Liza Horvath, Senior Advocate: Protecting inherited assets from divorce

Question: I have three children and all are married. I have been fortunate to invest wisely and after many years have a pretty good nest egg. My first wife and I had an A/B Trust; she passed away some years ago and I created an Exempt Trust per our trust. I remarried a few years ago and signed a prenup agreement with my new wife. My children are the sole beneficiaries of my assets. When I pass, they will inherit various assets of mine along with the Exempt Trust.

I hope that my children’s marriages will last a long time but there are no guarantees. Would I be wise to set up my estate so that upon my death a Trust is set up for each child and their individual share of the estate would go into their Trust? My other option would be to leave a letter to each one “suggesting” that they set up a new account with their inheritance and don’t co-mingle the inheritance with their own marital assets. However, that might make it very awkward in dealing with their own spouses and create issues. What are the pro’s and con’s from your years of experience in dealing with these kind of situations? Do you have other suggestions?

Answer: This is a bit tricky and it seems that no matter how you slice it, it could cause some marital strife. California is a community property state but inherited assets, such as the ones you are describing, are considered the separate property of the inheritor right up until the time they are comingled with marital assets. If your children were to receive their inheritance outright and place the funds into accounts titled solely in their names, the assets would continue to be separate property. They could layer on a postnuptial agreement and that would certainly lock in the separate nature of the funds.

But let’s look at this practically: Say your son received a large amount from your estate and placed it in a separately titled account and did get his spouse to sign a post nuptial relative to the funds. I would submit that most spouses would view both actions as a lack of commitment to the marriage and could be the seed for resentment. Also, I have witnessed, firsthand, that prenuptial and postnuptial agreements rarely hold up in a long-term marriage. The spouse of an inheritor, over time, pulls more and more out of separate property holdings and over to their side of the ledger. It just happens and the inheritor is under a great deal of pressure to release funds. It can set up an ongoing flashpoint in the marriage.

Further, younger spouses and those in a first marriage generally build their “estates” together over their marriage and both fully commit to saving, earning and investing together. It is a healthy way to fully invest in a marriage, right? But realistically we know that many times marriages don’t work out and, when a divorce occurs, marital assets that are commingled are usually split between the ex-spouses regardless of the origin of the assets.

The best way to set up your children’s inheritances and avoid creating friction in the marriage is to leave the assets to your children in a separate trust. Attorneys may refer to these trusts as “divorce protection trusts.” Your trust would direct your trustee to set up separate trusts in each of your children’s names and their shares of your estate would flow into those trusts. The trusts can allow your kids to withdraw assets freely and could even name each child as their own trustee. This places a bit more of a wall between your child’s assets and those of the marriage. If you wanted to be extremely careful, you could name a third party as trustee of these separate property trusts and give that trustee the discretion to release funds under certain conditions such as for the child’s health, support and education. In this scenario, if the spouse wants funds, your child has to ask the trustee and the “bad guy” trustee can say no. Yes, setting trusts up for your child with a third-party trustee will mean annual trustee fees so you will want to weigh out the costs, but it would give you the most protection against divorce or the commingling of inherited assets.

Liza Horvath has more than 30 years of experience in the estate planning and trust fields and is the president of Monterey Trust Management, a financial and trust management company. This is not intended to be legal or tax advice. Questions? Email liza@montereytrust.com or call (831)646-5262