No matter what happens to the estate tax in the future, estate planning will continue to be essential for most families. That’s because tax planning is only a small component of estate planning — and usually not even the most important one at that.  An equally important strategy is asset protection. And a spendthrift trust can be an invaluable tool for preserving wealth for heirs.  Let’s talk about how to use a spendthrift trust.

Spendthrift trusts aren’t just for spendthrifts

Now that the estate tax exemption has reached $5 million, fewer estates are subject to federal tax.  And even though as of this writing there’s some uncertainty over the future of the estate tax.  Unless Congress acts, the estate tax exemption will drop to $1 million in 2013. There are some who believe that Congress will not let that happen but will act and reduce the estate tax exemption back to the 2009 rate of $3.5 million.

No matter what happens to the estate tax, however, estate planning will continue to be essential for most families.  That’s because tax planning is only a small component of estate planning — and usually not even the most important one at that.  The primary goal of estate planning is to protect your family, and saving taxes is just one of many strategies you can use to provide for your family’s financial security.

Another equally important strategy is asset protection.  And a trust with a spendthrift clause can be an invaluable tool for preserving wealth for your heirs.

“Spendthrift” is a misnomer

Despite its name, the purpose of a spendthrift trust isn’t just to protect profligate heirs from themselves.  Although that’s one use for this trust type, even the most financially responsible heirs can be exposed to frivolous lawsuits, dishonest business partners or unscrupulous creditors.

A properly designed trust with a carefully drafted spendthrift clause can protect your family’s assets against such attacks.  It can also protect your loved ones in the event of relationship changes.  If one of your children divorces, your child’s spouse generally can’t claim a share of the trust property in the divorce settlement.

Also, if your child predeceases his or her spouse, the spouse generally is entitled by law to a significant portion of your child’s estate, particularly property you left the child outright.  In some cases, that may be a desirable outcome.  But in others, such as second marriages when there are children from a prior marriage, a spendthrift trust can prevent your child’s inheritance from ending up in the hands of his or her ex-spouse rather than in those of your grandchildren.

Safeguarding your wealth

A variety of trusts can be “spendthrift trusts”.  It’s just a matter of including a spendthrift clause, which restricts a beneficiary’s ability to assign or transfer his or her interest in the trust and restricts the rights of creditors to reach the trust assets.

Keep in mind that in most states you can’t create a spendthrift trust that provides for your own benefit, though a few states permit so-called “self-settled spendthrift trusts.”

It’s also important to recognize that the protection offered by a spendthrift trust isn’t absolute.  Depending on applicable law, it may be possible for government agencies to reach the trust assets — to satisfy a tax obligation, for example.  It is not uncommon for a court to reach assets in a spendthrift trust for purposes of satisfying a child support obligation.

Generally, the more discretion you give the trustee over distributions from the trust, the greater the protection against creditors’ claims.  If the trust requires the trustee to make distributions for a beneficiary’s support, for example, a court may rule that a creditor can reach the trust assets to satisfy support-related debts.  For increased protection, it’s preferable to give the trustee full discretion over whether and when to make distributions.

A worthy trust

Spendthrift language is a simple yet powerful way to build some creditor protection into a trust. But if your beneficiary is in a high-risk profession or is otherwise exposed to potentially devastating legal liabilities, consider more sophisticated options, such as domestic asset protection trusts or even offshore trusts.