career or business venture, you may be worried about the prospect of future lawsuits which would try to place a claim on directly inherited assets. Even unexpected medical costs can derail even the most well-adjusted children.
You can use a trust to protect assets from these types of situations, however the trust must be drafted in a way so that the child cannot directly draw from it. As long as the child does not have access to the assets of his own volition, the assets should be out of the reach of creditors.
In this case, you may want a appoint a friendly trustee – like a sibling – who will closely follow the beneficiaries wishes. For additional protection, you could consider an “offshore” trust making it expensive for a creditor to try to reach.
A family limited partnership may also be a useful option. You’ll want to involve a lawyer as these different entity structures can become very complicated.
Sudden Wealth Syndrome
As I mentioned above, most lottery winners are broke with 5 years of winning. This is because they do not know how to handle a large amount of “sudden” money.
This is a big concern for many families trying to transfer relatively large amounts of wealth. Not only could the inheritance cause stress from having to manage the new wealth, but it could also undermine the child’s independence and motivation to live a productive life.
The point of wealth is to enhance the quality of life for your heirs, but in many cases it can have the opposite effect. Great care must be taken to transfer the wealth in a responsible manner, but also prepare the child to be able to handle the money.
The same approach can be taken as mentioned above with staggering of payments and limiting access. If you really want to be successful in this transfer, you need to communicate with your children as early as you deem reasonable.
If you can prepare your heirs for the wealth they will be receiving, they can better preserve and protect it. Be careful not to make them think they don’t have to work hard and achieve some level of success on their own.
You can set milestones in your estate plan (through an incentive trust) to make sure they – to some extent – lead productive lives. An example of this is to only transfer the assets if they graduate from a 4-year University. <see: Why the Young and Wealthy Tend to Lose it All>
Wealth Transfer In Summary
Transferring wealth is a difficult process if you want to do it the right way. There are many people, emotions, taxes, and legal issues that must be considered.
Money is a powerful tool that if used properly can enrich our lives and those we care about. However, if un-prepared a sudden wealth transfer can destroy lives. Start giving some thought to your own plan for transferring wealth. Then, sit down with an attorney and go over your wishes, concerns, and lay out a plan for your family.
About the Author
Phillip Christenson, CFA, is a Fee-Only independent financial advisor and co-owner at Phillip James Financial, a wealth management company located in Plymouth, MN. They provide comprehensive financial advice related to retirement planning, investments, and taxes.