6 Steps to Doing Your Kids' Trust Fund Right

By Rick Kahler

NEW YORK (AdviceIQ) -- How do you stop your offspring squandering their inheritance? When passing wealth to your kids, consider creating a trust to limit the later generation's ability to tap into the principal.

Several astute readers suggested this strategy after my recent article cited research that shows 90% of inherited wealth is gone by the third generation.

There is no question a trust, done correctly, can go a long way to preserve wealth after the death of the wealth accumulator. Let's explore what "done correctly" means.

1. Trust law is complex. Engage an accountant and attorney with strong skills and expertise in trusts.

2. Be sure the assets you intend to go into the trust will actually transfer.

Retirement plans such as individual retirement accounts, 401(k)'s and profit-sharing plans will pass to whomever you listed as the beneficiary. This must be the trust. In addition, the trust must include a number of special provisions for a retirement plan to be distributed according to your wishes and not as a fully taxable lump sum.

Annuities, insurance policies and accounts with a transfer-on-death clause will also pass to the named beneficiary.

Assets held in joint tenancy will not. Many married couples jointly own most of their major assets, such as the family home, investment real estate, brokerage accounts or bank accounts.

3. Be sure there are enough assets in the trust to justify the trustee fees. Most professional corporate trustees charge $3,500 to $10,000 annually, or up to 1% of the trust assets. If a trust with $100,000 incurs an annual fee of $3,500, your hard-earned estate will benefit the trustee as much as your heirs. A trust probably doesn't make financial sense if the total fees exceed 2%.

4. If a trust still seems like a good strategy after the above caveats, the next question is how much to limit heirs' ability to withdraw money. From an actuarial standpoint, it's fairly simple. If you limit annual withdrawals to 3% of the principal, there's a strong probability of the money lasting several generations with its buying power intact. Provided, that is, the trustees pay close attention to the next point.

5. To generate sufficient returns to pay out up to 3% annually to heirs and keep up with inflation, the majority of the portfolio must be invested in assets that will grow over time, such as stocks, real estate and commodities. The holdings need to be diversified broadly among many asset classes and countries.

The trustees must also limit the fees paid to manage the investments. Many corporate trustees have an inherent incentive to use their own bank's mutual funds, which can have annual fees as high as 1.5%. One way to avoid this conflict of interest is to instruct the trustee to place the funds with an investment adviser who has a largely passive approach to managing money. This could cut the portfolio fees by 50% or more.

6. Finally, before setting up any trust, pay close attention to taxes. Congress recently increased the top income tax bracket to 39.6% on wealthy taxpayers. Any trust that keeps more than $11,950 of annual income is considered "wealthy."

So here is the problem: If the trust retains enough earnings to increase the principal and offset inflation, it will have to pay substantial income tax and will probably need to restrict annual withdrawals to 1% or 2%. All of a sudden, a multimillion-dollar inheritance becomes simply a source of secondary income similar to Social Security.

Trusts are valuable estate planning tools. But like any other powerful tools, they are best employed by someone with the skills to use them well.

-- By Rick Kahler, CFP, president of Kahler Financial Group in in Rapid City, S.D.

AdviceIQ is a network of financial advisors that writes insightful articles for the public about investing and wealth management. All articles are edited by AdviceIQ's editor in chief, Larry Light. AdviceIQ certifies that all its advisors have no regulatory infractions.

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AdviceIQ is a network of financial advisors that writes insightful articles for the public about investing and wealth management. All articles are edited by AdviceIQ's editor in chief, Larry Light. AdviceIQ certifies that all its advisors have no regulatory infractions.

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