A spendthrift trust is one of the most effective tools for protecting, preserving, and passing wealth on to heirs.
It's a unique tool for keeping a family's money safe—not only from creditors but from the heirs themselves. It retains most of its assets for an extended period of time, making only quantified distributions to beneficiaries, not transferring assets to them entirely and all at once.
An Overview of Living Trusts
A living trust is a legal entity that's created to hold ownership of the grantor's property—the individual who created it. A grantor is sometimes referred to in legal terms as the trustmaker.
After the trust is set up and a trustee is named to manage it, the grantor retitles their assets into the trustee's name and ownership. The trust documents set the terms for transferring those assets to the trust's beneficiaries at specified points in time.
A living trust avoids probate. A trust can transfer its assets to beneficiaries without the need for court oversight or involvement.
Revocable vs. Irrevocable Trusts
All trusts are either revocable or irrevocable.
Grantors usually act as trustees of their own revocable trusts because they retain the right to move assets in and out of the trust, to sell them, add more, change beneficiaries, or even shut the trust down entirely. A successor trustee is named to step in and take over should the grantor die or become incapacitated.
Irrevocable trusts are more ironclad. A grantor cannot act as trustee of their own irrevocable trust. They must forever relinquish all right and control over the assets funded into it. They can't change their minds and dissolve their trusts, taking their property back, at a later point in time.
In exchange for the grantor permanently giving up these assets, irrevocable trusts offer additional benefits that revocable trusts don't, including asset protection and avoidance of estate taxes.
A Spendthrift Trust vs. Other Trusts
A spendthrift trust is an irrevocable living trust that's overseen on an ongoing basis by a trustee, from the time of its inception and continuing on after the death of the grantor.
Many trusts are closed down after their grantor dies and their assets have been distributed to their beneficiaries, but a spendthrift trust remains up and running. It continues to hold its assets for incremental distribution to the beneficiary or beneficiaries.
The idea behind a spendthrift trust is to prevent certain beneficiaries from receiving their inheritances all at once. This might be because they're...well, spendthrifts. There's a risk that they'll blow through the money and assets in a short period of time.
In other cases, they might have numerous creditors, they might be married to someone who's greedily eyeing that windfall before filing for divorce, or they might have a drug or alcohol addiction.
The beneficiary's inheritance is therefore meted out in portions over an extended period of time. The beneficiary has no right to the money and can't spend it before actually receiving any of these distributions, and creditors and others can only reach the money that the beneficiary has actually received—not the portion of the inheritance that remains in the trust.
The trustee might have discretion to decide when and why payments are made, or the creator of the trust can set these terms in the trust documents when the trust is created.
Let's say that you leave $5 million to your favorite nephew. The trust generates $250,000 in income that's paid out to him annually, but it retains control of the $5 million in assets that produces that income.
Your nephew can't pledge the trust assets as collateral to take on debt. His creditors would be out of luck if he should take on a $3 million mortgage to buy a house, then find himself unable to perform on the loan because he took on more debt than he was able to support.
The only cash they could collect from him would be his $250,000 distribution. The principal of the spendthrift trust is still in place, generating dividends and interest safely and securely for decades to come.
The principal isn't subject to division with a spouse in a divorce because your nephew doesn't yet technically own them.
Exceptions to the Usual Rules
Many states will only protect a spendthrift trust's assets up to a certain extent. Some debts are exempt from the usual rules, such as government claims, child support, or spousal support.
These debts often remain payable from the trust's assets as well as from any distributions the beneficiary has received.
How a Spendthrift Trust Is 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.
Individual states can have differing requirements to some extent, and the language of the provision must exactly meet the requirements in your location.
Limitations on Self-Designated Spendthrift Trusts
If this great protection from creditors exists, why not simply create a spendthrift trust and name yourself beneficiary? Most states won't allow this for public policy reasons. There are some exceptions, specifically the Alaska Trust, but you should contact a qualified attorney for guidance.