Trusts and Protecting Inherited Wealth from Divorce, Creditors and Addiction

You’ve worked hard to create a nest egg that you hope to pass down to your children to make their lives better.  But what happens to that inheritance if your child goes through a divorce?  Take the case of Sarah, whose father passed away, leaving her a substantial inheritance of stocks and bonds. Sarah planned to use the money to finally start her own business, a lifelong dream. However, just a year later, she found herself facing a bitter divorce. Despite her attempts to argue that the inheritance was separate property, the court ruled that because the funds had been commingled with marital assets (used to pay down the mortgage on the marital home and contribute to joint investment accounts), a significant portion was subject to division. Sarah lost a substantial part of her inheritance, and her entrepreneurial dreams were put on hold.

Can that inheritance, intended for your child’s security and future, be considered fair game in a divorce settlement? Sadly, the answer can be a resounding "yes." And the consequences can be devastating. Is there something you can do to protect the inheritance from divorce claims?  Happily, the answer is also “yes”.  Stories like Sarah's highlight the critical need for proactive planning. I often see clients grappling with the same anxieties: how to ensure their hard-earned assets truly benefit their children and grandchildren, even amidst life's inevitable uncertainties. We all want to provide for our loved ones, but sometimes simply leaving a lump sum isn't the smartest way to secure their future. Divorce, creditors, and even addiction problems can quickly erode an inheritance, leaving your children worse off than you intended.

Fortunately, there are strategies to protect your inheritance from the potential financial fallout of a divorce. One of the most effective tools is a trust. Think of a trust as a customized toolbox, allowing you to tailor the way your assets are distributed and managed, offering layers of protection your child simply wouldn't have if they inherited the money outright.

Why Trusts Are an Important Tool: Shielding Against Life's Storms

Here's how a well-structured trust can protect your children's inheritance in Pennsylvania:

• Divorce Protection: This is a big one. Pennsylvania is an equitable distribution state, meaning that in a divorce, marital assets are divided fairly (though not always equally). Inherited assets are generally considered separate property, BUT, commingling those assets with marital funds can make them subject to division in a divorce. The increased value of an inherited asset such as real estate that appreciates in value or funds in a bank account that accumulates interest during the course of the marriage is considered a marital asset. In other words, the increase in value may be subject to equitable distribution, even if the original inheritance is not. A trust avoids this by holding the assets separately, making it more difficult for a divorcing spouse to claim them. The trust, if drafted correctly, should be considered a separate entity entirely and not subject to division.

• Creditor Protection: Life happens. Financial difficulties, lawsuits, and unexpected debts can arise. A properly drafted trust protects the assets from your child's creditors. In a discretionary trust, the trustee has the power to decide when and how much to distribute to the beneficiary. Because the beneficiary has no legal right to demand distributions, creditors generally cannot reach the trust assets directly.

• Addressing Addiction Concerns: This is perhaps the most sensitive, but also one of the most important reasons to consider a trust. Addiction is a devastating disease, and providing direct access to a large sum of money can tragically exacerbate the problem. A trust allows you to appoint a trustee who can manage the assets responsibly, paying for treatment, housing, and other essential needs while limiting the beneficiary's access to cash that could fuel their addiction. You can even include provisions that require drug testing as a condition for receiving distributions.

Types of Trusts: Finding the Right Fit

There are several types of trusts that can be used for inheritance protection, each with its own advantages:

1. Testamentary Trust: This type of trust is created through your will and comes into existence after your death. It allows you to dictate the terms of the trust and how your assets will be managed for your children.  Testamentary trusts of certain limitations.  First, do not avoid the expense and delays associated with the probate process.  They cannot provide benefits to you, such as asset protection in the event you need nursing care.  Finally, they cannot receive gifts during your lifetime for tax planning purposes. 

   
   

2. Living Trust (Revocable or Irrevocable): This type of trust is created while you're alive. A revocable living trust allows you to maintain control over the assets during your lifetime and can be changed or revoked as needed. An irrevocable living trust offers stronger asset protection, especially in the event you need skilled nursing care.   It’s important to understand with an irrevocable trust that you give up some (but not all) control over the assets.

   
   

3. Special Needs Trust (SNT): If your child has a disability, a SNT allows them to receive inheritance without jeopardizing their eligibility for government benefits like Medicaid and Supplemental Security Income (SSI).

Key Considerations for Pennsylvania Trusts:

• Goals:  Before deciding that a trust is right for you, it’s important to think about what goals you’re trying to achieve with your estate planning. Do you want to avoid the costs and delays of probate? Minimize taxes and protect assets in the event you need nursing care in the future?  Maybe your goal is to protect loved ones from the storms of life, ensure that your assets are never paid to your children’s spouse or family or protect their eligibility for crucial government benefits? Whatever they are, your estate planning attorney can help guide this discussion to enable you to make informed decisions.

• Trustee Selection: Choosing the right trustee is crucial. This person (or institution) will be responsible for managing the trust assets and making distributions according to your instructions. Consider their financial acumen, trustworthiness, and understanding of your family dynamics.

• Clear Trust Language: The trust document must be clearly written and unambiguous, outlining your wishes and the trustee's responsibilities. Vague or poorly drafted language can lead to disputes and legal challenges.

• Pennsylvania Law: Ensure your trust complies with Pennsylvania's trust laws, including the Uniform Trust Code. A Pennsylvania estate planning attorney can guide you through the legal requirements.

• Spendthrift Clause: This clause prohibits the beneficiary from assigning or transferring their interest in the trust to creditors. Pennsylvania recognizes spendthrift clauses, providing an extra layer of protection.

• Consider a "Trust Protector": This individual, independent of the trustee and beneficiary, can be granted the power to modify the trust to adapt to changing circumstances and ensure the trust continues to meet the beneficiary's needs.

Don't Leave Your Legacy to Chance: Talk to a Pennsylvania Estate Planning Attorney

Protecting your children's inheritance requires careful planning and a thorough understanding of Pennsylvania law. Don't leave it to chance. Consult with one of Fiffik Law Group’s qualified Pennsylvania estate planning attorneys to discuss your specific circumstances and create a customized trust that will safeguard your family's future. We can help you navigate the complexities of trust law and ensure your wishes are honored.