Using Trust Funds To Incentivize Your Children

Over 86% of millionaires in the United States are self-made. Of those self-made millionaires, almost 90% came from households that earned between $45,000 and $125,000 per year. Essentially, it is the current middle class that acts as the origin of America’s future millionaire households.

This is understandable. If you are born into extreme poverty, the cultural obstacles that you must overcome are so significant that it can be difficult to acquire the skill of being a provider and an investor within a single lifetime. And when you are born into households that earn hundreds of thousands or more per year, it can be difficult to light the spark of self-sufficiency because there is no need for you to provide for yourself in order to get the things you want.

This often creates a problem for the estate planning of the wealthy: How do you leave behind your assets in a way that conveys the love and affection you have for your children while also satisfying the interest to see them produce things doing their lives? If you are too miserly with doling out your money, your kids will resent you because they will witness you bestowing funds upon individuals and institutions that you presumably love less than them. But if you give them too much, you can trigger learned helplessness and the often scoffed-at affluenza.

How should wealthy individuals balance the desire to provide security without encouraging idleness?

My view is that a revocable living trust or an irrevocable trust that provides a baseline level of support plus incentives tied to earned income is the way to achieve both ends.

If a trust fund provides $2,000 per month automatically regardless of whether your son or daughter is a bum, there’s no real harm done from your largesse. You’re just guaranteeing them food and shelter for life. That doesn’t destroy the incentive to work, and also recognizes that no matter how disappointed you may be by the personal life decisions of your kids, you will always want them to have a place to live and food to eat.

From there, you attach incentives in the trust instrument that offer greater rewards based on their earned income. If they got a job paying out $60,000 per year, maybe you will include a $0.50 on the dollar match that will result in a $30,000 Christmastime distribution. Maybe, if your estate is vast enough, you will provide a full dollar for dollar match that enables them to receive $60,000 per year from the trust if that is what they earn in the labor markets. They more they produce, the more they receive from you.

It is also permits them to choose socially useful occupations and enjoy a lifestyle greater than they would otherwise receive. If your son wanted to be a teacher, he can make $45,000 there and receive $45,000 from the trust each year so that he effectively has full middle-class spending power of $90,000 per year. Your son would be doing something useful with his life, but he’d also be able to get a little something for himself that is a bit nicer than what the occupation salary would strictly permit.

To ensure the viability of the trust, such an arrangement usually includes some kind of cap on the maximum payout from the trust fund. Maybe it will pay $0.50 on the dollar until it makes a $60,000 annual distribution and that will be it for the year. Otherwise set the cap at the amount of income generated from the trust. Others set the cap at the amount of income generated by the trust or up to 3% of the trust principal, whichever is higher.

It also helps if you provide clear communication to the child throughout your life about what to expect. If they do not learn about these types of provisions until your death, they won’t receive the opportunity to plan their life in a way that most effectively responds to the incentives that you create while making tradeoff decisions that they personally find acceptable.

If you promise a $2,000 per month income stream to them, it’s not something that will cause them to lose their minds and get reckless. It will be understood that only the very basics are provided for. From there, you are providing clear instructions that you are using the family assets to open financial doors for them, but it will be up to them to walk through it.

Also, it is important to include a clause that makes an allowance for medical emergencies. State court case laws are filled with horror stories about these types of incentive structures leading to unintended consequences when a child becomes disabled and unable to earn an income. A competent trust attorney ought to have a conversation with you about a disability provision if you intend to create an incentive-laden trust fund.

And lastly, there is a question of child resentment. Most siblings don’t earn identical incomes. With the lower earner come to resent you and his other siblings for receiving less from the estate? My view is that this can be cured through my clear communication recommendation outlined above. If all children know from an early age that they will receive what they earn, they are on equal footing. There is nothing stopping them from earning more. Any sense of unfairness would arise if you kept your mouth shut and the estate provisions get revealed after your death to trigger a response of “If I had known about this, I would have chosen career X instead.” But if you clearly establish the ground rules before any career paths are chosen, you are providing a fair lesson on cause-and-effect as you provide for your kids.

Some people find these types of trust funds too controlling, and therefore, less appealing than outright distributions to family with no strings attached. I share that view regarding trust funds that incentivize marriage timing and selection, numerosity of grandchildren, and other provisions that enable the trust-fund creator to live vicariously through their kids. But income-based incentives are so unrestrictive of occupation and lifestyle that they don’t limit the autonomy and free will of the child. Instead, it merely provides a way to turbo-charge the decisions that your kid makes anyway and actually gives them more freedom to know they can pursue careers they love and enjoy better lifestyles than can be supported by those occupations. It also provides added legal protection than an outright distribution, as trust funds can escape the reach of your child’s future creditors and ex-spouses.

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