You already know that trust funds can be a fantastic tool for building, protecting, and passing on wealth. Like all things in life, they have a downside and are not perfect. Here are some of the major disadvantages that came come from using trust funds, as well as some suggestions for how you might be able to avoid, or at least lesson, those shortfalls.
1. Trust Funds Have Unfavorable Tax Rates Compared to Other Ways of Holding Property
Congress routinely updates the tax brackets to adjust for the inflation rate. Unfortunately, for decades, it has held the tax rates of trust funds steady, serving as the economic equivalent of a massive tax hike on assets held in trust funds. Using the 2012 tax year as an example, trust income of over $11,650 per year is taxed at 35%. For most individual taxpayers, that same 35% tax bracket is not reached until $388,350 of income is earned.
Although it is more complex due to the rules governing trust funds, a married couple earning $500,000 would pay $144,140 in Federal taxes. That same $500,000 in income generated in a trust fund would owe $173,934 in Federal Taxes. That is $29,794 more. Of course, good accountants and investment managers can reduce the higher tax rate burden on trust funds through the type of assets they have the trust acquire, the amount of distributions made from the trust, and a host of other factors.
Then, there are monstrosities such as the generation skipping tax, which can apply to trust funds. As with the income tax, good, qualified advisors can help minimize the rates you pay.
2. Trust Funds Can Create Dependence and Harm the Beneficiary
Behavioral psychology tells us that most people need meaning in their life and that money alone cannot provide meaning once the basic necessities have been met. Imagine for a moment, two fictional men, David and John.
David has a net worth of $1,000,000. He lives well. The clothes on his back, the home in which he lives, the furniture he enjoys, the cars he drives, the vacations he takes, the food he puts on the table, the watches he wears, the fires in his fireplace, the new money added to his investments, the candy bars he picks up from the gas station, the concert tickets he purchases, and the donations he makes to charity, all come from funds generating by his success. The money is a by-product of his achievement and accomplishments.
John also has a net worth of $1,000,000. He lives well. However, everything comes from the trust fund his grandfather setup for him years ago. For John, the clothes on his back were provided by another man's labor. The home in which he lives was funded by another man's accomplishments. The furniture, cars, vacations, food, and watches he has are only there because of the provision set aside by the success of someone else. None of it reflects his contribution to society. He has done nothing.
The sense of depression and aimlessness that fill a significant portion of people in John's position has been given a name: Affluenza. Books have been written about how to escape the "golden ghetto" that comes from being born into a trust fund situation. When you know you will never have to work, it can cause you to avoid taking chances and going outside of your comfort zone. For most people, growth comes when we are forced outside of our comfort zones and made to do things we don't yet think we are ready to do. With the financial resources to avoid that pain, it can destroy self-worth.
How to you avoid this situation? One way is to only give money to children who have been successful on their own. A 35-year old son who grows up and is earning $300,000 per year running a chain of restaurants he founded is not going to be spoiled by a few hundred thousand, or even million, dollars. Yet, an 18-year old just leaving home probably would. Consider waiting to see how far the apple fell from the tree before making major gifts to your offspring. Some people can handle it, some can't.
Your job is to help your children develop into self-sufficient, happy, healthy adults. It is not necessarily to give them money. Sometimes it helps, sometimes it hurts. Wisdom is knowing which applies in a specific situation.
3. Assets Transferred to a Trust Are No Longer Yours
This is a double-edged sword. When you transfer assets to a trust fund, you can't treat those assets as if they belong to you, any longer. The reason is simple: They don't. You must, by law, work solely in the interest of the beneficiary. That is because you have a fiduciary duty. This is not to be taken lightly.
On the other hand, it is this very fact that makes trust funds an ideal mechanism for protecting assets from creditors. As long as you don't engage in a so-called fraudulent transfer, which means specifically moving money into a trust in anticipation of a potential adverse legal claim, in which case a judge might reverse the transaction, money gifted to a trust can often be beyond the reach of creditors. If you go bankrupt, lose everything, and find yourself destitute, but you spent decades building up legitimate trust funds for your children, they shouldn't be hurt. As a parent, you would have provided an inheritance for them despite losing everything yourself.
You could take advantage of this. If you have a parent that plans on leaving you money, ask that the cash be put into a trust fund that you can't access with specific annual dividend distributions. That way, you can live off of the dividends, interest, and rents, but your creditors should not be able to touch the principal since, technically, it doesn't belong to you.
For more information, read What Is a Trust Fund?, an article that will explain some of the most important terms you need to know.