Bad Heir Day: How To Prepare Your Estate

Bad Heir Day: How To Prepare For Your Bequest Going To A Spendthrift

Passing along your wealth to the next generation can be a crap shoot. Will they spend it wisely? What if you know that a beneficiary isn’t financially responsible? What can you do? Rick Kahler, president of Kahler Financial Group in Rapid City, S. D., has some good ideas on this fraught subject:

Larry Light: As people draw up their wills, how should they deal with the possibility that an heir might spent the bequest poorly?

Rick Kahler: A common estate-planning question is whether it makes sense to leave inheritances with strings attached. My typical answer is “it depends.” It’s natural to want your legacy to be used wisely, but trying to control from beyond the grave can have unintended consequences.

One approach is the “I won’t care when I’m dead” philosophy. Indeed, an inheritance is ultimately the heir’s responsibility. It’s not only difficult, but may even be emotionally unhealthy, to try to protect heirs from themselves.

Others may want an inheritance used for only certain expenses, like education, a home, or to help fund retirement. If the initial recipient won’t use it in that way, it can go to someone who will put it toward the purpose the giver wants to support. 

Light: But that can be tough it it’s your beloved children involved.

Kahler: Perhaps the most common reason for wanting to control a legacy is a spendthrift heir. Giving a chronic over-spender an inheritance in hope that it will help change their money behavior is almost always magical thinking. Most lump sum inheritances disappear within a few years in the control of an over-spender.

In my experience, parents of someone with a lifetime pattern of financial chaos and crisis don’t usually want to disinherit that child completely. They commonly want to protect such heirs from themselves. Their goal is often to provide the heir an income but safeguard the inheritance in hopes of having something left for grandchildren.

Light: How do you do that?

Kahler: One way is to leave the money in a “spendthrift” trust. An independent trustee invests the money and oversees the distributions. The money in the trust is beyond the control of the heir and protected from any claims of creditors. The distributions can be very rigid.

For example, the trust can distribute 3% of the principal annually, in equal monthly sums, with no provisions for any other distributions. Using a formula like this almost assures there will be something to pass on to the grandchildren upon the death of your adult child. It can be a win/win for everyone.

Light: Is there a downside to a spendthrift trust?

Kahler: The cost. Trustee fees often start around $5,000 a year and go up from there. My rule of thumb, which isn’t one-size-fits-all, is that the trustee fee needs to be 1% or less of the principal. So, a fee of $5,000 only makes sense if the inheritance is $500,000 or more.

What if you want to leave $100,000 to a spendthrift heir? Paying $5,000 a year in trustee fees will burn up the money exponentially fast.

Light: Does an alternative exist?

Kahler: I suggest that the money be left in the form of a single premium immediate annuity, or SPIA. In return for a one-time cash investment paid for by the estate, this would provide a guaranteed income for the heir’s life. For example, for a one-time premium of $120,000, one company will provide a 65-year-old woman with an annual lifetime income of $8,040.

The drawback of an SPIA is that it will pay no death benefits to grandchildren. One popular option is an annuity called life with cash refund, where the insurance company pays the annuitant’s heirs any remainder of the initial deposit that was not paid out during the annuitant’s lifetime.

An SPIA locks in an income for life that isn’t subject to market fluctuation, creditors or raids on the capital by the beneficiary. They can be wonderful vehicles to protect someone who is a chronic over-spender or who has a limited income, few assets, and little financial knowledge.

Beyond using either a trust or an SPIA, I generally advise against trying to over-control an inheritance. Ultimately, it is up to your heirs to choose how to use the legacy you give them.