These are the most common mistakes I see in my practice every day. There are many myths and misconceptions out there about estate planning. This article will help you recognize and avoid the most common mistakes families make in estate planning and help your family save thousands of dollars in unnecessary taxes and probate fees.
Mistake #1: Not Understanding How Your Assets Will Pass upon Your Death
Many people think their wills control how all of their assets will pass upon their death. Yet because many people hold much of their wealth in the form of retirement plan accounts or life insurance, many assets today pass outside of wills or trusts. Wills and trusts control real estate and other property that you own, but there are certain assets, like life insurance and IRAs, that are not normally subject to probate and which a will or trust cannot affect.
These assets will pass to the beneficiaries you name in a beneficiary designation form (*however note that a revocable trust can be the beneficiary on these types of accounts with the proper trust provisions—there are many advantages to having your revocable trust as the beneficiary of which we will discuss later in this book).
Example: While still single, Don named his brother as the beneficiary on his retirement plan and his life insurance. Don later got married. After his marriage, Don changed his will to leave everything to his wife. But because Don never changed his beneficiary designations on his retirement account and life insurance, the bulk of his estate passed to his brother on his death and not to his wife.
This problem can be avoided by reviewing your beneficiary designations for life insurance policies and retirement plans when major life changes happen to make sure they fit your current situation and your estate planning goals.
Mistake #2: Trying To Plan Your Estate around Specific Assets
Unless there are compelling reasons why a specific asset should go to a specific person, I strongly discourage clients from trying to plan around specific assets.
Example: Bill had three children and wanted to treat them all equally. His will even confirmed this. Several years before he died, he transferred half of his home to his older son, added his daughter as a signer on his savings account, and named his younger son as the beneficiary on his life insurance policy. When he did this, all three assets were about equal in value. But between these actions and his death, he sold the home, put the proceeds in the savings account, and let the life insurance policy lapse. The savings account passed to the surviving owner and not pursuant to his will. By planning around specific assets, he actually disinherited two of his children! This is not what he intended and this could have easily been avoided with proper planning.
Mistake #3: Failure to Minimize Estate Taxes
The estate tax exemption, which is the maximum amount you can pass to your heir’s estate tax free will soon be $1,000,000 (2011). Many people tell me things like, “My estate is only about $800,000 – I don’t think I will even have a taxable estate.” Perhaps they don’t want to pay for an estate plan that includes estate tax planning. But consider the cost of not planning. If a surviving spouse dies in 2011 with $2 Million in assets, the estate tax bill will be $410,000! This estate tax could be totally avoided with a properly structured estate plan containing the proper tax planning provisions in your revocable trust. Remember that your estate will grow over time, and plan ahead for that.
Mistake #4: Relying On Co-Ownership of Property to Avoid Probate
In California, co-ownership of property does nothing to avoid an eventual probate. At the death of the surviving owner, a probate must be opened. Adding someone to title simply gives them ownership of half the property and can cause tax problems you are unaware of. For instance, if a mom decides to make her daughter a co-owner so that the property will pass to her daughter upon her death (with right of survivorship), yes, she has accomplished that if the property is in joint tenancy. However, she may have also created a host of tax issues for her daughter as well. The first of which is a reduction in the mother’s Federal Estate Tax Exemption because she gave a lifetime gift (if the half of the property was valued greater than $13,000 in the calendar year of the gift—as of 2010).
A second issue is the capital gains tax. Because mom gave half the property to her daughter during her lifetime, the daughter takes her mother’s original basis in the half given to her. This could mean a capital gains tax would be due upon the eventual sale of the property on the half given to her. However, if the mother had given the property to her daughter upon death (say through a trust), the daughter would have obtained a full step-up in basis to the fair market value of the property at the date of death of her mother. Thus, no capital gains tax would have been due if the property was sold shortly after her mother’s death.
A third disadvantage to making her daughter a co-owner is that she opens the door to any potential creditor claims her daughter might have in the future. The property could be subject to a claim and taken to satisfy the debt. As you can see, there are numerous tax and legal implications in the art of estate planning that could be missed by an unskilled person, costing your family big time.
Mistake #5: Losing Control by Adding Someone to Your Bank Accounts
When you simply add someone’s name to your account, you are subjecting that account to his or her creditors. You don’t have to be a bad person to be sued these days or to be subject to a tax lien. You may also be inadvertently giving that person an ownership interest in your account (which could affect your gift tax exemption). If you need help managing your finances, you can appoint an agent using a Durable Power of Attorney and give them authority to manage your affairs without exposing your assets to their creditors. You can also use a revocable living trust to achieve the same result by transferring your bank accounts to your trust and listing the person you want to help manage the accounts as either the current trustee of your trust or as a co-trustee with you.
Mistake #6: Putting Your Children on Title to Your House
When you put your home (or any other asset) in co-ownership with your children, your children become co-owners of the property with you. This causes several problems.
First Problem: Putting your home in joint tenancy with your children is a taxable gift under IRS regulations. This means you have to file a gift tax return for the year in which you made the transfer if the value of the interest transferred to each child is more than $13,000 (2011).
Second Problem: If your child has any lawsuits against him or her, is going through a divorce, or has a tax lien filed against them, you may find out that you no longer own the house with your child, but with your child’s creditors. In many jurisdictions, creditors can actually foreclose on (force the sale of) your home to get at your child’s fractional share.
Third Problem: When you go to sell the home, you can use your primary residence capital gains exclusion ($250,000 for individuals and up to $500,000 for married couples) only on your fractional share. Each of your children may have a LARGE long-term capital gains tax bill to be paid that could have been totally avoided if the house had still been titled in the name of your revocable trust.
Mistake #7: Failure to Protect a Disabled Beneficiary
If you have a disabled beneficiary, perhaps a handicapped child, you should consider leaving them their inheritance in a specially-drafted trust to protect your child and keep them eligible for public assistance. Without public assistance, many such children would have to spend their entire inheritance within a few years on medical and other needs. If you leave the inheritance to them outright, they may be ineligible for public assistance until they spend the inheritance down to the statutory limit ($2,000 limit in California). If you leave the disabled child’s inheritance to another child with the understanding that that child would help the disabled child, that child may die, get a divorce, or be sued. This could result in the inheritance not being available to the special needs beneficiary.
Mistake #8: Failure to Make Special Provisions for a “Problem” Child
After you are gone, will your beneficiaries use their inheritance in a constructive manner? Or will they waste it foolishly? How are they today at managing their money? That may give you some idea as to how their inheritance will be spent after you are gone. Will it be available for the education of your grandchildren, or will it all be gone in just a few years?
Many of my clients like the idea of holding an inheritance in trust until their beneficiary reaches a certain age, such as 30 years of age. Others like giving their children 1/3 after they are both gone, with another 1/3 in five years, and the last third five years after that. But this gives the beneficiary three chances to blow it! I’ve even had some clients who are so disillusioned with a child that they have required that the child’s share be distributed in monthly payments over 20 years or have decided to asset protect that child’s share until that child’s death. This could be as strict as not allowing him or her to demand money from the trustee (in this situation, the trustee is in complete charge of giving the beneficiary money for his or her needs).
Other clients have required that their children be tested drug or alcohol free monthly for three years before receiving an inheritance outright. Remember, as long as an inheritance is being held in trust, it can be protected from the beneficiary’s spending habits, from creditors, and even from divorcing spouses. Also, your trust can control where the inheritance goes upon the death of the beneficiary. Many of my clients would prefer to see a deceased child’s inheritance go to their other children or grandchildren rather than their deceased child’s spouse.
Mistake #9: Sloppy Drafting
Example: John had three children. His will left his estate to “my surviving children.” Sounds good, but is that what John meant? If his daughter were deceased, did he really want his estate divided between his other two children, or would he have wanted his deceased daughter’s share to pass to her children (his grandchildren)?
Example: Janet’s will left her estate equally “to her descendants.” At the time she drafted her will, she had two children and no grandchildren. But by the time she died, her son had four children and her daughter none. Under some state laws the term “descendants” includes children, grandchildren, great grandchildren, etc. Thus, by law each descendant gets one-sixth of her estate. Is this what Janet wanted, or do you think she wanted her estate to go half to her son and half to her daughter?
A properly drafted estate plan could have made this clear. For instance, I leave my estate equally to my living descendants, “per stirpes” is probably what both John and Janet meant. This language makes it clear that if there are two children the property is split between the two children. If the daughter is deceased, then her half of the estate will be split equally between her children.
Mistake #10: Trying To “Do It Yourself”
Although the previous example shows how easy it is to botch simple planning, there are many other examples available. John and Mary didn’t want to pay an attorney to draft their estate plan, so they bought a living trust kit under which they or the survivor would serve as trustee. In modifying the trust to meet their personal situation, they decided to change the language in the Family Trust which allowed distributions to the surviving spouse for “health, education, maintenance, and support” by adding the words “comfort and welfare”. This addition seemed harmless enough to them.
But the IRS regulations make it very clear that this addition results in the Family Trust being included in the survivor’s taxable estate, which was exactly what they were trying to avoid.
Your estate, even if it is modest, still represents big bucks to your spouse and children. Use a competent estate-planning attorney to make sure that your estate plan and any changes are properly drafted.
Mistake #11: Failing To Realize That Wills Can Be Changed By the Maker
Jeff and Sara had been married for over 25 years. Each of them had two children by a prior marriage. They wanted to provide for each other first, and then leave the assets equally to all four children. Although their Wills stated this intention, the survivor could always change his or her Will to leave everything to his or her children only. Or if the survivor’s will cannot be found (perhaps destroyed by one of the survivor’s children), then all of the assets would pass to the survivor’s children.
The use of trusts can help protect children from a prior marriage by either having separate trusts or by having a joint trust listing the assets of each spouse on a separate property schedule. There are also special provisions for sub-trust funding at the death of the first spouse that can be crafted to protect children of a previous marriage. Second marriage planning is often complex and doesn’t get the attention it usually deserves, even from many attorneys who supposedly specialize in estate planning.
Mistake #12: Relying On Beneficiary Designations
A beneficiary designation is a very simple form of estate planning which does not handle contingencies very well. For instance, if you name your son and your daughter as the beneficiary on your life insurance policy, and your daughter predeceases you, do you think the insurance company will pay the proceeds all to your son? Or do you think the insurance company will pay your daughter’s half of the proceeds to your daughter’s children?
Most of us would like to think the later, but most of the beneficiary forms we’ve seen say just the opposite: The forms usually say “Unless otherwise indicated, we, the insurance company, will pay to the surviving named beneficiaries.”
By naming a trust as the beneficiary of your life insurance, your trust can control exactly how the proceeds will be distributed, including such contingencies. The trust can also name a person who will manage and distribute the money for minor children or grandchildren.
Mistake #13: Trying To Leave Property to a Minor Child or Grandchild
No insurance company will knowingly pay $500,000 to a twelve year old. They will only pay it to a court-appointed guardian for that child, who may not be the person you would want. The cost of obtaining such a court order can also be substantial.
Example: Your will or beneficiary designation indicates that your deceased daughter’s share is to go to her children. If they are minors, a guardian will need to be appointed by the court. The court would give priority to the children’s father, who may be your ex-son-in-law.
Generally, in a guardianship, the money is required to be turned over to the minor once he or she reaches 18 years of age. That age is perhaps one of the worst ages to turn over a significant inheritance to a child or grandchild. An inheritance left in trust for such a beneficiary can specifically indicate who is going to manage the funds and make distributions for college and the like. It can also indicate the age at which the funds will be turned over to the beneficiary or when the child could become the trustee of their own trust. For instance, in many trusts that I draft, I encourage my clients to select a trustee that is an independent trustee (a successor trustee that is not related to or subordinate to them or their children). With an independent trustee in place, a court CANNOT force a distribution from that child’s continuing trust.
Remember, as long as the inheritance is held in trust with an independent trustee in charge, it can be protected from:
- your child’s bad spending habits
- your child’s future divorcing spouse
- your child’s creditors or lawsuits lodged against them
A continuing trust can also indicate who receives the inheritance in the event of your child’s death, and with proper investment, the inheritance can grow, providing more financial support over time.
Mistake #14: Failure to Consider Who Pays Estate Taxes
John drafted his trust to leave his home to go to his companion of many years and the remainder of his estate to go to his children. But he and his attorney never discussed who would pay the estate taxes, and his trust said (as many trusts do) that taxes and expenses would be paid out of the “residuary estate,” that is, from the remainder distribution after specific distributions. Therefore, on John’s death, the estate taxes will be paid solely out of assets which pass pursuant to the residuary clause of his trust, and therefore, out of his children’s inheritance.
In this extreme example, the home was worth $5 million and the remaining assets were worth $5 million. The estate taxes were $4,430,000 (in 2003) and the expenses were $70,000, so the kids received only $500,000, while the companion walked away with the $5 million palatial home estate tax free. We doubt that is what John would have wanted if he had considered who pays the estate taxes.
Many trusts say “pay all taxes out of the residuary estate.” Phrases like that sound good, but may not be what you want unless you fully understand exactly what they mean.
Mistake #15: Failure to Consider the Income Tax Aspects of Your Assets
Marlene’s two major assets were her life insurance and her (traditional) IRA; and they were of equal value. So she named her son as the beneficiary on the life insurance, and named her daughter as the beneficiary on her IRA. The proceeds of life insurance are income tax free, but the proceeds from an IRA are generally all subject to income tax. The daughter lost approximately one-third of the proceeds to income taxes.
This is one of the reasons we discourage our clients from leaving specific assets to specific persons.
Consider naming all children as beneficiaries, or better yet, leaving all assets to your trust, with the trust dividing them equally and providing who will receive what in the event a child should predecease you.
Mistake #16: Failure to Consider All the Tax Consequences of a Gift
Mary was diagnosed with terminal cancer. She had heard that probate could cost her children thousands of dollars. She heard that probate could be avoided by deeding her home to her kids while she was alive. Luckily, none of the problems we previously discussed developed, such as a child’s divorce, lawsuits, tax liens, etc. But when the kids sold Mary’s home after her death for $180,000, they discovered that their “basis” (cost for determining taxable gain) was Mom’s cost 30 years ago, which was $20,000. The taxable gain was $160,000 and at 25% (the federal and state tax on the capital gain at the time), the tax was $40,000.
Their accountant correctly informed them that if Mary had owned the property on her death (or if it were owned by her Living Trust), then the children would have inherited it with a “step up in basis”. That means that their basis (or cost for determining taxable gain) would have been the fair market value on Mary’s date of death. There would have been no capital gains tax payable on the sale shortly after Mary’s death. Mary’s gift to avoid probate cost her children $40,000! If the children had acquired the home on Mary’s death (and not by gift) and did not sell it, but rented it out, they also could have taken depreciation based upon its fair market value on their mother’s date of death.
Mistake #17: Using the Wrong Assets to Fund a Gift to Charity
Mark wanted to leave $100,000 to his church upon his death, and the rest to his children. Mark’s attorney was inexperienced in estate planning, and but for a very reasonable fee drafted Mark’s trust as instructed: “$100,000 to my church and the balance equally to my children.” Mark’s large IRA passed to his children, who had to pay income tax on it.
Had Mark funded the charitable bequest with his IRA, there would have been $100,000 less taxable income to the children, increasing the amount that passed to them after income taxes by, perhaps, $30,000 (at a 30% rate for both federal and state income taxes). Charities don’t care if they receive taxable income property because they don’t pay income taxes anyway.
Michael saved a few dollars on the drafting side which later, in effect, cost his children $30,000.
Mistake #18: Failure to Fund Your Living Trust
Bob and Carol had a Living Trust, but neglected to re-title their assets as instructed by their attorney. The attorney even deeded their home to their trust, but they later sold the home and purchased another home in their personal names and not in the name of the trust. Bob died a few years ago, and on Carol’s death, all of the assets were subject to probate and were part of her taxable estate. By not titling their assets in the name of their trust, they defeated two of their planning goals: avoiding probate and reducing estate taxes.
Moral: If you have a living trust, be sure to fund it with your assets by changing record title or beneficiary designations as instructed by your attorney. Or better yet, hire an attorney that offers this as an option in their legal services.
Mistake #19: Not Contacting an Attorney after the Death of the First Spouse
I’ve seen time and time again instances where a surviving spouse has not contacted an attorney to help with the trust administration after the death of their spouse. The most common situation where this can spell big trouble is if the couple had an A/B type trust. Upon the death of the first spouse, the trust property is to be split (according to the formula laid out in the trust document) into an “A” trust for the surviving spouse (which remains revocable by the surviving spouse) and a “B” trust which holds the decedent’s half of the estate. This is usually in an irrevocable trust for the benefit of the children, passed to them at the death of the surviving spouse.
Many times however, the surviving spouse subsequently becomes incapacitated and the baton is passed to the successor trustee. The successor trustee steps in and tries to understand how to deal with the trust and if they are smart they end up talking to an experienced estate planning and trust administration attorney. What they often find out is that the surviving spouse did not do what they should have. This creates a legal and accounting nightmare for the successor trustee. We then have to try to “fix” the problems that have arisen from the improper or lack of trust administration by the surviving spouse. This ends up costing the family a lot more money than if the surviving spouse had simply contacted an experienced trust administration attorney to set up the trust split when the first spouse died.
The moral of the story is to seek help and never assume that a trust administration will be simple (it might be but you always want to check with an attorney to ensure things are being properly administered).
Mistake #20: Missing a Disclaimer Deadline
A disclaimer is a refusal to accept an inheritance. A qualified disclaimer is one that complies with IRS and state law requirements, one of which requires that the disclaimer be made in writing within nine months of the decedent’s death.
So why would someone want to disclaim an inheritance? Let’s say a couple has a taxable estate and holds considerable property. The wife dies. If the husband disclaims his wife’s half, her half will pass to their children. Or, if the couple has a properly drafted Living Trust, it could pass to a Credit Shelter Trust for the benefit of the surviving spouse and then later pass to the children. If the disclaimer is made pursuant to IRS regulations, the disclaimer is not treated as a taxable gift.
Example: Michael was in poor health when his wife died in 2006. Their combined estate was $4.0 million. They each had a simple will leaving everything to the other, a sound plan so they thought. However, if Michael had executed a qualified disclaimer within nine months of his wife’s death, her half of the estate would have passed to their children instead of him, and would not have been treated as a taxable gift by Michael. If Michael then died in 2008, no estate taxes would have been due.
This could have also been accomplished by having a trust with an optional disclaimer sub-trust provision built in. But because Michael missed the deadline, his wife’s half of their assets was included in his taxable estate, and on his death in 2008, the estate taxes were $900,000 – all of which could have been avoided if Michael had made the qualified disclaimer.
Qualified disclaimers are an important planning tool in many estates. In fact, many estate plans are designed to anticipate the use of disclaimers for saving on estate taxes. Disclaimers are just one of the many reasons why it is important to see an experienced and knowledgeable estate planning attorney to plan ahead to minimize or eliminate your estate taxes.
Mistake #21: Not Doing an Estate Plan While Divorce Is Pending
If you get a divorce, in most states your ex-spouse is automatically disinherited from your will. But what if you die before the divorce is final? In that case your soon-to-be ex-spouse will still inherit under your will or trust. Therefore, it is very important to change or amend your estate plan as soon as a divorce is filed.
Many people will usually wait until the divorce is final, which, by then, is often far less important. Also keep in mind that a divorce decree does not automatically change beneficiary designations, such as on life insurance and qualified retirement plans. You must file a change of beneficiary designation form.
Mistake #22: Failure to Have Proper Beneficiary Designations on Your IRA
After his wife died, Fred was advised to name his three children as the beneficiaries on his IRA. He assured us that he had already done so (or that they were the contingent beneficiaries).
On Fred’s death, it was discovered that he had never made the change and that the original beneficiary form had only named his (predeceased) wife as the beneficiary. His IRA agreement with the custodian stated that if there is no surviving beneficiary designated, the IRA would be paid to his estate.
Although that provision still gets the IRA to his children through a probate, it means that they have to liquidate the IRA in a very short period of time, perhaps within only five years, creating a greater tax liability because income tax will be due on the IRA.
Had he named the children on the IRA beneficiary form, the children could have pulled it out over perhaps 40 years, allowing it to compound tax deferred. Fred’s small IRA could have actually funded his kids’ education or retirement had he named them as beneficiaries.
Therefore, it is very important to VERIFY your beneficiary designations (or file a new form) and NOT depend on your memory.
Mistake #23: Failure to Have Gifting Powers in Your Power Of Attorney
Harold was on his deathbed. His son knew Harold had a taxable estate, so Harold’s son, acting under a Durable Power of Attorney, made gifts of $13,000 (the annual gift exclusion amount in 2010 and 2011) each from Harold to his 5 children and their spouses.
This gifting had the potential of removing $130,000 from Harold’s taxable estate, saving at least $58,500 in estate taxes.
But the IRS ruled that because Harold’s Power of Attorney did not specifically grant his son the power to make those gifts, his son operated in violation of the law, and the IRS deemed the gifts incomplete.
A Power of Attorney generally does not give the agent the authority to give away your assets. The agent is supposed to operate in your best interests. If Harold had a legal right to recover the gifts, the IRS will include them in Harold’s taxable estate. The omission of gifting provisions in the Power of Attorney cost this family over $58,500.
The moral: If appropriate, be sure your power of attorney contains specific gifting provisions.
Mistake #24: Assuming That All Estate Plans Are Equal
I have seen many poorly-drafted Trust-based estate plans drafted by inexperienced attorneys and even some drafted by financial planners and CPAs.
Some revocable living trusts will not even avoid probate, as such trusts say “Upon my death my trust shall be paid to my estate.” Many trusts drafted for married couples don’t even have estate tax planning provisions.
A trust can be as short or as long as you want to make it. There is no such thing as a “standard living trust.” A one-page trust might technically be a valid trust, but it probably does not do most of the things it should do that we have discussed in this book.
Assuming that all estate plans are basically the same can be a costly error. If you have any doubts, we suggest getting your estate plan reviewed by an experienced attorney.
Mistake #25: Not Having an Estate Plan At All!
If you don’t have an estate plan, most states have one for you, and it may not be what you would want. Not many people would purposely let their state legislature draft their estate plan for them, yet that is what you get if you don’t plan yourself.
For instance, under California law, if you are married with children, your property could go to your children and your spouse proportionally if you have no plan. We find that is rarely what our married clients want. Most couples want to give more control over their assets to their surviving spouse and see their kids get an inheritance only after they are both gone. One of my Probate clients had this happen to her and her minor children. Their house and several investment accounts were titled in her husband’s name alone. According to the Probate Code, two-thirds of his property passed to his two minor children and one-third to his wife. No matter what she knew his intent to be, that is what the law required because they had no estate plan in place.