WASHINGTON — There’s a sense of pride knowing that you have accumulated valuable assets to pass on to the next generation. There’s also fear in having to deal with your own mortality and losing control of the wealth that you worked so hard to build.
There are many “what ifs” to consider when giving your children or grandchildren an inheritance — from when and how to let them know they are receiving an inheritance to protecting your gift from becoming the property of a future ex-spouse and another family altogether.
How do you make sure your wealth gets distributed to the people you care about most in accordance with your intentions?
Before we answer that question, I want to be clear that any estate-planning and legal documents should be properly discussed and drafted by an estate attorney. As a financial adviser, we work with clients who are inheriting assets and those who plan to give an inheritance to their heirs.
The key is to have your financial adviser collaborate with your estate attorney, so that your advisers work together on a plan that meets your needs.
Have a conversation with your children
Having that first conversation with your children about an inheritance can be hard for you, as the donor, and them, as the recipient-beneficiary. For many parents, this is the first time they are actually revealing their net worth to their children as more-mature adults.
When children first learn about an inheritance, they are processing a lot of new information about their parents’ wealth. Both parents and children have their own preconceived beliefs and values about money that they bring to this conversation. Their views are often not the same.
As Mary Ann Mancini, a partner in the trusts and estate group of Loeb & Loeb, aptly stated, “Beware of your emotions, and make sure to talk to your kids about their inheritances.”
As a parent, your vision may be longer-term, because your decisions impact not only your immediate children and family, but also potentially your children’s spouses, grandchildren and future generations. It’s only natural that you would want to protect assets you give to your married children from becoming mixed up in a potential divorce.
Let’s look at three common questions clients ask me about how to protect an inheritance they are giving to their heirs.
How can my children protect their inheritance from becoming their spouse’s property should their marriage end in divorce?
The simple answer is that your child’s inheritance is their sole and separate property so long as they take the proper steps to always keep it separate from marital assets.
What does this mean? Your child should make sure any inherited accounts or property are titled in their name only, not jointly with their spouse, and your child should continue to maintain the titling this way.
Unfortunately, separate property held by one spouse has a way of becoming marital property if the inheritance is not handled properly.
For example, when a couple buys a new home and uses previously inherited assets (assets that were titled in separate name) as a down payment to purchase a home that they jointly own, the home (which now has a deed in joint name) can be deemed to be marital property subject to 50-50 division in the event of a divorce. The same holds true for any investments purchased with separate assets that become titled in both the husband and wife’s name. These assets are more likely to be considered martial property upon divorce.
A more-difficult scenario is when someone inherits property that needs repairs and uses marital assets to fix the property. As a married couple, income earned during the marriage is typically marital property. If marital income is used to repair the property your child inherited, it becomes more marital and less separate.
Let’s say a home-equity loan is used to pay for the repairs, then marital income to make the monthly loan payments. The couple has transmuted a separate, inherited asset into marital property.
Bottom line: Your child should keep inherited property titled in their separate name at all times and not commingle assets in joint name.
What are the benefits of setting up a trust to transfer an inheritance?
Rather than transferring assets outright, parents can set up a trust to transfer wealth to their children and potentially protect these assets in the event of a divorce. When assets are owned by a trust, they are not owned directly by your children and are more difficult for your child’s spouse to pursue in the event of a divorce.
Many, but not all states, recognize trust assets as separate property that is not subject to division upon divorce. However, courts in some states have considered the trust income when determining spousal alimony or child support to the non-beneficiary spouse. In some cases, where one spouse will be in a much better financial situation because they will be the beneficiary of a sizable trust, the court may decide to award the spouse who does not have this type of access a larger share of the marital estate.
Depending on the state and circumstances, trust assets may be more at risk when a beneficiary is their own sole trustee and has broad discretionary powers to distribute assets to anyone, including themselves.
Essentially, these trust assets are easily accessible and available to the beneficiary. It’s that “present ownership interest” in the trust assets by the beneficiary that may give rise to a family law court factoring the trust assets into property being awarded to the beneficiary’s ex-spouse upon divorce.
Adding some provisions that help restrict the beneficiary’s control over the trust assets may help safeguard a trust as separate property in the event of divorce. One recommendation from Mancini is to add an independent co-trustee to the trust and give them total authority to withhold or make distributions to the beneficiary in his or her sole and absolute discretion.
Other layers of protection include:
- Adding multiple beneficiaries instead of only one primary beneficiary.
Requiring that the “distribution” trustee be a corporate or professional trustee (and not the beneficiary’s relative or close friend).
- Making sure the beneficiary does not hold a general power of attorney to direct trust assets.
- Creating a trust that lasts for multiple generations instead of outright age-based distributions.
Because trusts are complex, we strongly encourage you to consult with an experienced estate-planning attorney to make sure your children understand the trust terms and importance of maintaining the assets under the trust’s ownership to the fullest extent possible.
Should my child have a prenuptial agreement?
A prenup agreement allows your child and their spouse to agree before they get married who owns what and each person’s property rights after the marriage (upon divorce or death).
While prenups can save time and money and preserve your child’s inheritance in the event of divorce, they must be entered into voluntarily with each party providing the other with full and fair financial disclosure.
Some of the benefits of a prenuptial agreement to consider are:
- By keeping premarital assets including pensions, investments and business assets as nonmarital property, you will not have to prove in court what was or wasn’t your asset before marriage. You should also specify that future income and appreciation generated from these premarital assets be deemed nonmarital assets and not subject to division in the event of divorce. This is particularly relevant for women marrying a second time who have children from a previous marriage and who want to make sure that assets acquired during the first marriage go to their children, rather than a second husband.
- You and your fiancé may own and run separate businesses before you marry, and agree in your prenup that these businesses and income earned will remain separate property after marriage.
- The importance of understanding each other’s premarital debt can be unintentionally overlooked. Consider limiting your responsibility for your future spouse’s debt and agree that certain debts will be satisfied from separate personal assets and not from your marital assets.
- Other important provisions include specifying alimony and property settlement terms in the event of divorce and death. Keep in mind that child support may not be predetermined in a prenuptial agreement.
Prenups, like trusts, have many different provisions, and enforceability varies state to state, so seek legal advice before drafting and signing this contract.
The best strategy for protecting your children’s inheritance for them and your future generations is to consider all of your options, and have open, honest conversations with them about your intentions and concerns.