Trusts are useful because of their flexibility. There are very few trust provisions that a court will strike down. As a result, a trust lawyer can create a document that addresses issues specific to your situation.
Spendthrift trusts were created to address some specific problems grantors historically faced during estate planning related to a beneficiary’s spending habits. This type of trust can protect assets from creditors, as well as the beneficiary’s poor financial decisions.
What Is a Spendthrift Trust?
Many grantors have beneficiaries who are too young, immature, or irresponsible to have unrestricted access to trust assets. Another issue arises when the grantor wants to ensure that the trust assets are used for certain expenses, such as college tuition, before others.
Spendthrift trusts are entities that hold and distribute assets to beneficiaries according to a set of rules called a spendthrift provision. The grantor writes these rules, and the trustee enforces them. The trust’s terms ensure that the beneficiary can only access the assets on the terms defined by the grantor.
For example, a spendthrift clause might limit a child’s trust income each year. Similarly, a provision might restrict the trustee from distributing assets to the child for anything other than educational expenses until they turn 25.
These types of provisions preserve assets by protecting them from the beneficiary’s reckless spending, debts, or other legal issues.
How Spendthrift Trusts Work
A trust is an entity created by a lawyer using a trust document drafted according to the Texas property code. The trust functions to hold and distribute property.
Such an entity involves three parties. A grantor funds the trust by transferring assets into it. For example, a grantor might transfer the deed for a piece of property into the trust’s name. The grantor often creates a trust as part of their estate plan.
A trustee manages the trust. The trustee might be a bank, lawyer, or trustworthy relative. The trustee protects the assets and enforces any restrictions imposed by the trust document.
A beneficiary receives the trust assets. In some trusts, the beneficiary simply obtains the assets in their entirety. In others, the assets remain in the trust, and the beneficiary receives a stream of payments from the assets and whatever income they earn.
Spendthrift trusts involve these same three parties. However, the trust agreement includes a spendthrift clause restricting the beneficiary’s access to the assets or their income. These spendthrift provisions address a specific concern with one or more of the beneficiaries to ensure that it provides for their long-term support.
Benefits of Asset Protection
The beneficiary’s interest in the trust is “equitable” rather than “legal.” This means that the beneficiary doesn’t own the trust assets — they’re simply entitled to them according to the trust agreement’s terms.
As a result, the beneficiary’s creditors can’t go after the trust fund to satisfy the beneficiary’s debts or legal obligations. The one exception under the Texas family code allows a judge to order the trustee of a spendthrift trust to pay the beneficiary’s child support obligations.
Since the trust is a separate legal entity from the grantor, it may also offer asset protection from the grantor’s creditors. However, this protection depends on whether the trust is revocable or irrevocable.
The grantor can terminate a revocable trust. Therefore, the assets are considered the grantor’s property, and the creditors can pursue them. The grantor can’t terminate an irrevocable spendthrift trust. As a result, the spendthrift trust assets don’t belong to the grantor, and their creditors can’t pursue them.
Disadvantages of Spendthrift Trusts
The primary disadvantage of spendthrift trusts is a lack of flexibility.
The trustee can’t violate the trust’s restrictions even if the beneficiary needs the money. For example, a beneficiary might need large sums of money for medical care after a cancer diagnosis. However, the trustee can only pay the controlled distribution permitted in the trust agreement.
Another downside of spendthrift trusts is the lack of direct access to trust assets for beneficiaries. As a result, the beneficiary can’t direct how the assets are invested or distributed.
Additionally, a spendthrift trust may incur ongoing expenses for a professional trustee over its lifetime. These fees may erode the trust assets unless the trustee and grantor reach an alternate legal arrangement for the fee payments.
Who Can Benefit From a Spendthrift Trust?
Both grantors and beneficiaries can benefit from spendthrift trusts. The grantor knows the trust assets will provide for the beneficiary’s ongoing financial support. Grantors who can benefit from spendthrift trusts include those planning for the support of any of the following:
- Young children
- Dependents with special needs
- People with a history of overspending
- People with substance abuse or gambling issues
- People with mental illness or cognitive disabilities
At the same time, the beneficiary knows that such a trust will provide financial security. While they may disagree with the restrictions, a spendthrift trust nonetheless offers protection from their own monetary mismanagement.
Setting Up a Spendthrift Trust
Spendthrift trusts are established like all other trusts: A lawyer writes a trust instrument containing the instructions to the trustee.
Before you set up a trust, you should discuss the benefits and drawbacks of a spendthrift trust and the specific restrictions you wish to impose. Your legal professional can explain any potential legal or practical issues that might arise and suggest ways to overcome them.
For example, a lawyer might suggest giving the trustee discretion to pay additional amounts for emergencies or medical expenses. They might also recommend building in alternative instructions to avoid stranding the assets in the trust if the beneficiary doesn’t use them as instructed.
Consequently, rather than saying the trustee will only pay for educational expenses, the trust might allow payment of educational or medical expenses until the beneficiary graduates or turns 35. Upon either of those events, the trustee can pay the beneficiary $50,000 per year for the rest of their life.
Such an arrangement encourages the beneficiary to attend college but also gives the trustee flexibility to pay medical expenses. It ensures that the beneficiary receives the money if they graduate but also supports them if they don’t.
Trust Assets
Trust assets can encompass any type of property, including cash, securities, and real estate. When setting up a spendthrift trust, many grantors include income-generating assets so the trust doesn’t run out of money. For example, a trust may own a rental home and all the income it generates.
The trustee decides how to invest the assets to carry out the terms of the trust. The trustee of a spendthrift trust might rely on a conservative investment strategy, putting any cash into interest-bearing accounts and bonds to ensure that the trust can pay for the beneficiary’s long-term support.
Tax Implications
The main advantages of trusts include asset protection and avoidance of probate. However, trusts don’t shelter assets from taxation. If the assets earn income, that income is typically taxable. If they appreciate in value, they’re subject to capital gains taxes.
The trustee is responsible for reporting and paying any federal or state income tax on the trust’s earnings. Additionally, when trusts are part of an estate plan, the assets are included in calculating the estate taxes.
Termination of a Spendthrift Trust
Spendthrift trusts last for the period designated by their grantors. In some cases, a trust may last until a specified event, at which time any remaining assets are distributed.
For example, a trust might only pay the grandchild’s educational expenses until graduation from college, then distribute the remaining assets to the grandchild without any further restrictions.
Alternatively, the trust may continue until the assets are gone. Thus, a trust may pay the beneficiary a designated amount per year until all the assets are paid out.
For example, a grantor might transfer $100,000 into their trust. The trust instructions might state that the trustee pays the grantor’s child $20,000 per year for five years starting upon the grantor’s death. Any remaining amount in the trust from interest, dividends, or other earnings gets paid in the sixth year. The trust then terminates.
Finally, a trust might continue for the beneficiary’s lifetime. Large sums can earn enough income through interest and dividends that the trustee might never need to touch the amount originally deposited. The trustee uses the trust income to pay the beneficiary according to the instructions until death before disposing of the original amount.
With this approach, a grantor might set up a spendthrift trust to provide a fixed annual payment to their child for life, then distribute the originally deposited amount to charity upon the child’s death.
Alternatives to Spendthrift Trusts
Spendthrift trusts have many variations, including self-settled spendthrift trusts (also called living spendthrift trusts) and special needs trusts. Each of these trusts is specifically designed to address a particular issue.
Living Spendthrift Trusts
Living spendthrift trusts are created during the grantor’s lifetime, with the grantor as a beneficiary.
When they’re irrevocable, they can provide asset protection to a grantor/beneficiary and ensure that they have a financial safety net. However, an irrevocable living spendthrift trust can’t be changed or terminated early if the grantor/beneficiary needs to access their money.
Special Needs Trusts
Special needs trusts also regulate the amount paid to the beneficiary. However, they do so to avoid jeopardizing the beneficiary’s government benefits.
For example, a special needs trust agreement might pay the beneficiary just below the threshold to receive Supplemental Security Income (SSI) from the Social Security Administration. As such, the beneficiary would receive both their trust distribution and SSI.
Frequently Asked Questions
What Does a Spendthrift Provision Look Like?
Spendthrift trusts don’t necessarily have a title that says “spendthrift trusts.” Rather, they’re identified by the restrictions they contain to control the trustee’s disbursement of funds to one or more beneficiaries.
A spendthrift provision will typically identify the benefits and any limits on how they’ll be distributed; for example, “one-third of the assets to my son, paid at a rate of $10,000 per year.”
Can the Beneficiary’s Creditors Reach Assets Held in Spendthrift Trusts?
Since the beneficiary doesn’t own or control the assets, they aren’t considered their property. Consequently, their creditors can’t get to the assets in spendthrift trusts, with one notable exception: Texas law specifically allows judges to order trustees to pay beneficiaries’ child support obligations.
Who Determines the Beneficiary’s Access to Trust Assets?
The trustee controls the distribution of assets and income. They implement a process for the beneficiary to request money. If the trust instrument allows the release of funds, the trustee issues them. However, the trustee must comply with any specific guidelines set out by the grantor and can’t disburse money for restricted uses.