How can you protect your child’s inheritance? One really powerful tool is using a dynasty trust. In this article, I’m going to explain all about dynasty trusts:
- Why they’re not just for the super-wealthy anymore
- How they protect your children’s inheritance
- Best dynasty trust strategies to get the most out of Dynasty Trust California
What Is a Dynasty Trust?
A dynasty trust is a type of irrevocable trust that can reduce the taxes paid on that money transferred from one generation to the next (your children, then grandchildren). It can also protect your child’s inheritance in the event of divorce, lawsuits, and other disputes. It’s most commonly set up by a parent (known as the settlor or grantor) to benefit their child (the beneficiary) and can be managed by the child or a third party.
A dynasty trust is also called a lifetime trust or asset protection trust.
Why Is it Called a Dynasty Trust?
Dynasty trusts are really interesting trusts. They were actually created for the rich and famous. But I think they can be used for just about anyone.
The original purpose was to avoid the generation-skipping transfer tax (GST).
So what does that mean? You know, people are smart. Years ago, they figured out that “every generation I’m going to be subject to estate tax, and I don’t like that.” So they asked themselves, “What if I could skip over a generation and skip paying the tax?”
So grandma gives her money to her grandchild and skips mom. Less tax.
Well, that sounds like a good deal, right? But then the IRS figured out what was going on. And they said, “Oh, no, no, no, we don’t want people to skip a generation in taxes”. And so they imposed this new tax called a GST tax or generation-skipping transfer tax to reclaim this lost tax.
The dynasty trust is meant to provide GST tax protections. The idea is that money goes into the dynasty trust, which benefits the beneficiary, your child, and your grandchildren.
As a trust, it doesn’t count as your child’s own money. So it goes to the grandkids free of estate taxes. It’s really cool!
Who Needs a Dynasty Trust?
Anyone with a taxable estate should definitely consider a dynasty trust to protect their child’s inheritance. Plus, you may want one for other non-tax reasons. I’ll explain.
First, how do you know if you have a taxable estate?
Right now, it’s 2022. The estate tax exemption is $12.06 million per person, but drops to about $6 million in 2026. So that means unless you have over that amount, you’re not subject to estate taxes.
So you might say, “Ellen, I don’t need a dynasty trust. Why are you even talking to me about this?”
We’re going here today because there are two other amazing protections you get with dynasty trusts, and I think these will catch your attention.
So the first amazing protection is that it protects your children in case they ever endure a divorce.
Divorce Settlement Protection
So remember when I said all the money that goes into the dynasty trust is not considered your child’s money? It’s basically an asset protection trust. The trust is drafted to say that the money is to be used for just about everything that the child needs. But it’s outside the child’s estate. And it’s segregated as their separate property.
So if your child ever gets married and then endures a divorce, anything held in the dynasty trust stays with your child. It does not go off to that horrible ex-spouse.
But at the same time, the money in the dynasty trust can really be used for anything your child wants. It can be used to buy a house that the whole family enjoys. It’s just that the dynasty trust will buy the place that the family enjoys, not your child. Legally speaking, it’s not your child’s (or grandchild’s) money — even though they can use it for just about anything they need. I told you trusts are cool!
Now, if the couple gets divorced — and there’s a high divorce rate in the US for sure — then your child gets the entire house back because the trust owns it.
This is a very interesting and compelling protection that many of my clients really like.
Debt Collection Protection
The other really important protection that a dynasty trust provides is creditors’ protection.
So let’s say that your child has some money in a dynasty trust and then somebody sues them. Well, as long as the child is not acting as trustee, they can say hey, that’s not my money.
That’s money in the trust, and then that money is not subject to the creditor’s claim.
Legal Judgment Protection
So let’s say your child is in a litigious career or profession like a doctor, accountant, lawyer, financial advisor, realtor, or business executive; the likelihood of a lawsuit is high. One judgment could wipe out a sizable inheritance.
A dynasty trust protects the inheritance in these cases — even if somebody hits their car and blames it on your child, that money is still protected again –, as long as the child is not the trustee.
How Does a Dynasty Trust Work?
Now, in California, it’s very difficult to set up an asset protection trust for yourself. But you can set one up for your child, your grandchild, or other people who you would want to inherit your assets. And setting up dynasty trusts and accessing its assets is easier than you might think.
You might be thinking “a dynasty trust that sounds really restrictive for my adult child. I want them to make their own decisions about the money”.
I work with a lot of families who have a child with special needs, but that may not be the case for you.
Now, I want to note here that when I say “child” in this section, I’m not speaking about a minor child. Your child will always be your child no matter how old they get.
Your child can act as trustee of his or her own dynasty trust, so the child can make their own decisions about management and everything. It’s important to explain to them the protections they’re getting so that they continue to manage the trust properly.
Now, we did discuss that if they are the trustee, they can blow the protections listed above, so putting a little distance between themselves and the money can be smart if they’re not the best at money management.
You decide your child is not up to being the trustee because maybe they are extravagant spenders. And they may grow out of that. But you don’t want that money gone before they do. They could withdraw everything and say, “I don’t like that trust anymore”.
If you have this concern, you can name a bank as co-trustee or even sole trustee.
If you make a bank the co-trustee with your child, neither the bank nor your child can act independently. They have to agree, and the bank is obligated to work in the best interest of the beneficiary (usually your child), which becomes a safeguard. You can also make the bank sole trustee, and they have total management power.
Dynasty Trust Pros and Cons
The pros are clear:
- Avoid inheritance taxes to pass down more wealth
- Above mentioned legal protections
- A bank can manage the trust if your child can’t or doesn’t want to
But what about the cons? What are the drawbacks to a dynasty trust?
Well, I think the main drawback — and it’s really a small one — is that you have to upkeep the trust.
Dynasty Trust’s cons include having to:
- Set up a separate tax ID number for the trust
- File separate fiduciary tax returns every year. This is what actually tells the IRS that it’s not your money. The money is actually owned by a trust. And so, the IRS doesn’t get to tax that money.
You can leave that up to your child to let them know these are the powerful protections, and if at some point they decide not to utilize them, then that’s up to them as well.
How Long Does a Dynasty Trust in California Last?
In California, we follow the federal rules, which say that we don’t want money stuck in a trust forever for public policy reasons. We call this the “rule against perpetuities”. Some believe that it’s not socially responsible to have a trust last forever.
So they let it last from the birth of the youngest beneficiary of the trust to the end of their lifetime, plus 21 years.
If the trust can last a young living beneficiary’s life expectancy plus 21 years, the trust might last 90 or 100 years total.
So that means that really the trust can last for about three generations, and then it needs to distribute out.
You can set up dynasty trusts in other states, like Nevada, Delaware, or South Dakota, and they have longer perpetuity savings times. However, usually, you need to set up the trust in that state with a trustee located there, and that limits your ability to manage the trust assets yourself.
You know, dynasty trusts are also called many different things. They’re called lifetime trust. I actually like the term “lifetime trust” better because when I think of dynasty trust, I think of that show Dynasty, from the 1980s. And all the bling and fancy stuff. My clients usually aren’t into all that fancy stuff. They’re into protecting their kids. And so I think of a lifetime trust as protecting your child.
Whatever you want to call it, the important thing for you is to understand the concept and see if this might be the right planning tool for your child. Maybe it is, or maybe you need to explore other estate planning options.
If you have some estate planning questions, I have a full-length webinar where I go into the details of everything you need to know about estate planning.
Watch the estate planning webinar now.