Spendthrift Trust: What Is It and How Does It Work?
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A spendthrift trust is a trust that limits the beneficiary’s access to the trust assets according to specific terms the grantor sets. Spendthrift trusts help ensure that beneficiaries can’t squander their inheritance; they also protect trust assets from creditors.
Rather than allowing the beneficiary to receive a lump sum, the trustee releases the money incrementally. For that reason, a spendthrift trust can be especially useful if your beneficiary is:
Not mature enough to make wise spending choices.
Impulsive with money.
In heavy debt, or at risk of going into heavy debt.
Easily fooled or defrauded.
Suffering an active addiction that might cause excessive spending.
A child with functional needs and is eligible for SSI or Medicaid.
Involved in or at risk of getting a divorce (courts may not consider trust assets as marital property when dividing assets).
Employed in an industry where lawsuits are common (creditors typically can’t seize trust assets to pay settlements).
How does a spendthrift trust work?
A spendthrift trust is a separate legal entity with three major elements:
A grantor: Also known as a “settlor,” the grantor is the person who creates the trust and transfers their assets into it.
A beneficiary: This is the person who receives benefits from the trust.
A trustee: This is the person who manages the trust assets in accordance with the terms of the trust. You may be able to appoint yourself as trustee, but if you do so, you’ll need to also appoint a successor trustee who can take over after you die or become incapacitated.
» MORE: How a power of attorney works
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What distinguishes a spendthrift trust from other types of trusts is that it contains a spendthrift clause (also known as a spendthrift provision). This spendthrift clause designates the trust itself as the only owner of trust assets, rather than automatically transferring ownership to your beneficiary when you die. The terms of the trust explain exactly how and when the trustee will release the funds to your beneficiary over time according to a schedule you create.
You can limit the beneficiary’s access to funds. The trustee can transfer fixed amounts on fixed dates, for instance, or you can allow the beneficiary to draw up to a certain amount of money from the trust at certain times. You can even design exceptions for emergencies.
Potential creditor protection
Although assets in a spendthrift trust are often safe from creditors, there are a few exceptions to be aware of, and you should check your state’s rules before proceeding:
Child support obligations.
Federal tax liens.
Creditors with an enforceable court judgment against the beneficiary.
Trust income that’s higher than the beneficiary needs for support.
One alternative to a spendthrift trust is a spendthrift living trust (an inter vivos trust), which disburses funds in increments while you’re still alive. You can act as trustee and make the scheduled disbursements yourself. However, you must name a successor trustee who can take on this responsibility after you die.
Spendthrift trust examples
Here are a few examples that show a spendthrift trust in action.
Miriam is 95 years old and wants to leave her entire estate, worth $450,000, to her beloved great-nephew, Kyle. Although Kyle is mature and responsible, Miriam doesn’t want to give him access to his inheritance all at once. Kyle is still carrying massive medical debt from a major emergency surgery that he’s fighting with his health insurance company to cover. With it unlikely that the insurance company will ever pay out, and creditors constantly hounding Kyle, Miriam decides to create a spendthrift trust that gives Kyle a monthly allowance of $3,000. This will give Kyle enough to make his life more comfortable as he recuperates, but it will also protect the bulk of the estate from creditors, because whatever remains in the trust is considered a trust asset and not Kyle’s personal property to garnish.
Edward wants to leave his granddaughter, Amanda, $50,000 when he dies. Although Amanda is a sweet and loving granddaughter, she’s only in her early twenties and has a notorious history of reckless spending. To prevent Amanda from squandering her inheritance, Edward decides to create a spendthrift trust that allows Amanda to draw up to $1,000 monthly from the account. This lets her treat herself to some luxuries without immediately spending her whole inheritance.
Are spendthrift trusts revocable or irrevocable?
Spendthrift trusts can be revocable (meaning they can be modified at a later date if desired) or irrevocable (meaning they cannot ever be changed).
Revocable spendthrift trusts have the advantage of flexibility, so that you can adjust the terms if your beneficiary matures or their situation changes.
Irrevocable spendthrift trusts have the advantage of potentially reducing estate taxes.
Spendthrift trust pros
Spendthrift trusts bring a number of advantages:
May protect the beneficiary’s trust assets from most creditors and lawsuits.
Gives the beneficiary a reliable stream of income while preventing irresponsible spending of the assets.
Grantor can retain control over the assets.
Spendthrift trust assets are often excluded from the overall estate for tax purposes.
Not subject to probate if established while you’re alive.
Spendthrift trust cons
There are a few disadvantages to spendthrift trusts:
They can be costly to set up and maintain.
If your trust is irrevocable, you won’t be able to modify it if circumstances change.
» MORE: What is an advance directive?
How to set up a spendthrift trust
You can set up a spendthrift trust yourself by using an online estate planning platform that can guide you step by step. However, you may prefer working directly with an estate planning attorney because even minor errors could compromise or invalidate your trust. Also, states have different rules about when spendthrift trusts are allowed; which creditors can go after assets in spendthrift trusts; and what can happen to the disbursements.
Consider a few important questions that can help ensure your trust will operate according to your needs and wishes:
Who will act as trustee? If you’ve chosen yourself as trustee, who will be your successor trustee if you’re no longer able to fill that role?
If your beneficiary is a minor, who will you appoint as their guardian to manage the trust payments?
Do you want your trust to be revocable or irrevocable?
How often should the beneficiary receive payments, and in what amount?
Do you want the payments to be a percentage of the trust principle or a percentage of trust income?
Should payments occur on a strict schedule or leave room for some flexibility?
For how many years should payments continue? Do you want payments spread over the expected lifetime of the beneficiary or over a limited number of years?