Naming Your Trust as Your Contingent Beneficiary to Protect Your Kids from Themselves
When it comes to estate planning, protecting wealth isn’t just about minimizing taxes or avoiding probate. It’s also about managing human behavior over time. And sometimes, naming your children as direct beneficiaries can backfire.
For instance, your young adult children might lack the financial maturity to responsibly handle a large lump sum all at once. By contrast, if the assets flow into a trust, you retain the ability to stagger distributions, using preset milestones (such as at ages 25, 30, 35), or tie distributions to achievements, such as completing an undergraduate degree.
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For instance, if your college-aged son directly inherits $500,000 at age 21, it could disappear before he ever even walked across the stage to receive his diploma. But if instead that same $500,000 flowed into a trust with provisions for phased distributions, he would still be able to benefit from those resources, while avoiding the dangers of "sudden wealth syndrome.”
When it comes to developing an estate plan, people will often focus on writing out a detailed will or even creating a trust. However, they tend to underrate the importance of beneficiary designations. Particularly when it comes to life insurance policies, brokerage accounts, and retirement savings, the simple act of naming a contingent beneficiary can profoundly influence how, when, and in what manner your wealth is passed on to your heirs.
One incredibly powerful strategy is to name your revocable living trust as the contingent beneficiary on these assets. Doing so can give you significantly greater control over how your wealth is distributed while your children are too young to handle the financial responsibility of their inheritance.
Tactically, most estate plans structured this way work in two steps. A married couple would typically name each other as primary beneficiaries on their major financial accounts and life insurance policies. This ensures that if one spouse passes away, the other has immediate access to the assets to maintain their lifestyle.
However, the contingent beneficiary is the person or entity next in line if the primary beneficiary is unable or unwilling to inherit your assets. And since assets that have designated beneficiaries, such as life insurance policies, IRAs, and 401(k) accounts, typically pass with no questions asked, you’ve effectively handed them full control at the moment of your death.
This is where establishing a revocable living trust and naming it as the contingent beneficiary can act as a safeguard against the risks of sudden wealth. Doing so would allow you to set detailed parameters around any and all asset distributions. And by channeling assets through the revocable living trust, the parents retain a measure of control over how the inheritance is used long after they are gone.
One important nuance is that naming a trust as the beneficiary of a pre-tax retirement account can have significant tax implications, sometimes eliminating the ability to "stretch" distributions over the lifetime of an heir. Instead of the beneficiary being allowed to take distributions slowly over a 10-year period, assets inherited by a trust could become taxable, depending on the structure.
Thus, if a primary goal is maximizing the tax efficiency of the inheritance, naming individual children directly as beneficiaries of IRAs or 401(k)s may make more sense. But if parents are more concerned about protecting their children from poor financial decisions than they are about tax efficiency, directing these assets into a trust can still be the optimal solution.
It’s a common misconception that estate planning is primarily about protecting minor children. In reality, the risks associated with sudden wealth do not magically disappear when a child turns 18 or 21. Thus, a revocable living trust allows parents to maintain more control over their financial legacy and help improve the chances that the wealth they worked so hard to build actually lasts for generations.
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Malcolm Ethridge is the Managing Partner at Capital Area Planning Group, based in Washington, D.C. His areas of expertise include retirement planning, investment portfolio development, tax planning, insurance, equity compensation and other executive benefits.
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Disclosures:
The information provided is for educational and informational purposes only, does not constitute investment advice, and should not be relied upon as such. Be sure to consult with your legal advisors before taking any action that could have tax and legal consequences.
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