Estate planning is the process of accumulating, managing, and disposing of your property to maximize the goals of the estate owner. The various goals of estate planning include making sure the greatest amount of the owner’s property passes to the owner’s intended beneficiaries, including paying the least amount of taxes and avoiding steep probate and executor fees and years of probate court involvement. Additional goals include providing for and designating guardians for minor children, planning for incapacity, medical care, privacy protection, and protection against creditor claims.
On the personal side, a good estate plan includes directions to carry out your wishes regarding health care matters, so that if you ever are unable to make medical decisions yourself, someone you select would do that for you according to the guidelines you set, including authorizing heroic measures and other end-of-life decisions.
The term “estate” consists of all the property a person owns or controls, whether in his or her sole name, held in a partnership, in a joint ownership arrangement, or through a trust, and all other monies that would be generated on the person’s death, such as through life insurance. It includes:
(1) Real property and things attached to it (houses, buildings, barns, etc.)
(2) All personal property (including automobiles, bank accounts, stocks and bonds, mutual funds, stock options, cash, furniture, jewelry, art, collectibles, etc.)
(3) All businesses and business interests (sole proprietorships, partnerships, corporations, joint ventures, and the goodwill, inventory, tools and equipment, accounts receivable, and other business property, etc.)
(4) Powers of appointment (the right to direct who gets someone else’s property)
(5) Life insurance and annuity contracts, pension benefits, IRAs, 403(b)s, etc.
(6) All debts and obligations owed to others, and
(7) All claims you have against others, such as for the pain and suffering from an auto accident.
Several of the following documents are typically used as part of the estate planning process:
Will. A Will, sometimes called a “Last Will and Testament”, is used to distribute property you own at your death to the person(s) and/or organization(s) you want to have it. A Will also names someone you select to be your Personal Representative (or “Executor”) to carry out your instructions. A Will only becomes effective upon your death, and must be probated with the court, and subject to executor fees, legal fees, and potentially unnecessary taxes. Probate also is a very long process taking 1-3 years to complete.
Living Trust. A “Living Trust” is used to hold your property and provide a mechanism to manage and distribute property during your life and upon your death. You can select the person or persons you want — often even yourself — as the Trustee(s) to carry out the instructions you want in the Trust and name one or more Successor Trustees to take over if you cannot. Unlike a Will, a Trust usually becomes effective immediately, continues in force during your lifetime even in the event of your incapacity, and continues after your death. Most Trusts are “revocable” which allows the person who creates the Trust to make future changes, modifications and even to terminate it. (If the Trust is “irrevocable”, changes, modifications and termination are very difficult (and sometime impossible), although such Trusts often carry some tax benefits.) Trusts also allow you to avoid or minimize the expenses, delays and publicity of probate.
Advanced Health Care Directive. An “Advanced Health Care Directive” allows you to appoint a person or persons to make health care decisions for you in the event you cannot such as in the case of your permanent incapacity; for example an irreversible coma or persistent vegetative state. A health care directive also provides your stated wishes and instructions regarding the nature and extent of the care you want should you suffer permanent incapacity as well as end of life decisions. A health care directive also allows one to provide other wishes as it pertains to making anatomical gifts, donating parts of your body, authorizing an autopsy, and specifying burial or cremation arrangements.
Living Will. A “Living Will” or “Directive to Physicians” is an advance directive which gives doctors and hospitals your instructions regarding the nature and extent of the care you want should you suffer permanent incapacity, such as an irreversible coma. The Living Will is an inferior document to the Advanced Health Care Directive which allows greater flexibility and powers.
Durable Power of Attorney for Assets. A “Durable Power of Attorney for Assets” allows you to appoint a person or persons to act for you and handle financial matters should you be unable or perhaps unavailable to do so. These powers can be immediate, or “springing” by allowing a person or persons to act for you in financial matters such as when two licensed physicians state that you are mentally incapable of doing so.
Nomination of Guardianship. A “Nomination of Guardianship” document is a comprehensive document that allows you to nominate individuals to serve as the guardian of your minor children. The guardian can be nominated to handle the personal care of your minor children or the assets set-aside for your minor children or both. In the Guardianship document you can also provide specific instructions concerning, medical insurance for your minor children, moving out of state, religion, contact with other family members, et cetera.
Probate is the legal process with the court by which your property is transferred from your estate to your beneficiaries upon your death. Since you can’t take it with you, the court determines who gets it.
If you die with a Will (“testate”), the probate court determines if the Will is valid, hears any objections to the Will, orders that creditors be paid and supervises the process to assure that property remaining is distributed in accordance with the terms and conditions of the Will.
If you die without a Will (“intestate”), the probate court appoints a person to receive all claims against the estate, pay creditors and then distribute all remaining property in accordance with the laws of the state. The major difference between dying testate and dying intestate is that an intestate estate is distributed to beneficiaries in accordance with the distribution plan established by state law which may differ considerably from what you want; a testate estate (after payment of debts, taxes and costs of administration) is distributed in accordance with the instructions you provided in your Will.
State law sets the cost of probate. Below is a schedule of charges and costs to probate an estate in California. The probate and executor fees are calculated as a percentage of the gross value of your property. Gross value is the total value before deduction of any debts or liabilities. This means if you own a home worth $500,000 and carry a mortgage of $400,000 you are charged a percentage of $500,000, which could completely wipe out the net value ($100,000) of the home.
Probate is also a public proceeding where private details of your life and property are disclosed to the public.
The fees listed below are the California statutory fees used to compensate attorneys and executors in probate cases based on the gross value of the estate.
In addition to the fees shown below, there are filing fees charged by the Superior Court, appraisal costs, and extraordinary legal fees are routinely added at the attorney’s hourly rate depending on the nature of the work performed.
Just as with a Conservatorship, an estate plan uses several tools to prevent a court from gaining jurisdiction over your estate in the event of your death. The Durable Power of Attorney for Property enables your attorney-in-fact to handle your financial affairs and make last minute arrangements should your death be imminent.
A common technique used by your attorney-in-fact, who is often your Successor Trustee as well, is to transfer property, which is not currently held in your Trust into the Trust, so legal title to the property is held by the Trust at the time of your death.
Property placed in your Trust is not part of your estate at the time of your death. The instructions for the management and distribution of your property are set forth in the Trust, and carried out by your Successor Trustees in the event of your incapacity or death; there is no need to have the court grant authority to someone.
By getting a Trust in place and transferring ownership of particular properties to it, you avoid the need to get a court involved with a Conservatorship in the event of your incapacity, or probate in the event of your death. A well-coordinated estate plan can help you maintain a semblance of control over your property even after your death.
Estate taxes are taxes calculated against the net value of your estate. These taxes are in addition to probate and executor fees covered in the preceding sections. Unlike probate and executor fees, estate taxes are charged as a percentage of the net value of your estate. Below is a schedule of projected estate taxes on various size estates as of 2006, 2007 and 2008.
In 2011, the estate taxes shown in the table above will increase dramatically, unless Congress passes legislation to renew the current estate tax system. Of course, it is impossible to predict what Congress will do at that time. Therefore, it is important to consider all possibilities and contingencies when planning your estate.
Everyone gets a “credit” against Federal Estate Taxes on an exemption amount of $2 million in 2006, 2007 and 2008. (Unless previously used up, in whole or in part, as a result of gifts of more than $12,000 to any person in any year starting in 2006. Individuals and married couples with a total estate value less than the current exemption level don’t have to worry about Federal Estate or Gift Tax (the exemption amount slowly increases in steps to $3.5 in the year 2009 but then drops back to $1 million when the estate tax is reinstated in 2011).
For those who are married, there is an unlimited marital deduction. All estate taxes can be avoided upon the death of the first spouse to die. However, the surviving spouse would have to remarry and give his/her entire estate to the new spouse in order to get another unlimited marital deduction. Most people would rather their children or other relatives benefit from the estate than a new spouse and his/her family.
An estate plan can take advantage of certain tax avoidance techniques for those who have accumulated some wealth; this gets more of your property to your intended beneficiaries and less to the federal government.
By using a By-pass Trust at your death to hold property for your children but enable it to provide for your surviving spouse during his/her lifetime. This enables you to place up to $2,000,000 (or the current exemption amount) in a Trust for the benefit of your surviving spouse and children (which will not be subject to estate tax upon the death of your surviving spouse). Coupled with your surviving spouse’s estate and gift tax credit, this enables your spouse and you to send up to $4,000,000 (or the applicable exemption level in that calendar year) to your children free from Federal Estate and Gift Tax which would translate into a huge tax savings.
Additionally, by utilizing Irrevocable Life Insurance Trusts and/or devising a gift program employing other “Crummey” Trusts it is possible to savings hundreds of thousands more in estate taxes.
A bypass trust is the same as a Living Trust except that it provides greater estate tax savings. A bypass trust is particularly useful for spouses who plan their estates together. By leaving property to each other in bypass trust form, they can guarantee that the property will only be taxed once between the two of them. Each person can pass $2,000,000 (the exclusionary amount in 2006) free of estate taxes. However, in a Living Trust when the first spouse dies all of the property typically passes to the surviving spouse.
Then, when the surviving spouse dies the property is typically passed to children or other family members and friends. As a result, the first spouse to die did not use his or her $2,000,000 exclusionary amount and when the second spouse dies they can only exclude their own $2,000,000 exclusionary amount. A bypass trust is set-up to utilize both spouses exclusionary amounts so that they can pass up to $4,000,000 without paying any estate taxes.
To effectively save taxes, a bypass trust must follow certain rules laid out by the IRS. Let’s suppose your will sets up a bypass trust for your husband, and you die first. In order to keep the trust from being subject to estate tax when your spouse dies, the following conditions must be placed on the trust:
You must limit your spouses’ power to access the trust during their lifetime.
Your spouse must not have an unrestricted right to withdraw principal on a portion of the trust assets. However, they do have the unrestricted right to withdraw principal to provide for his health, education, maintenance, or support, in any amount up to the whole of the trust estate, and they can also have the right to withdraw up to $5,000 of principal per year for any purpose, or 5% of the total principal, whichever is greater.
You can also give your spouse the unrestricted right to all income from the trust property (e.g., interest, dividends, etc.), and you can appoint your spouse. As trustee, they would have full discretion to decide whether principal is needed for their “maintenance” or “support.” Thus, this condition is ultimately quite flexible.
You must limit your spouse’s power to distribute trust assets upon their death.
Except as provided above, your spouse cannot have the right to give the trust assets in a portion of the trust to themselves, their creditors, their estate, or their estate’s creditors. You can, however, give your spouse the right to name in their will specific persons who will succeed to the trust upon their death. For example, you could authorize your spouse to leave the trust to any of your nieces and nephews, or to divide it as they please among your children. Alternately, you can specify who gets the trust next and leave your spouse no discretion.
Although a bypass trust can be very flexible in practice, it is critical that the trust be drafted with absolute precision. The IRS has specified the words that may be used in a bypass trust, and if these words aren’t duplicated perfectly, the trust might not be excluded from tax in the second estate. Even the slightest drafting error can cost hundreds of thousands of dollars in taxes, so be sure your bypass trust is being drafted by an attorney who is knowledgeable about federal tax law.
What is a life insurance trust?
A life insurance trust is a trust that is set up for the purpose of owning a life insurance policy. If the insured is the owner of the policy, the proceeds of the policy will be subject to estate tax when he dies. But if he transfers ownership to a life insurance trust, the proceeds will be completely free of estate tax. (The proceeds will be exempt from income tax either way.)
Given the current estate tax rate of 46%, a life insurance trust can save hundreds of thousands of dollars in estate taxes. However, there are several drawbacks to such an arrangement:
You can’t change the beneficiary of the policy.
The insured must give up the right to change the beneficiary of the policy (the trust itself will be the beneficiary). The trustee alone has that right, and the insured cannot serve as trustee of his own life insurance trust. Of course, the insured will designate the beneficiaries of the trust (for example, his children). But because this designation cannot be changed after the life insurance trust has been set up, the insured will lack the flexibility to deal with changed family circumstances with this particular policy.
You can’t borrow from the policy.
The insured can no longer borrow against the policy. If the trust allows him to borrow against the policy, he will be deemed to be an owner of the policy for estate tax purposes.
You can’t transfer an existing policy to the trust — unless you live for at least 3 more years.
If the insured transfers an existing policy to a life insurance trust and dies within the next three years, he will be treated as the owner of the policy and it will be taxed in his estate. Even if he survives another three years, he will have made a taxable gift in the amount of the cash value of the policy (of course, this is usually preferable to having the entire face value subjected to estate taxes). If the life insurance trust takes out a new policy on the insured’s life, however, the insured will never be deemed to own the policy. Furthermore, no cash value will have built up yet, so no taxable gift will be made.
The life insurance trust must be irrevocable.
Once you set up and fund the trust, you cannot get the policy back. If you become uninsurable, you will be committed to this trust as your only life insurance.
Premium payments may use up your estate tax exemption.
If the policy has not yet endowed, you must find a way to pay the premiums without using up your estate and gift tax exemption. If you transfer securities to the trust so that the trustee will have income with which to pay the premiums, the full value of the securities will be a taxable gift. If you transfer cash to the trust each year to pay the premiums, each transfer will be a taxable gift. However, you may be able to exempt these premium payments from gift or estate taxes by setting the life insurance trust up as a Crummey Trust (see the FAQ on Crummey Trusts). Then each premium payment can be sheltered by your annual gift tax exclusion, which is $12,000 (indexed for inflation) per trust beneficiary.
You must find or hire a trustee.
The insured cannot serve as trustee of the life insurance trust. That means that he will have to find or hire a third party trustee. However, many banks and trust companies offer reduced fees for life insurance trusts because they involve essentially no investing decisions.
Despite these drawbacks, many people find that the tax saving potential of a life insurance trust is worth the cost and hassle. It allows you to remove from your estate a significant asset that you are unlikely to want access to during your life. And it ensures that the life insurance proceeds go 100% to the beneficiaries, not the federal government.
Many people wish to make lifetime gifts to their children in order to save estate taxes. As long as a parent gives his child no more than $12,000 per year, the gifts will be entirely excluded from gift or estate taxes. (That $12,000 limit increases regularly with inflation.)
The problem with gifts so large is that children do not have the legal capacity, or in many cases the maturity, necessary to handle so much money. You can solve the issue of legal capacity by appointing yourself as custodian of the funds you have given your child (such as by making the gift subject to the Uniform Transfers to Minors Act), but under a custodial arrangement, the child obtains access to all of the money upon turning 21, or in some states 18. To many parents, this is still too young.
To keep the money out of a child’s hands until he is, say, 28 years old, you must set up a formal trust. You would then make your gifts to the trust, and the trustee would invest the money. To conserve costs, you could even serve as trustee yourself. The trust documents would direct that the assets be distributed to the child when the child reaches age 28. Some people have the trust distribute the funds in steps: the child receives one-third when he turns 25, one-third when he turns 30, and the final third when he turns 35.
The one catch to all of this is that the $12,000 annual exclusion only applies to gifts in which the recipient has a “present interest” in the gift (as opposed to a “future interest”). In order to completely avoid gift or estate tax on the money you give to the child’s trust, you must give the child some right that qualifies as a “present interest.”
What qualifies as a present interest? Generally, the child has to have the right to take the money and spend it immediately. However, you can place significant restrictions on this right without losing the gift tax exclusion. A common method of doing so is to set up what is known as a Crummey Trust. It’s named after the Crummey family, who set up such a trust. The IRS tried to deny them the annual gift tax exclusion, but they went to court and won.
A Crummey Trust does not give the child any rights to the income. It does, however, give the child the right to withdraw the amount of each gift for up to 30 days after each gift is made. Since the withdrawal right begins immediately after the gift is made, it is considered a present interest. If the child does not withdraw the gift within the 30 days, the withdrawal right lapses and the money remains in the trust until the child reaches the designated distribution age.
Of course, the parent must still convince the child not to withdraw the money during those 30 days. However, even if the child decides to withdraw the money, he can only withdraw the amount of the most recent gift, not the entire trust. And after that the parent can eliminate all future withdrawal opportunities simply by ceasing to make any more gifts. The property in the trust will still remain intact and growing until it’s ready to be distributed.
A Special Needs Trust allows a parent, grandparent or guardian to provide funds for a disabled child without disrupting the child’s eligibility for government aid. If your family is caring for a child with disabilities, you may not be aware of options that would allow you to use funds from your child’s inheritance or personal injury settlement / award to help your family provide care and enhance quality of life for your child now, while maintaining his or her eligibility for Medicaid at a later date.
If you suffer from an incurable disease or are involved in a debilitating accident and are unable to manage your own affairs, state law might require someone to go to court to have a conservator appointed by the court. The conservator is given the authority to make financial decisions and handle your financial affairs, under court supervision, when you lack the capacity to manage them on your own.
The conservator has to make periodic reports to the court and petition the court for additional authority under certain circumstances. Typically, the conservator may be paid for services rendered on your behalf and there will be attorney fees as well. In addition, the court will often require your conservator to purchase a “surety bond” which is a type of insurance policy, to protect the conservatorship estate. Your estate pays the costs and expenses of a conservatorship.
An estate plan uses several tools, which can prevent the court from gaining jurisdiction over your affairs.
A Living Will or Directive to Physicians is used to determine if artificial life support systems are to be used or withheld.
A Durable Power of Attorney for Health Care is used to provide authority to a person, in whom you have the utmost trust and confidence, to make decisions regarding health care treatment when you are unable to provide informed consent.
A Durable Power of Attorney for Property enables you to authorize a person to act in your place and stead in the event of your incapacity. This attorney-in-fact can manage your financial affairs without the need to have intervention by the courts.
A Trust is used to hold property; the Trustees manage the property held just like you would if you were not incapacitated.
Thus, a properly prepared estate plan can enable you to avoid a Conservatorship proceeding over your estate. Compared to the cost of a Conservatorship proceeding, an estate plan can be very attractive.
When nursing home care is needed, Medicare is of only marginal assistance. Medicare covers the first 20 days and a portion of the next 80 days of care in a nursing home as long as you are receiving treatment and you are improving. Medicare does not cover long-term health care and extended time in a home. Medicaid is the only government program that will pay for long-term care and is designed to help low income people with medical bills. Medicaid will cover long-term care costs for qualified people and it will even cover some costs left over from Medicare. Unless an individual is impoverished, a nursing home stay can wipe out the assets accumulated over a lifetime.
To avoid this occurrence, an estate plan can give away an elderly person’s assets over time for the purpose of qualifying for the Medicaid program. The goal is to reduce the assets below the minimum amount for Medicaid. This strategy prevents an elderly person’s assets from being used up to pay for uninsured health care expenses or nursing home costs, and allows the assets to be transferred to children or other family members.
Medicaid rules prevent a person from receiving benefits by transferring assets right before going into a nursing home. A skilled estate-planning attorney can plan ahead for residential care needs and minimize the financial impact on an elderly person’s estate. It is certainly advisable for people to prepare for these issues prior to becoming senior citizens, but it is never too late to take control.