Chapter 26
Estate Planning 101
In This Chapter
- Understanding what an estate plan does and why you need one
- Thinking carefully about your executor
- Controlling assets with trusts and gifting
- The perils of dying without a planned estate
- Knowing the top 10 mistakes of estate planning
If you think that estate planning is only for elderly people who have lots of property and money, it’s time that we clear up a major misconception. Estate planning, which is simply the process of planning for the transfer of your property, is not only for elderly folks—or for rich ones.
A person’s estate is simply his or her property and possessions, regardless of how much, or how little. Perhaps you have a home, a business, stocks, bonds, or money in the bank. All of those assets, and others, make up your estate. An estate can be worth $5,000, $500,000, or $5 million.
In this chapter, we’ll take a look at how you go about planning for your estate in the manner that will provide the greatest benefit to your family. Good estate planning can ensure that more of your assets get passed along to your heirs, and fewer to the government, attorneys, or needless expenses.
The Purpose of an Estate Plan
Many people in their 40s and 50s feel that they’re too young to think about estate planning. Realistically, however, we all know that things happen. People die in accidents. Others get incurable diseases and don’t live into old age. Because life is uncertain, it’s best to plan ahead.
Estate planning helps to assure that your assets will be distributed in the manner you would like. It also can help to reduce the amount of tax your heirs will have to pay, and to keep certain assets out of the public court proceedings called the “probate process.” Not only people with lots of assets benefit from estate planning, although it may be more important in order to protect those assets.
Why Everyone Should Have One
Having a good estate plan in place can give you great peace of mind. It also will help your family to manage your finances and proceed in an orderly fashion if you were to die.
When a person dies, whatever property he owned is transferred to another person or persons. Basically, there are three methods of property transfer.
Operation of Law
This type of transfer occurs with property that is owned jointly, such as in the case of a husband and wife. If you and your spouse own property that is held jointly with the right of survivorship, the property automatically passes to the surviving spouse when one of you dies. The law directs who will own the property at death. This law applies to any assets that are held jointly, not just property in the sense of land or a home.
Adding It Up
There also is a form of ownership that occurs among a husband and wife. It’s called tenants in the entirety, and is similar to the joint tenants with the right of survivorship form of ownership. Tenants in the entirety, however, is exclusively held between spouses.
Joint property is very common in families, and a frequent way that property is transferred. A particular kind of joint ownership is known as tenants in common. The tenants in common law allows property to be passed to someone other than the person with whom the property is jointly owned. Let’s say that you own a share of a vacation home with your three brothers and sisters. Tenants in common allows you to stipulate in your will that, when you die, your share of the vacation home will be passed along to your children—not automatically transferred to your siblings, with whom you own the house. If you’re married, the property most likely would be passed along to your spouse, and then to your children.
Contract of Law
This method distributes property through a beneficiary designation. A beneficiary designation is simply a document that states who should receive a person’s property at the time of death. Contract of Law is the method by which IRAs, pensions, life insurance policies, and trusts are distributed at the time of the death of their owner. Transfer is made to the designee, without any worry of the decedent’s will or joint property.
Probate
Probate is the process of verifying a will, and is conducted in public court. The court gives authorization to an executor to gather assets, pay death taxes and expenses, and then transfer property to the beneficiaries of the will, as directed. If a person dies without a will (but you’d never let that happen to you, right?) a judge will appoint an executor.
During probate, everyone who has a stake in the will of the person who has died is contacted and informed that the process has begun. Stakeholders include heirs, beneficiaries, and creditors. The estate of the deceased person is inventoried and appraised, and then everyone who is due money from the estate is paid. Whatever is left over is then distributed to the heirs.
Probate can be a long and expensive process, sometimes costing thousands and thousands of dollars in legal fees. Knowing how to keep some of your assets from passing through probate through smart estate planning can save both time and money.
Go Figure
The name of the local government office that handles probate varies from county to county. It could be called probate court, probate office, surrogate’s office, or register of wills.
Regardless of how your property is transferred after your death, it is imperative that you have a will. Drafting a will is the most important aspect of estate planning. It specifies distribution of all property not transferred by operation of law or contract, and spells out your specific wishes and requests. If you don’t have a will, have one drafted immediately.
Choosing an Executor
Choosing an executor for your estate is a decision that should not be made lightly. The executor (or executrix, if a woman) will be named in your will, and is responsible for administering your estate. Many lawyers will recommend naming an executor and an alternate executor, in case the executor dies or becomes incapacitated before your death.
We briefly discussed the duties of an executor or executrix in Chapter 24, but you should understand that administering an estate can be a lengthy and time-consuming job. The duties of an executor include the following:
- Identifying and listing all debt
- Notifying creditors that they need to file claims for payment
- Filing claims with insurance companies
- Inventorying all assets
- Arranging for appraisals of assets
- Closing bank and investment accounts of the decedent
- Setting up a checking account to use to pay bills
- Gathering and then distributing all assets according to the decedent’s wishes
- Filing final income tax returns
- Filing the state and federal death tax returns, if applicable
The executor of your will should be a person you trust, who is capable of, and willing to undertake the tasks involved. Be sure you ask whomever you choose if they’re willing to be your executor before you name that person in your will.
Methods of Controlling Assets
Even in death, you can’t avoid taxes. The so-called “death tax,”—the money the government grabs out of your estate after you die, is a hot topic these days, and currently in the process of being revised.
Basically, if you had died in 2001, before the death tax revisions, your estate would have been taxed if it was valued at $675,000 or more. That number will jump to $1 million in 2002, $2 million in 2003, $3 million in 2004, and $3.5 million in 2009. That is, all money within an estate over those amounts will be taxed.
Go Figure
The federal tax rate is based on the value of the estate, ranging from 37 to 50 percent. The top tax bracket, however, is set to drop to 45 percent in 2009.
If your estate is valued at less than $675,000 (in 2001), no federal taxes would apply, but it still may be subject to state death taxes.
In order to avoid taxes, people with sizable estates plan to remove assets from their estate, thereby reducing the value of their property. Two primary methods of shrinking an estate are through trusting and gifting.
Trusts
Many people set up trusts in order to manage their assets while they’re living, and to transfer those assets at the time of their death. Trusts allow you to transfer ownership of property or money to a person who is designated to manage and distribute the assets according to your instructions, for the benefit of another.
Some trusts may provide significant tax advantages, while others are for the benefit of persons unable to handle their affairs. Other trusts provide income for a spouse or beneficiary who is not included among your heirs.
The person who establishes the trust is called the “grantor.” The person who manages the trust is known as the “trustee,” and the people who eventually receive money or other assets from a trust are called “beneficiaries.”
Don’t Go There
Only certain types of trusts will help reduce taxes on your estate. Be sure to consult a lawyer who specializes in estate planning if you’re setting up trusts with the intention of shrinking your estate.
Trusts also are necessary if you have minor children. You can specify in your will that any money left to children who are under a certain age, be placed in a trust for their benefit until they reach the age stated. You appoint a trustee, who will see that the money is properly invested and available for the child if necessary. When the child reaches the age stated in the document, the trust is dissolved and the child receives the remaining assets. In most cases, income tax on the money earned by the trust is taken out of the trust until the child reaches the age stated in the document. At that time, the child usually has to pay income tax.
There are many varieties of trusts, but all fall under two basic flavors: revocable and irrevocable. Revocable means changeable, irrevocable means it’s beyond your control—it’s not changeable. Within each category are various types of trusts. Let’s have a look at some common kinds of trusts.
Testamentary Trust
This type of trust is laid out in a person’s will and established after his death. Until a person dies, the document can be changed, since the will can be changed at any time. However, once you die, the trust becomes irrevocable. The testator keeps control of the assets included in the trust during his lifetime, and can stipulate when beneficiaries should receive their money or property from the trust.
Testamentary trusts can help to reduce estate taxes at a second party’s death (usually a spouse). Testamentary trusts can be funded directly with assets that come from a beneficiary designation, such as proceeds of a life insurance policy that names the trust as its beneficiary. Or it can be funded through assets that are subject to probate.
Revocable Living Trust
This type of trust is set up while the grantor is still living, and allows the grantor to keep full control of the assets. The grantor also has the ability to revoke or amend the terms of the trust, or change the appointed trustee, while living. A revocable living trust becomes irrevocable when the grantor dies or becomes incapacitated. Many people consider a revocable living trust to be a substitute for a will, because the trust also can instruct how assets should be distributed. It’s extremely difficult, however, for a trust to include everything covered in a will—it can be done but it takes a great deal of planning.
If you have a revocable living trust, you should still have a will. A revocable living trust can reduce the cost of settling an estate, and also the amount of time it takes. Funds held in a trust can be distributed much sooner than assets in an estate. A trust can also protect privacy because assets included in the trust don’t have to pass through probate, which is a court proceeding in which a person’s estate is settled. As stated earlier in this chapter, all creditors are paid off during probate, and heirs receive their shares of the estate after everything is settled. Waiting isn’t usually necessary with a trust—distribution can occur when the trustee feels comfortable making distribution. And, while wills can be contested, trusts very rarely are contested.
Go Figure
A will is a public document, available for inspection at your local courthouse when it goes into probate. Anyone who happens to be interested can make a trip downtown, obtain a copy of your will, and read all the details—juicy, or not.
A revocable trust can be funded or unfunded at death. If unfunded, the document is held (like your will) in a safe place, and then used when assets are paid to it. If the trust is funded prior to your death, you re-register assets from your name into the name of the trust. Shares of stock for example, are re-registered from belonging to Daniel Smith, to belonging to the Daniel Smith Trust, with Daniel Smith and Susan Jones as trustees. If you fund a trust prior to death, all assets held in the trust bypass probate.
Irrevocable Trust
Usually established and used by people with a great deal of assets, irrevocable trusts, as the name implies, can’t be amended or destroyed. Once the trust is set up, it remains in place, giving the grantor no opportunity to change his mind.
Irrevocable trusts are used primarily to reduce estate taxes, though they are also used to protect property for minor heirs. Irrevocable trusts also can be set up to provide income for a beneficiary, and then to divert the income to another place when the beneficiary dies.
Property that is turned over to an irrevocable trust, if set up properly, is no longer considered part of the estate of the person who turned it over. It still may be subject to other taxes, such as gift or capital gains, but those traditionally have been far lower than estate taxes. As with a revocable living trust, assets included in an irrevocable trust do not have to pass through probate.
There are various types of irrevocable trusts, the most common of which is the irrevocable life insurance trust. In that case, the trust “owns” a large life insurance policy, from which proceeds are paid directly into the trust at the time of the death of the grantor. Other irrevocable trusts include residuary trusts and marital trusts.
There are many types of trusts, all with different rules and benefits. Consult a financial planner or lawyer who specializes in estate planning for more information, or check out some of the resources listed in Appendix B.
Money Morsel
Assets that are in your control at the time of death generally are subject to federal estate taxes. Those not in your control, such as in a irrevocable trust, are not subject to federal tax because they’re not considered as part of your property.
Gifting
Another means of shrinking an estate to reduce taxes is through gifting. Most of us aren’t in a position where we’d benefit from handing out gifts of $10,000 in order to avoid taxes. If your parents’ estate is large enough that they’re looking for ways to reduce it, however, you may want to suggest gifting.
An individual can give $10,000 per year to as many people as he or she wants, with no one paying death or income taxes on any of it. Wealthy people often use gifting to reduce the size of their estates. It’s effective because there is no limit to the number of people to whom you can give money.
Tax-free gifts in addition to a $10,000 gift may be made if the money is paid directly to an institution for medical costs or education. Gift money sent directly to a college to be applied toward tuition, for instance, would not be subject to gift tax, even if the college student already had received $10,000 in the same year.
There is a catch to gifting, as you might have imagined. The total of any gifts given over $10,000 per year are subtracted from the amount at which estate taxes kick in (called the exemption amount). That means, if you—or perhaps your parent—gives away $100,000 in gifts, your estate (or Dad’s) will be taxed at anything over $910,000 instead of the usual $1,000,000. And gifts of more than $10,000 are subject to a federal gift tax that mirrors the estate tax. This gift tax, however, isn’t due until the amount of all gifting is greater than the federal estate exemption amount.
Gifting has been an estate planning tools for generations. It will be interesting to see what impact the ongoing estate tax revisions may have on gifting.
Dying Without an Estate Plan
Even if your estate is simple and straightforward, you need to have an estate plan, the most important part of which is your will. If you never set up a trust or make a gift, that’s okay. If you fail to draft a will and die without one, however, that’s another story.
Until the World Trade Center catastrophe, few of us thought about the probability of dying without a will. An untimely death can occur anytime, so be prepared by getting a will!
Every state has laws concerning how your property will be distributed if you die without a will. They’re called laws of intestate succession. They are, in fact, actually the state’s way of writing a will for you, if you neglected to do it yourself. Although the laws strive to distribute property fairly—such as equal division among children—they can only do so much.
A law of intestate succession can’t know, for instance, that you and your cousin have always been closer than any other two people on earth, and you really wanted her to have your house, which she loves.
When somebody dies without a will, all community property generally is passed to the spouse. Property owned separately gets divided between the spouse and children. If there is no spouse or children, the property usually passes to the next closest relative. If property is passed to minor children, it’s generally placed by the court in a blocked bank account or guardianship account, and is not available to the children without a court order until they’ve reached majority, usually 18. And, a court order normally is awarded only in an emergency situation, not so that the money is available for the daily upkeep of the child.
These laws also don’t make provision for leaving property to your church or a charity, as many people like to do. In short, dying without having your estate planning complete (especially your will), is not a good idea. If you are ever in a situation of having a loved one die without a will, you should seek legal advice.
Ten Most Common Estate Planning Errors
Actually, there are 11 most common estate planning errors. The first, and worst, mistake is to have no plan at all. The other 10 mistakes, according to financial experts, are listed as follows:
- Improper use of jointly held property. Owning everything jointly makes the provisions of one’s will ineffective. Property held jointly with the right of survivorship is left outright to the survivor. Frequently, an inequitable amount of property goes to a joint tenant because he or she receives the property directly, and the decedent’s will divides the assets transferred by probate to the remaining heirs on a percentage basis, such as thirds. Since the will only covers probate property, an equalization of all of your assets need not be made.
- Improperly arranged life insurance. If the primary beneficiary of your life insurance policy is deceased, and you never named a secondary beneficiary, your family can be in for big problems. If your children are minors, and you haven’t designated a trust to hold the life insurance proceeds until they reach a certain age, your insurance proceeds are subject to claims in the estate, and will pass through the estate.
- Lack of liquidity. Not having enough ready cash available to cover death taxes and other final expenses is a major concern for many people
- Choosing the wrong executor. Often, an executor hasn’t got the time to devote to the often long and drawn-out process of estate administration. Or, how do you know that your executor will be fair and knowledgeable, and not display a conflict of interest?
- Will errors. Too many wills do not get updated. People tend to draft wills when they get married or divorced, or when they have their children. The will often remains neglected for years after that. An incorrect will can pass property to an incorrect heir.
- Leaving everything to your spouse. There can be serious tax consequences if you pass all your property to your spouse, and then he or she passes it along to your children. Leaving everything to a spouse isn’t always the best way to proceed.
- Improper disposition of assets. This is when your assets get passed along to the wrong person. A 20-year-old, for instance might receive a larger amount of money than he or she is capable of handling. Inequitable distributions due to incorrect beneficiary designations is a major error.
- Failure to stabilize and maximize. It’s very important that you know, and record, the value of your business interest, and have an agreement in place that makes provisions for the business if you die. It’s also important to make sure you’ve got primary and secondary beneficiary designations on all contracts—from pensions plans to tax-deferred annuities. IRAs and other retirement vehicles often are a family’s largest asset beside their home, yet they don’t plan the accurate disposition to maximize death tax and income liabilities.
- Lack of adequate records. Where are your assets located? Do you have an updated list of the names and numbers of your closest advisors? An executor needs access to last year’s tax returns, the locations of all your bank accounts, information about insurance policies, and so forth. Make sure you record all relevant information and have it in an accessible location.
- Not having a master plan. You can learn everything you can about estate planning, but if you don’t have a well-thought-out master plan, you’ll still be at square one. Be sure to take the time once a year to quantify in dollar terms your financial needs and objectives, and chart a plan for reaching your goal in the most efficient and effective way.
Having a clear and intelligent estate plan can help to put your mind at ease about the future, and assure that your heirs will get maximum benefits from what you leave behind. Estate planning is a useful tool, not something to be avoided or ignored.
The Least You Need to Know
- A well-thought-out estate plan can help you to reduce taxes and make sure that your property is distributed the way you want it to be.
- Estate plans are not just for people who own a lot of property or have a lot of money, and they are not just for elderly people.
- You should choose an executor for your estate carefully, giving thought to the time and effort that will be required.
- Setting up trusts and gifting money are common methods of reducing the value of an estate.
- Dying without a will means that your property will be distributed according to state law, not your wishes.
- There are common errors that many people make when planning their estates.