Recently, a client came to us with a problem. He had amassed a healthy portfolio and planned to leave it to his two children. He was worried that his daughter’s impending divorce might leave her portion of the inheritance vulnerable to her soon-to-be ex-husband. How do you protect your assets — and your children — from poachers?
Dave Bartlett is in his 80s and recently widowed. He has more money than he’ll ever spend and intends to leave a considerable legacy to his children, Bonnie and Eric. Dave and his late wife created an estate plan consisting of two sweetheart wills, health care proxies, and durable power-of-attorney documents. Dave’s two children are his only beneficiaries. Besides being sorely out of date, Dave’s overly simplified estate plan would give Bonnie’s husband access to her inheritance should Dave die before the divorce is finalized.
At his passing, Dave’s children would each inherit half of his assets after probate. Probate is a legal process that establishes a will is genuine and allows creditors to claim money owed them before the assets go to the decedent’s beneficiaries. Because Dave’s IRA designates Bonnie and Eric as beneficiaries, it would bypass probate and pass directly to his children in equal parts in the form of inherited IRAs. The total amount of Bonnie’s inheritance exposed to creditors (including her inherited IRA) would be $2.5 million (her half of her father’s total estate). If her husband were to play hardball during the divorce proceedings, he might attempt to claim a portion of Bonnie’s inheritance. It’s unlikely that Dave will die within the timeframe of the divorce, but the thought of Bonnie’s inheritance falling into the wrong hands sends shivers down his spine.
The estate planning challenge is to protect Bonnie’s inheritance from her soon-to-be-ex-husband, while still allowing her access to the money. We suggested that Dave work with an attorney to create a Revocable Living Trust and fund it with as many of his assets as possible. A Revocable Living Trust, or RLT in estate planning lingo, can be thought of as a bucket with a set of instructions attached. The bucket holds things — in this case, Bert’s house (virtually) and most of his financial assets, except for his IRA. The instructions describe who will receive these assets, how much they’ll receive, and under what circumstances they’ll receive them. Dave is the grantor of the trust (also known as the trust maker), as well as the trustee. As trustee, Dave has complete control over these assets while alive. Upon his death, any property in the trust will bypass probate. The trust instructions, drafted with the help of an attorney, can be simple or more detailed according to the client’s wishes.
How do you fund a trust? You change the ownership registration of your accounts from your name to the name of your trust. It’s a straightforward process. For example, Dave would submit paperwork to his bank and brokerage firm to change the ownership registration of his financial accounts from Dave Bartlett to The Dave Bartlett Revocable Trust. He would also change the name on the deed to his house to the name of his trust. Presto! These assets now reside in and are owned by Dave’s trust. Because Dave is the trust maker and trustee of the trust, he retains full control over these assets, just as if they were registered in his name. The only remaining asset not yet in Dave’s trust is his IRA. By law, an IRA must remain under individual ownership while the account owner is alive. However, if Dave assigned his trust as the primary beneficiary of his IRA instead of his two children, his trust would become the IRA owner at his death. Because his children are the beneficiaries of his trust, they would still receive the IRA assets as part of their inheritance. Dave needs to consider how his IRA names the trust as the beneficiary, but his estate planning attorney will guide him on that.
You might wonder why Dave would go to the trouble and expense of creating and funding a trust if nothing really changes. While nothing changes while Dave is alive and well, when he passes on, his revocable trust will become irrevocable, meaning that it cannot be revoked. It will become two irrevocable sub-trusts split 50/50 for Bonnie and Eric, as specified in the original trust instructions. Dave’s IRA assets will also be split 50/50 (as specified in the IRA account’s beneficiary designations) and moved into two inherited IRA accounts, one for each of his children. Both inherited IRAs will then be owned by the irrevocable trust. What’s so special about an irrevocable trust? The language of the trust can be drafted so trust assets are excluded from the beneficiaries’ estates and are not considered marital assets in case of divorce. If the assets are not in their estate, creditors cannot get to them. Specifically, Bonnie’s husband will have no claim to any of her $2.5 million inheritance.
Additional modifications will strengthen Dave’s estate plan. Every trust or sub-trust needs a trustee, someone who controls access to the assets in the trust. The trust maker normally assigns trustees for the sub-trusts even before the sub-trusts are created, but there’s a dilemma. If Dave makes Bonnie the trustee of her sub-trust and grants her full control, depending on state law, it may leave the sub-trust vulnerable to creditors and trust invaders (like her ex). As a temporary measure until the divorce is finalized, we suggested that Dave consider making Bonnie’s brother the trustee on her sub-trust, as well as his own. If Bonnie needs money from her sub-trust, she can ask Eric to arrange it because she will have no direct control. Fortunately, Bonnie and Eric are close, so this should not be a problem. However, if Eric becomes uncooperative, the trust instructions can be written to allow Bonnie to replace him as trustee and appoint someone else. Once the divorce is finalized, Dave (assuming he is still alive) can modify the terms of his trust and make Bonnie the trustee of her own sub-trust.
Under the new arrangement, Dave retains full control of his money and real estate while alive and protects his daughter’s inheritance from creditors and anyone else who tries to invade the trust. Dave liked this strategy and has reached out to an estate planning attorney to fill in the details and draw up the documents.
Dave had concerns and came to Sensible Financial. We suggested a solution that his estate attorney could help him refine and accomplish. He sleeps better knowing the assets he worked hard to earn will go to the people he loves.