Avoiding Restrictions With a Discretionary Trust

When it comes to defining the terms of a trust, people are often led by their worst fears.

"The most common refrain I hear from clients is they don't want their money blown on frivolous things," says David Sessions, a wealth strategist at Schwab based in Phoenix. "A close second is they don't want their assets going to a divorcing spouse; they want it preserved for their kids and grandkids."

These types of concerns frequently lead trust creators, or grantors, to include highly prescriptive distribution rules that the administrator of the trust, or trustee, is obliged to follow—often with unintended consequences.

On the one hand, terms that are too vague can leave room for interpretation—and sow the seeds of future disagreements between beneficiaries and trustees. On the other, overly restrictive language can tie trustees' hands, particularly as beneficiaries' circumstances change.

So, when does a rule become an inadvertent roadblock?

Consider a grantor whose trust requires the distribution of no more than $2,000 a month to her adult daughter. Should an emergency arise—for example, the daughter's car gets totaled—the trustee may be unable to advance more money for a new vehicle.

So-called termination provisions can be similarly thorny. Let's say a grantor stipulates that their grandchild will receive the assets in their trust only upon graduation from an accredited four-year college or university—the implication being that their education has prepared them for the responsibilities that accompany such a windfall.

Aside from financial readiness, which no college education can guarantee, what if the grandchild is offered a one-time opportunity that doesn't require a degree and may be gone by the time they graduate? "You could end up holding them back in their career because they think, Well, I have to do this to get my inheritance," says Austin Jarvis, director of estate, trust, and high-net-worth tax at the Schwab Center for Financial Research.

Similarly, substance abuse provisions can exclude beneficiaries based solely on an alcohol or drug dependency. "Today, substance use disorders are widely considered to be a disease," David says, "and excluding an addict from the estate could actually stand in the way of their successful treatment and recovery."

"People change, and just because someone has a problem today doesn't mean the trust should deny them funds forever," Austin adds. "You don't want to write a rule book that may not apply five years down the line."

Rather than locking beneficiaries into rigid rules, David and Austin prefer using a discretionary trust, which gives the trustee the ability to respond to beneficiaries' changing needs and circumstances. This type of trust cannot be changed once established and may require more oversight, which, consequently, can incur higher administrative costs. "As Austin points out, we have no idea what the future will bring, so this approach allows the trustee the flexibility to deal with the inevitable unknowns," David says.

Of course, this means granting the trustee sole authority over distribution—a level of control that places enormous importance on the selection of the right trustee. Ideally, you'll want to choose a trustee who is emotionally equipped to bear the responsibilities and follow through with your intentions (see "Incentives and protections").

"Your trustee doesn't need a degree in finance to be effective," David says. "Rather, choose someone whose judgment you trust implicitly. That person can always hire professionals to help with investment decisions, taxes, and the like."

Indeed, Austin often suggests pairing a personal trustee who understands your family's dynamics with a professional co-trustee who can handle the trust's administration and investments.

Even if you establish a discretionary trust, you can still add provisions that encourage positive outcomes or protect assets. "It's understandable you'd want to encourage education or a healthy lifestyle," David says, "but it can be more productive to do so through positive reinforcement rather than punitive restrictions."

Incentive-based clauses, for example, can offer extra distributions to beneficiaries for milestones like completing education, starting a business, or achieving financial independence—so long as you're not too restrictive with your definitions.

"Here, too, it's important to leave room for your trustee's discretion," Austin says. "Your idea of a business might be a brick-and-mortar shop or a tech startup, while your heir might want to pursue a career as a freelance artist. If their efforts lead to a fulfilling career, isn't that what truly matters?"

Adding spendthrift provisions, on the other hand, may help protect trust assets from creditors or divorce settlements, depending on which state laws govern the trust. Similarly, adding what's called the HEMS standard—which stands for health, education, maintenance, and support—can protect assets by limiting their distribution to those particular purposes. Paired with a discretionary trust, a HEMS provision allows you to set some safeguards on how the assets are spent, which can help prevent the depletion of the trust's assets through wasteful distributions.

"With the right trustee in place, a trust with open terms often leads to the best outcomes," David says, "especially when supplemented with a precatory letter from the grantor that provides background information and goals for the assets. While not legally binding, it can help guide the trustee's future decisions."

Tensions often arise when an overly restrictive trust meets a beneficiary who bristles. "That's when heirs are most likely to hire lawyers, thinking, It's my money and I should be able to access it!" Austin says.

Of course, there are legal guardrails and limits, but even irrevocable trusts can be altered. "A lot of clients are surprised to hear their wishes can be challenged under certain circumstances, which highlights the need to really think through what you want to happen both now and after you're gone," David says.

That's why communication is key. "Have conversations with your heirs and advisors, explain your intentions for the trust, and be open to feedback," David adds. "The more buy-in you can get up front, the fewer surprises there may be later, and the better off your heirs will be—which is ultimately the purpose of most estate plans."