This overview presents the key issues to consider when designing and executing the best estate plan. Also, the work does not stop at signing your estate plan documents; you must also complete the follow up work of beneficiary designations, memorandum to fiduciaries, etc. The goal is to avoid the pitfall of no plan done and the disaster when wills and trusts are in place but the asset ownership and beneficiary designations frustrate the plan by having assets pass to the spouse and not the trust.
If you do nothing else after reading this, write and deliver a “Memorandum to Survivors” and review asset ownership, all as described at the end of this post.
A comprehensive estate plan can accomplish many goals, such as providing for survivors, ensuring your children are cared for, determining the flow of your assets upon your death, and reducing the amount of taxes your estate will pay while administering your estate. The most important goal is that you have peace of mind knowing that your estate will be administered in accordance with your wishes.
Estate Planning Pyramid
Constructing a pyramid can be helpful for understanding all that goes into an estate plan, much like nutrition and investments. Each level of the pyramid addresses a new level of complexity in your family and financial situation – that is, everyone needs level one, but not all need the later, more complex levels.
Pyramid: Level One
The first level of estate planning provides the most basic protections so it is most suitable to single individuals with no children and few assets. This level of estate plan typically includes the following forms:
Health Care Proxy: This document allows you to appoint people to make decisions about your health care and treatment when you are not capable of doing so. You typically select the surviving spouse and then have a first and second alternate if you wish. Some states call such documents “medical directives” or “medical powers of attorney.”
Living Will: This makes your wishes clear as to whether or not you want to have heroic means used to prolong your life.
Anatomical Gift Instrument: This allows you to have a hospital use organs and other body parts for others in need of a transplant.
Pyramid: Level Two
The second level is most appropriate for individuals in committed relationships. This level includes all the forms listed in the first level, but adds a durable power of attorney. This document grants a power of attorney to the other to manage your financial affairs if you are absent or you become incapacitated.
Pyramid: Level Three
When you have children, you want to ensure that they will be both cared for and provided for in the manner you wish. To achieve this, you need a will to appoint a guardian, for the “care,” and create a trust to manage assets, for the “providing.”
A will is a formal document that designates your personal representative or executor, any alternates, plus a guardian and any alternates for children under age 18, then instructs your personal representative to pay off your debts, and distribute your estate per your wishes.
A trust is an entity that you create and can be used for many purposes. The trustee acts as the owner of what the trust holds, while the beneficiaries get all the benefits from what the trust holds. For estate planning, trusts are used to reduce estate taxes in various ways. Trust vehicles can also describe how and when assets are distributed. For example, the grantor of a trust could insist that assets not go to children until they are age thirty-five. The trust vehicle could also provide where assets flow if all family members die without issue. For example, assets could flow to a charity or educational institution.
Providing for Survivors: You need to address how your assets and any life insurance flow after your death in order to ensure that your resources allow those who survive you to maintain the same standard of living, during their life expectancies, that you all had during your life. If your investments are not sufficient, even after making liquid certain kinds of personal property (e.g., a second home), then there is a need for life insurance.
Life Insurance: Term insurance, providing only a death benefit, funds the shortfall between assets required to maintain the lifestyle of the survivors and actual assets available. Whole life, variable or other types of insurance should only be used when permanent insurance is required, as in the case of maintaining estate liquidity throughout your lifetime.
Flow of Assets: After you determine the assets required to support the lifestyle of the survivor, you determine to whom the assets flow. For example, at Levels One and Two, you can leave everything directly to survivors, while at Levels Three to Six, you use a trust, and at Level Six you may even separate some portion of the assets by gift now.
Control Over Assets: In Levels One and Two, the survivors have complete control over the assets. At higher Levels, trust vehicles are used for the estate tax savings. However, you also gain a heightened level of attention on the assets: you have engaged a trustee to focus on providing for the surviving spouse, maintaining his or her lifestyle, while still attending to the interests of other beneficiaries, such as children. In this way, the trustee will try to preserve the trust assets in the best way possible for the longest duration. Finally, the trustee must distribute the assets per your instructions; if assets went to a survivor, they are not bound in any way to follow your wishes, so you may not achieve your estate planning goals.
Fiduciaries: In designing the estate plan, many choices revolve around the fiduciary that you select for a particular role.
Personal Representative or Executor: This is the person who “marshals” all assets of the estate together, pays death expenses and transfers ownership of property to the surviving spouse or trust. This is approximately a nine-month task.
Guardian: This is the person whom you select to love and care for your children in your absence. The spouse selects the surviving spouse and then a second or third choice beyond that. This job lasts until each child has reached majority (age eighteen).
Trustee: This person has potentially the longest-term job because he or she must manage the trust assets and make distributions of income and sometimes principal to the surviving spouse, children and even grandchildren. Depending on the terms of the trust, this job could last until the children are young adults.
Beneficiary Designations and Ownership: ownership and how life insurance proceeds and retirement plan assets flow is described below.
Pyramid: Level Four
This level of planning addresses state taxes. When the potential combined estate of a husband and wife exceeds $1 million, and they have other beneficiaries for whom they want to maximize the estate after taxes, then trusts are typically used. States such as Massachusetts impose an estate tax over $1 million. Other states have similar amounts, but many are increasing, such as New York which will match the federal credit in 2019. Therefore, additional planning is required if you reside in a state with an estate tax.
Pyramid: Level Five
The fifth level contains trusts that address federal estate taxes, as well as state. Congress has retained the unified gift and estate tax credit, now at approximately $5.34 million (inflation adjusted) with a 40% estate tax rate (up from 35% last year). In addition, the unused portion of the estate tax credit of a deceased spouse is “portable”, allowing it to pass to the estate of surviving spouse.
With the trust structure, sub-trusts can be created so that both the credit and the marital deduction are used. This structure takes advantage of the credit at the first and second deaths. In contrast, wills that pass all assets outright to the surviving spouse would only take advantage of the credit at the second death. The total tax savings for an estate of $10 million or more is excess of $1.75 million for the combined estates.
Life Insurance Trust: You can also make an irrevocable trust the owner of any insurance on your life to exclude all proceeds at death from both estates, avoiding estate taxes. That is, the proceeds are completely estate tax free. However, this requires an irrevocable transfer to the trust; you cannot get the insurance back out. You can use this trust to receive insurance proceeds that can pay for estate taxes, thereby preserving more of your estate after taxes without increasing the taxable estate.
Pyramid: Level Six
The final level is for complex estate planning that minimizes federal and state estate taxes through multiple generations. An example of this is a generation-skipping trust. These trusts transfer assets from the grantor’s estate to his or her grandchildren. This is what allows the grantor’s estate to avoid taxes that would apply if the assets were transferred directly to his or her children. The grantor’s children can still enjoy financial benefits of the trust by accessing any income that is generated by the trust while leaving the assets in trust for grantor’s grandchildren.
Other entities: Separating assets by gift now would be important if you wanted to ensure some minimum funding for children, such as guaranteeing coverage for their college expenses.
529 Plans: you can use 529 plans or trusts for gifting to cover college costs of a child.
After the Plan has been Executed
Ownership and Beneficiary Designations
Once the documents and insurance are in place, make sure to review and complete the following:
Qualified Plans (IRA’s, 401k plans, etc.):
Primary Beneficiary – to the surviving spouse (so he or she can roll over the proceeds to an IRA and thereby defer income taxes); and
Secondary Beneficiary – to your children (or your own revocable, depending on whether you want the assets controlled or available to children).
Life Insurance and Annuities:
Primary Beneficiary – when not owned by an irrevocable trust, such as group term, to your own revocable trust (for estate tax benefits, e.g., using credit at first death); and
Secondary Beneficiary – to the surviving spouse (in case of trust has been terminated for some reason).
Consider changing ownership of any jointly held assets to ownership by one of you. Any assets held as joint tenants with rights of survivorship will go to the survivor by operation of law and never get to your revocable trust. (You want to be sure that you have sufficient assets going to the trust to realize the full tax reduction effect.)
You may even want to fund your trusts, moving investment accounts over to your own revocable trust. This has no impact on your income taxes.
You can also choose to fund your revocable trust now. This will save a significant amount of time for the executor, and the attorney he or she hires, as this will need to be done after your death otherwise.
Memorandum to Survivors
Compile a reference book or add to your financial plan book photocopies of important papers, identifying where the originals are, then adding a list of important contacts, instructions to your executor and trustee and other important notes for family and friends. You would update this at least annually with new asset statements (consider this as you gather information for preparing your taxes). To be more specific, the list (and copies) should include:
Location of original will, trust, etc.;
Location of health care proxy and durable power of attorney;
List of professionals with contact information: doctor, attorney, CPA, etc.;
List of fiduciaries with contact information: health care proxy, guardians, executors and trustees, attorney-in-fact for durable power of attorney, etc.;
Location of insurance policies and valuables such as original titles, etc.;
Location of safe deposit box for valuables and items in #5 or 7;
List of all bank and investment accounts and location of any stock certificates or other documentation for investments;
List of all mortgages, loans and credit card accounts;
Any appraisals or other listing of items by value;
All automatic debits that need to be addressed (stopped, changed); and
List of all password protected accounts (e-mail, on line banking and credit cards, etc.) and where to locate the passwords… and the password to access the password.