What is the basic purpose of inheritance? Most parents will respond that the purpose of an inheritance is to help the child "become a better person." Let's listen into a discussion between an advisor and John and Mary Parent as they discuss an inheritance plan for their three children.

Advisor: John and Mary, how do you feel about the way your children are progressing in life?

John: Well, all three children are doing fine. They have all finished their education and are working. We know that they will be making a good contribution to society in some manner.

Mary: Yes, they are all working. We've tried to teach them good principles and that they should be honest and caring persons.

Advisor: Do both of you think that it is good for them to have jobs and to eventually buy a house and acquire some savings?

John: Yes, they should have jobs and they should be responsible citizens.

Advisor: But with an inheritance you have the opportunity to give them additional security.

Mary: Yes, we think that is important. We recognize that we have been fortunate over the years to have acquired substantial resources, and we do want to help them.

Advisor: Have you thought about the difference between giving principal or giving income? I find that many people in your situation have been careful and built up their estate. They have substantial resources. And frequently they leave a substantial inheritance outright to the children. Have you seen examples of parents who have done that?

John: We certainly have. An uncle of mine passed away and left the estate to two children. One of them did fine. But the other spent his entire inheritance in 18 months.

When he was asked what happened to the inheritance he replied, "Well, I spent most of it on boats, cars and vacations -- and I wasted the rest!"

Advisor: You know, that story is all too often the case. When children in their late 20's, 30's and 40's receive substantial principal amounts, there are some who are responsible and save and invest for the future. Usually, that is what their parents desire. However, there are also what I call the "creative" children. "Creative" children will find new and interesting ways to spend their inheritance in a very short period of time. They look at the boats, cars and vacations as appropriate expenditures, but frequently can't even tell you where the balance went.

John: So, what is the solution? Is there a better way?

Advisor: I have watched this process with many families. The longer I observe the result of inheritance planning, the more I am convinced that a trust paying approximately 5% per year is the best plan for most families.

Mary: Why do you suggest a trust that pays 5%?

Advisor: Great question, Mary. If you were to visit with ten certified financial planners (CFPs) about retirement, they would share two principles. First, they encourage all of their clients to save, invest and to build up funds, especially IRAs and other tax-favored retirement funds. Second, they would have a fairly typical target payout for those retirement funds. Because there are times where the markets go down, such as the years 2001-2002, it is important to set up a payout rate from a retirement fund that makes it very likely the retirement fund will last. Most financial advisors suggest a withdrawal rate of approximately 4% to 5% in order to protect the fund.

John: You mean that with a withdrawal rate of 4% to 5%, even if the markets are going up or down the fund is likely to earn enough over time to maintain and hopefully increase in value?

Advisor: Exactly. With that payout rate, the fund should increase. With a 5% payout, a trust that is invested in a typical portfolio of stocks and bonds may earn 7% to 8%. This average return rate will usually permit a 5% payout with 2% or 3% growth to offset future inflation.

Mary: Does this 5% trust have a name?

Advisor: Yes, it is actually called a 5% charitable remainder unitrust. It can be created either for a term of years up to 20 years or it could last for the life of a child. There are two other important advantages of the unitrust. First, appreciated assets given to the trust may be sold tax-free. Second, the growth of the trust is also tax-free. A unitrust is very useful because of these income tax benefits. Finally, after the end of the payouts for 20 years or a life, the remainder in the trust will be given to your favorite charities.

John: If we were to set up one of those trusts, how much would we transfer to the trust?

Advisor: Let me offer a suggestion that has been helpful to some of my clients. You might think about it this way: If a person had one million dollars in a trust and it paid out 5%, that trust would pay $50,000 per year to the child. This $50,000 is in addition to their regular income from salary or from their retirement fund. You might use this 5% suggestion to estimate the amount of added security that you want to provide each child.

Mary: Well, we do want to provide some additional security, and that income would be pretty substantial. It's helpful to think about a certain amount of additional income per year. For our children, they probably would be able to increase their standard of living.

John: You know, they already drive a better car than we do. We need to think about how much additional income would be useful. We do want them to have some added resources for a future rainy day.

Advisor: This decision is up to you but I think it is useful for you to think about it in terms of a certain amount for the trust and how much income 5% of that trust will provide. Then, you should consider whether or not to set up a trust for a term of 20 years or for a lifetime.

John: I think that about $600,000 per child for the term of 20 years would be a good inheritance. That would be $30,000 of income each year for 20 years or an inheritance of $600,000 per child. For our three children, that means placing $1.8 million in this 5% unitrust.

Mary: Well, as I think about it, I am more inclined to think it would be best to have about $50,000 of the added income per year. They should have their salary and their retirement income as their base. But $50,000 per year for a lifetime would be a very substantial inheritance.

Deciding on the Amount of the Trust

John and Mary conferred for awhile and decided to proceed with a 5% trust that would pay $50,000 to each of their three children for the term of 20 years. The trust would need to be funded with $3 million, and would pay approximately $1 million as income to each child over that period of time. Hopefully, the trust will grow and provide inflation protection during the 20 years so that the purchasing power of each child's $50,000 remains constant.

Completing the Trust

John and Mary worked with their attorney to complete the documents. Their attorney suggested that the easiest way to create the trust is for John and Mary to sign a two life plus term of years unitrust. In their state, it is possible to have an unfunded trust. So, their attorney drafted a 5% standard payout unitrust for the duration of two lives plus a term of years. After they signed the trust, the trust was valid but not yet funded.

IRA Beneficiary Designation

John and Mary then selected the trustee of their unitrust as the contingent beneficiary of their IRAs. Because their IRA custodian permitted an online selection of their designated beneficiary, it was very easy for them to logon to their accounts and designate the trustee of their unitrust as the contingent beneficiary of their IRAs.

Both John and Mary selected the surviving spouse as the primary designated beneficiary. But when the second person passes away, the IRA will then be distributed to the trustee of the unitrust. The unitrust at that point will be funded and continue for the term of 20 years.

Will Formula Clause

John and Mary were very pleased with the ease and convenience of creating their 5% unitrust. They also worked with their attorney to include appropriate provisions in their estate plan. Using a formula clause, if the IRAs are not large enough to provide the full $3 million unitrust funding, an addition will be made from the estate to the charitable remainder trust. The balance of the survivor's estate over $3 million will then be distributed to their favorite charities.

Avoiding the Boats, Cars and Vacations Disaster

John and Mary are delighted with the unitrust protection for their children and comforted that they have avoided a "Boats, Cars and Vacations" disaster. While each child already has some resources, the 5% unitrust will provide a substantial added level of security. During a period of 20 years, their three children will have the opportunity to save, invest and be well-prepared for the future. Plus, they and their children know that a major future gift will be made to favorite their charities.

(Next month - how individuals with estates from $1 million to $25 million can avoid "a boats, cars and vacations disaster" even if they desire a very substantial funding in the 5% inheritance unitrust.)