How a Spendthrift Trust Can Protect Your Heirs from Themselves

An Introduction to Spendthrift Trust Funds for New Investors

Spendthrift Trust Funds
Hiring an attorney to draft a spendthrift trust fund can improve the protections available to your beneficiaries by forbidding them to pledge the trust principal as collateral. Paul Bradbury / Getty Images

One of the most effective tools for protecting, preserving, and passing on wealth to heirs is the spendthrift trust.  What is a spendthrift trust and what makes it so special?  In this article, I want to walk you through not only a basic definition, but illustrate how one might be used to save heirs from themselves or other creditors.  In short order, you'll discover how incredible this unique tool can be in keeping a family's money safe from not only creditors, but the heirs themselves.

First, we need to recover some ground in case you need a quick refresher.  In my article, What Is a Trust Fund?, you learned the fundamentals of trusts including the definition of terms such as grantor, beneficiary, and trustee, saw how a trust fund is structured, and were given a list of reasons an investor might want to use a trust fund to keep intact, or disburse in a controlled manner, the money and assets he or she accumulated either through fortune or disciplined hard work, often over a lifetime.  In addition, I've spoken about trust funds on multiple occasions.

With those out of the way, understanding a spendthrift trust should be easy for you.

What Is a Spendthrift Trust and How Does It Differ from an Ordinary Trust Fund?

A spendthrift trust is a trust account overseen by a trustee, such as an individual or corporate trustee, that controls the assets you leave, including hiring an asset management company, perhaps one structured as a registered investment advisor, to invest the trust's money, after you've made the trust irrevocable or died. The beneficiary is forbidden from spending the money before he or she actually receives distributions and the trustee has the authority to determine what payments are necessary according to the trust agreement.

For example, if you left $5,000,000 to your favorite nephew, and the trust account generated $250,000 per annum in income that was paid out to him, he couldn't pledge the trust assets as collateral. If he did spend more than he was able to support - say he bought a $3,000,000 house - the creditors would be out of luck should he find himself unable to perform on the loan.

The only cash they can collect from your nephew would be his $250,000 distribution.  The principal of the spendthrift trust is still in place, generating dividends, interest, and rents safely and securely for decades to come.

How Is a Spendthrift Trust Created?

The process of establishing a spendthrift trust fund is identical to creating any other trust fund except the trust instrument must contain a spendthrift provision.  Your attorney should be able to offer advice on the wording of this provision and what works best in your particular state.

There Are Some Societal Downsides to the Use of Spendthrift Trusts

For all of my affection toward them, I do wonder about some of the moral aspects of spendthrift trusts.  I've settled upon the notion that we sometimes have to permit a large amount of injustice in a few cases to preserve a superior outcome in a majority of cases even if it doesn't feel good or make us happy.

 If you're interested in the way spendthrift trusts can protect bad people from the consequences of their actions, read Is It Moral to Protect Spendthrift Trust Assets from Tort Claims?.

Limitations on Self-Designated Spendthrift Trusts

If this great protection from creditors exist, why not simply create a spendthrift trust and name yourself beneficiary? Great questions.  For public policy reasons, most states won't allow this. There are some exceptions, specifically the Alaska Trust, but you need to contact a qualified attorney for guidance.  The notion of self-settled asset protection trusts, as they are often known, is still relatively new.