Income – In or Out?

Did you ever wonder why the trusts in your estate plan for your children mandate a distribution of income when your children reach a certain age, such as 18 or 21? Most lawyers do not discuss this provision with their clients, although this planning can have significant consequences for your family.

The idea of distributing the income from a trust is rather old fashioned, but has been included for many years for several reasons. Assets in Florida cannot vest in a minor, so starting mandatory distributions or income or principal of a trust before your child reaches age 18 would require those distributions to be held in a guardianship. Until age 18, your child’s guardian could use those distributions for your child’s benefit after obtaining Court approval. Once your child attains the age of majority, he or she can use the guardianship funds for any purpose without any restrictions.

Distributions of income are usually mandated in trusts because it is generally viewed as by lawyers and accountants as “tax efficient.” At your death, irrevocable trusts created for your children become separate taxpayers. As a result, it is generally necessary for a tax return to be filed for those trusts in any year in which they have income. Generally, if income remains with the trust (e.g., income is not distributed during any year), the trust pays tax on that income. The top income tax bracket for irrevocable trusts retaining income kicks in at $12,500. This top tax bracket is 37%!

If a beneficiary of an irrevocable trust receives the trust income, in many cases the trust is not responsible for the income tax. Instead, the beneficiary pays the tax, presumably at a lower tax rate. Accordingly, it is very common for an irrevocable trust to distributed income to a child when he or she reaches the ages of 18 or 21, with the thought that a child would not likely be in the top tax bracket of 37% at such a young age.

A better reason to distribute income to a child may be that it serves as a “trial run” for larger distributions at later ages. In other words, distributions of relatively small amounts from the trust can be made at a younger age so that a child will have an opportunity to learn and grow prior to the receipt of mandatory distributions of principal, which typically occur at a much later age, such as 40 years old.

Naturally, a child in his or her early twenties is not likely to have much financial savvy, so distributions of income can allow that child to make mistakes, without losing all of the assets of the trust that you worked so hard to save for his or her benefit.

The next time you review your trust agreement, look at the provisions for your children and find out if the trust requires a payment of income at some age, such as 21. Depending upon your family’s unique situation, that age may be too young for a child to receive income, especially if your trust assets are significant. In that event, adjusting the age for distribution to a later age, such as 30, or having no mandatory distributions may be more beneficial. Perhaps, it may be worthwhile to give your children’s trustee discretion on making distributions of income and principal to your children.

Communication in your Estate Planning

Having working with a few clients over the years, I have learned that a lot of the problems that come up after a loved one dies are usually centered around communication. There’s miscommunication or no communication at all.

For example, mom names one child as her personal representative (executor) in the Will, and then mom dies. The child who is designated may not share information (even if he legally has to do so) with his siblings. You can guess what comes next: siblings are left in the dark, and then they start to question: is our brother stealing from us? Abusing power?

It seems to me that we can overcome these obvious problems with communication. Yes, I know that we are talking about death, and I know that no one wants to linger on that subject on their own and certainly not with their families.

However, I have seen many of my clients, specifically older clients with adult children, share their documents and wishes with their children in advance. They even invite them to meetings. Some will solicit suggestions on which child would be good in different roles (e.g., medical surrogate vs. financial agents). These types of discussions can be very healthy, especially in the event someone becomes incapacitated. If family has some information in advance, they will be better equipped to help an aging parent or jump in if there’s an emergency.

Of course, I recognize that you may not want to tell your children everything, such as how much money you have, but wouldn’t be nice if your children got along after your death? Maybe a simple conversation would help.

How does divorce affect your estate plan?

Occasionally, we meet with clients who ask how divorce would affect their estate plan.

Here’s the short version:

  1.  Wills and Trusts: Upon the entry of a final judgment of dissolution, an ex-spouse is treated as he or she predeceased the testator, thereby removing him or her as a beneficiary of an estate/trust. Ex-spouses can elect to maintain provisions for each other, although that is not common.
  2. Beneficiary designations on life insurance policies, annuities, IRAs, 401ks and other employee benefit plans: Same result as the Statutes for Wills. Ex-spouses are not entitled to these assets when a divorce if finalized. One practical difference – insurance companies and retirement plan custodians do not always know that their insured/client was divorced. As a result, they might allow an ex-spouse to collect this type of asset. If that happens, secondary beneficiaries will need to sue a testator’s ex-spouse for a recovery.
  3. Powers of Attorney and Medical Directives: Upon the filing of a divorce, provisions in favor of a spouse are nullified. Notice that these documents are affected when a divorce is initiated not upon completion.

While these law changes are helpful, they are really just a band-aid, of sorts, for those who may not get around to updating their estate planning upon divorce.  In reality, when you experience a significant life event, such as a divorce, a complete review of your estate plan, including beneficiary designations and asset titling, remains important and necessary.