Ensuring a Trust’s Funds Are Not Prematurely Exhausted

When a person sets up a trust to provide family members after he or she dies, many factors must be considered.  The most fundamental consideration is the purpose of the trust, because the purpose drives the drafting of the trust instrument.  Once that is established, the person setting up the trust (called the “grantor” or “settlor”) must take care that the trust does not run out of funds before its purposes are accomplished.  The best-drafted trust instrument is of no use if the trust has no assets.

To ensure that the trust is not prematurely exhausted, the trust must first be protected from non-beneficiaries, namely, the government and creditors.  Addressing taxes- especially federal gift and estate taxes- is essential.  Careful planning can greatly reduce tax burdens, especially if the settlor plans the trust well before his or her death.  Regarding creditors, Texas (and many other states) allows settlors to create trusts for beneficiaries that are generally exempt from the claims of the beneficiaries’ creditors.

Once the threat of non-beneficiaries has been addressed, the settlor must plan how distributions will be made to the beneficiaries.  While preserving the trust’s funds is important, it must be balanced with the desire for the funds to keep pace with inflation, and ideally, grow.  For example, a settlor who wanted to avoid any investment losses might consider investing trust funds in U.S. government bonds (widely considered to be of pristine credit quality).  However, some of these bonds currently pay an interest rate so low that it is projected to be negative after taking into account inflation.  A settlor interested in growing the trust’s assets would be interested in other investments, but generally, higher-returning investments have greater risk associated with them.  A settlor can manage this dilemma by providing that the fund’s investments will be diversified among various asset classes, such as stocks and bonds.

To prepare for years in which markets do poorly, the settlor might wish to limit the percentage of the trust’s principal (in addition to the income it earns) that may be distributed in a given year.  For example, the settlor could provide that only 3 percent of trust principal could be distributed in a given year.  That should be conservative enough to ensure that the trust lasts for years.  In contrast, a trust instrument that permits 10 percent of principal to be distributed each year could be exhausted relatively quickly if the stock market went through a prolonged downturn.  Along the same lines, the settlor could set strict standards for distributions to the beneficiaries, such as only for their health and education.  Distributions made for more nebulous standards, such as the “comfort’ of a beneficiary, can lead to overly-generous distributions to beneficiaries that exhaust the trust sooner than planned.  This is especially a concern where the beneficiaries are young and may not be disciplined enough to handle large amounts of money.

Finally, it is crucial for the settlor to select a trustee (and a backup trustee) with sound judgment and to provide that trustee with broad discretion.  Over the course of a trust’s term- which can easily last for 50 years- unanticipated circumstances are virtually certain to come up at some point.  When they do, a wise and dependable trustee can adjust to those circumstances in a way that best serves the settlor’s intent and the beneficiaries’ interest.

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