What is Sprinkling Provision
Sprinkling provision is a provision within a life insurance agreement that allows the policy's trustee to spread the death benefit around to beneficiaries at his or her discretion. The sprinkling provision gives beneficiaries in greater need of funds, the opportunity to receive a greater portion of the payout than if the funds were divided equally.
Understanding Sprinkling Provision
For example, let's assume that a policyholder recently died and the individual has four children. Let's also assume that two of the children are financially well-off and that the others have recently entered into financial difficulty. The sprinkling provision embedded in an insurance contract enables the trustee to attribute a significant portion of the death benefit to the children in need of the funds and give proportionally less to the ones who do not need the extra money.
- Sprinkling provisions are used to spread benefit around to beneficiaries at the trustee's discretion.
- Such provisions can be added to life insurance policies and trusts.
- Sprinkling trusts offer tax advantages.
- Spendthrift provisions are alternatives to sprinkling trusts.
How Sprinkling Works
In a trust, either the income or principal can be allocated in this way. The income could be paid equally and the principal sprinkled, or vice versa. Both income and principal can be sprinkled, and at some future date, the remainder can be distributed in equal shares. The trust can be arranged to sprinkle until the beneficiaries reach a certain age, then to distribute equal shares of the remainder.
Sprinkling trusts offer tax advantages to trustees because the assets held in a trust are not taxable until a future date, when the trust expires. Generally trustees include assets that have low current value but high future growth potential in sprinkling trusts. Sprinkling trusts also allow the trustee to exercise discretion on the distribution of trust assets to beneficiaries. This means they can choose an opportune time that is beneficial for their tax liability for trust distribution.
It's important to pick the right trustee, if you're contemplating a sprinkling trust. The trustee, sometimes a lawyer or member of a bank trust department, has broad discretion to disburse the funds. He or she is required to follow the HEMS standard in which the "health,education, maintenance, and/or support" of the beneficiary is taken into account before making a distribution from the trust.
It is incumbent on the trustee to gain a thorough understanding of the family situation and to document the needs and resources of each family member, a daunting task. Trustees can also be a friend of spouse or other family member. You set the rules of the trust, but the trustee has a lot of power, so choose wisely.
An alternative to sprinkling trusts is a Spendthrift Trust. This is a trust setup with "spendthrift provisions or clauses" that protect the trust assets and the beneficiary assets from creditors of the beneficiary. The trust is normally created to allow the trustee to control the distribution of the trust's assets to the beneficiary(s) in order to manage the spending habits of the beneficiary(s). The creator of the trust might also be afraid that the beneficiary would "blow through" the assets of the trust if a controlled budget and independent trustee was not in place to maintain stability.
Example of Sprinkling Trust
Nate and Jeremy have two children, Jake and Will, aged 11 and 13. Jake plans to become a doctor while Will aspirations to become an actor. The career paths for both are not simple. Medicine requires years of study and hard work, often for very little pay, while an actor's life is fraught with financial uncertainty.
To ensure that both of their kids do not face monetary difficulties, Nate and Jeremy create a trust and assign themselves as trustees. They dip into the trust to pay for their kids' financial needs as they pursue their ambition. For example, they use funds from the trust to pay for Will's medical care when he falls ill. The trust is also useful, when Jake receives partial scholarship to medical school.