Attach Strings to Your Bequests

EDITOR'S NOTE: This article was originally published in the June 2008 issue of Kiplinger's Retirement Report. To subscribe, click here.Chances are, you want to leave an inheritance for your children and grandchildren. But maybe you also want to impart your values along with your hard-earned money. If you do, you can create an incentive trust, which rewards a beneficiary for achieving particular goals while perhaps penalizing an heir who doesn't measure up.

Such trusts can encourage the younger generation to develop a strong work ethic or to spend wisely, experts say. Often the benefactor is an entrepreneur who took risks to succeed, says Renee Brown, principal at Wildwood Wealth Management, in Minneapolis. If there's a lot of money in a trust, the grantor may worry that the heirs will have little motivation to be productive. "They want to make sure their children and grandchildren know there are certain values they want to pass along with their legacy, such as education and hard work," Brown says.

But experts say that some parents and grandparents want to exert too much control from the grave. Such carrot-and-stick trusts, especially if the terms are too stringent or unrealistic, can also create family resentment, against you or other family members.

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Estate-planning lawyers and financial planners say that trusts should take into account possible differences in heirs' interests and abilities. For instance, some incentive trusts will pay for a grandchild's college education if the kid maintains a certain grade-point average. But some take this too far by paying more for an A than a C. "Kids have different abilities," says Brown, who discourages tying payouts to specific grades. "And a C at Harvard isn't the same as a C at a community college."

Some trusts provide a dollar-for-dollar match for an heir's salary. But this approach could create resentment among siblings and cousins who choose less-lucrative lines of work. Instead, you could reward heirs who choose professions with high moral value, such as social worker or firefighter.

The trust might pay $5 for every $1 in salary earned by heirs who work in these types of jobs. So someone making $40,000 a year in a social-service job would get $200,000 from the trust. "The purpose is to allow the children to all live in the same neighborhood," says James McNair, an estate-planning lawyer with Patton Boggs, in McLean, Va. "The kids who work for charities can live on the same streets as their doctor and lawyer siblings." Other trusts may encourage the work ethic by providing a down payment on a home if the heir has been employed for a certain number of years.

Paul Fitzpatrick, an estate-planning lawyer with K&L Gates in Spokane, Wash., says many grandparents don't want to punish grandchildren who leave work to raise children. "If you're home raising a family, we're not going to deny you the trust payments," he says. The payout could match the household income, rather than the individual's salary. For example, if a daughter stops working, and her husband makes $200,000, the couple would receive a payout based on his salary.

Grandparents may worry about an heir with a substance abuse problem. The trust could pay for counseling and rehabilitation, and perhaps a house and education once the kid stays clean for a while.

Setting Up the Trust

An estate-planning lawyer will set up the trust, which can be changed or dropped at any time while you're alive. An incentive trust works best for estates with upward of $5 million when you consider that it's divided among multiple heirs and typically pays 4% or 5% annually.

Once the senior generation dies, a board of trustees oversees the payouts. The board may include a corporate trustee, family friends and two beneficiaries. A majority vote is typically required for decisions about payouts. "You want beneficiaries to have a voice, but not a controlling voice, because they will inevitably want to increase the amount of money paid out of the trust to them," McNair says.

It's also up to the board to enforce incentives. If the incentive trust calls for a salary match, beneficiaries must provide an income-tax return, for example. For a trust that rewards a grandchild for kicking a drug habit, he or she may have to show the results of a drug test.

It's important to build in some wiggle room for the trustees, because situations may arise that you can't predict. "Leave enough flexibility so you're not ruling from the grave," says Fitzpatrick.

McNair recalls one trust where the grandparents provided matching dollars for work after college. But after they died, a granddaughter who had completed graduate school wanted to take an unpaid internship at a magazine. The board decided to provide her with money for living expenses.

One of Fitzpatrick's clients is a Native American businessman who takes children from the reservation on wilderness treks. His trust is set up to reward his own children for their involvement with the Native American community. A three-person board will oversee the payouts, but the man does not want the trustees to hold back money if his kids don't carry out his wishes. If the children can't prove how involved they are, Fitzpatrick says, the trustees should "err on the side of giving the money to them anyway."

If you don't like the idea of an incentive trust, a common alternative is a trust that increases payouts as an heir gets older. This assumes someone will be more responsible at 30 than at 20.

Jon Gallo, who heads the Family Wealth Group at Greenberg Glusker, a law firm in Los Angeles, has stopped drawing up incentive trusts. People should be motivated internally, not by external forces put in place by parents or grandparents, says Gallo, who conducts workshops on finances and family along with his wife, Eileen, a psychotherapist.

Gallo steers clients toward mission statements, which emphasize values rather than behaviors. For example, a mission statement may encourage heirs to use the money to start a business or to give to charity, but those activities are not required. "I tell them to think about what values they want their kids and grandkids to have -- typically work ethic and responsible management of money," Gallo says. "These are not the ten commandments."

If you opt for an incentive trust, consider including a statement of purpose, which describes your values and the reasons for the incentives. And it's critical that you meet with trustees and heirs to discuss the trust's provisions.

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