How to Protect Inheritance and Gifts From Ending up in the Divorce Pot

I’ve written before about prenuptial agreements and my concerns regarding their legal flimsiness. Prenuptial agreements may, or may not, be the best way to protect a couples’ separate assets. When it comes to inheritance or gifts, a prenuptial agreement alone is often not enough to protect those assets from ending up in the “divorce pot” to divvy up in case of a breakup.

Loosely defined, separate assets are those items brought into the marriage, or are inherited or gifted during a marriage. For example, if you have a bank account in your name with $4 million before marriage – and it remains in your name solely – that is a clearly defined separate asset.

Depending on what state you live in and the quality of the prenuptial agreement, the prenuptial agreement may be all that is required to protect those separate assets in case of divorce, but only if a few caveats are followed.

The big takeaway here is “separate.” Assets that you want separated from marital property must not be co-mingled with those of your spouse. In other words, that $4 million in an account we mentioned must be in your name only, and must remain in your name only. From this account, you should pay the taxes due on earnings from it.

If, for whatever reason, you place those assets in a joint account with your spouse, it may be considered marital property and can be considered for division during a divorce, regardless of what your prenuptial agreement says.

For gifts and inheritance received either before or during a marriage, there may be sturdier ways to protect them than from a prenuptial agreement alone.

Let’s say you inherit $100 million and you would like to keep this asset separate from your spouse. A good attorney will advise you to keep everything as separate as possible. Choosing an investment manager different from one used for the marital assets is a good start. This manager will open an account in your name only and carefully document where the money came from; exactly how much there is; and what it is used for.

It is important that you, and you alone, pay all the taxes on the income derived from this account. It also cannot be used for anything marital, such as household bills. There are rare exceptions to this hard and fast rule. For example, if you wanted to treat your spouse to an expensive trip using this money, that act wouldn’t in and of itself contaminate the account. I suggest consulting your investment manager and attorney first before making any assumption on usage.

The importance of this exercise is to maintain this account entirely separate with a lot of careful documentation. It will likely be considered martial property if:

  • You place it in a joint account,
  • You use it to pay the mortgage or other family bills
  • Your spouse, or joint assets, pay the income taxes on it every year

Another way of protecting a separate asset from becoming marital property is a trust, which provides another layer of isolation from marital property. For many wealthy families, this is done often when inheritance and familial gifts are given to ensure those assets stay within the family.

The beneficiaries of a trust can be anybody, children, charities and siblings. So if you have an inheritance or family gift you would like separate from your marital property, a trust may ensure that in the case of divorce it stays with you. In case you pre-decease your spouse, this asset will go to whomever or whatever you named as beneficiary.

Though laws in different states vary, it is near to impossible to break a trust. I had a case years ago that demonstrated this to me. A widow came to me upon her husband’s death with a dilemma. The deceased held a significant share of a valuable professional sports team, which was held in trust. She believed she was entitled to a share of this team. I thought she might be legally entitled to half or a third. We discovered that was not the case under Michigan law, which then held if an asset is held in trust, no one can take against the trust upon the death of the grantor.

For many wealthy families who have been passing inheritance down for generations, creating a trust is a common practice. It is a relatively ironclad way of ensuring the assets are used in the way, and for whom, it was intended, and a practice that should be adopted by donors or by spouses who wish to protect these family assets from becoming martial property.