“With great power comes great responsibility.”
Spiderman’s dead Uncle Ben
(Oh, and some other guy named Voltaire.)
So, too, with wealth.
One of the pesky things that nobody ever seems to tell you while you are accumulating it, is that is that having and keeping it requires effort. You must learn how to invest it and how to protect it from the many forces that would happily pull it from your pocket into theirs. And this Great Responsibility of Wealth continues after you die. How unfair is that!?
But if you shirk this responsibility, your wealth will flee from you; while you are alive or after you are dead.
So far on this blog we’ve only talked about the alive part. This is not because I don’t think the death part is important. I very much do and in fact have had my own Will and other documents in place for many years.
Rather it is because I am not qualified to write about this stuff. While it might not always show, I try to write about only those things I actually understand. For this topic my knowledge base is simply too limited. For my own needs I have personally relied on legal professionals to get it done.
Early on a reader calling himself Prob8 began showing up on this blog. His comments were always well reasoned and well written. In my mind I heard his name as Prob(ably)8 and wondered, as I sometimes do with internet names, what it meant.
Back in October I finally had the chance to meet him while attending FinCon, the conference for financial bloggers like me. Turns out he is an attorney with a practice focused on estate planning and “probate” is the correct pronunciation of Prob8.
Regardless of the pronunciation, it didn’t take me long to figure out that in Prob8 I had just the right guy to fill in a knowledge gap around here for which my own abilities came up woefully short. He graciously agreed and here is his Guest Post. In an appropriately lawyerly fashion it begins with a disclaimer.
Estate Planning Made Understandable
DISCLAIMER – You should contact a licensed professional to assist in the preparation of your estate plan. This post and any comments are not legal advice and will not create an attorney-client relationship. If you are not in the United States, this post may be useless to you and will probably suck to read. You’ve been warned.
At some point in your life I suspect you will question whether you need an estate plan. This may happen when someone you know dies, you reach a certain level of wealth, or perhaps when a friend or family member plants a seed in your mind. For me, estate planning did not make it onto the “to do” list until my first child was born.
If you have not yet planned your estate, you might be wondering why you need to make a plan. You probably don’t want to spend any more time than necessary in life with a lawyer. You certainly don’t want to give them any of your hard-earned money. I don’t blame you. I feel the same way.
At a basic level, you need to make a plan in order to deal with incapacity during lifetime and distribution of your assets in an orderly fashion at your death. But estate plans can accomplish much more than that. Additional goals for many who plan their estate include avoiding the probate process (more on this later), reducing or eliminating estate tax (more later), creating creditor protection for heirs, and creating guardians for minor children. Of course, this is not an exhaustive list and not all of these things will be relevant to you. If some are relevant, you should give serious consideration to preparing or reviewing your plan.
Not everyone has an estate plan and that might get you thinking about whether there are alternatives to formal planning with a lawyer. There are. Let’s discuss some of them.
Informal Estate Planning
The first thing you need to know is that your state has an estate plan for you already in place. The good news is that it’s free of charge and requires no formal documentation or effort on your part. The bad news is that it probably doesn’t say what you want and relying on it will likely lead to increased costs and aggravation for your family.
1. State Default Rules.
Let’s assume you have no formal documentation and your death occurs. For simplicity, let’s also assume your assets are solely in your name with no co-owners or named beneficiaries. Having failed to plan your estate, your family is now subject your state legislators’ opinions about how your assets should be distributed. Perhaps you are okay with your state’s plan. Perhaps not. If you’re unsure, you should do some research. You can start here (http://estate.findlaw.com/planning-an-estate/state-laws-estates-probate.html).
Example: Because I practice in Illinois (and because it’s the home of Jim’s alma mater) (jlc: Go Fighting Illini!), let’s assume you live here too. Let’s also assume you have a spouse and an adult child. At your death, Illinois law says your spouse would be entitled to the first $20,000. After that, the net assets will be distributed 1/2 to your spouse and 1/2 to your child. Is that what you intended? I don’t know . . . you’re dead. Unless your wife can channel your spirit through Oda Mae Brown*, I doubt we will ever know. I can tell you that unless your family gets along really well, someone is probably going to be upset with that result. Especially if this is a second marriage and the child is from a former marriage.
Death isn’t the only thing covered by your state’s default rules. You’re also covered in the event you become incapacitated due to accident, illness or otherwise. As with the death laws, the rules for handling your affairs while incapacitated vary from state to state. In some cases, your spouse might be able to make limited medical decisions on your behalf. More likely, some form of court proceeding (known as a “guardianship” in Illinois) will be required for making material and long-lasting medical decisions on your behalf. Please note that relying on state default rules for incapacity will probably be time consuming and expensive.
When it comes to money, someone will almost certainly need a court proceeding to make financial decisions and pay bills on your behalf during your incapacity. As you might imagine, involving money has a tendency to increase the contested nature of a court proceeding. This is fine with me as a lawyer: It helps in my efforts to accumulate my own F-You Money. It’s not so good for your efforts.
2. Beneficiary/POD/TOD Planning.
A convenient and mostly free way to reduce some of the potential problems, costs and uncertainty of having no plan is to plan by use of beneficiary designations, pay-on-death (POD) designations and transfer-on-death (TOD) designations. Making an account automatically pay to someone upon your death is as easy as completing a form provided by your bank, insurance company or other financial institution. In some states (http://www.nolo.com/legal-encyclopedia/free-books/avoid-probate-book/chapter5-1.html), you can even name transfer-on-death beneficiaries with respect to certain types of real estate and even vehicles (http://www.nolo.com/legal-encyclopedia/naming-tod-beneficiary.html).
There are some benefits to this type of planning. Being cheap and relatively easy is certainly a nice benefit. Planning this way will also help you to avoid probate provided your beneficiaries outlive you. Assets transferring in this fashion will generally not be subject to the claims of your creditors at death. Also a very nice benefit.
Planning this way isn’t all sunshine and rainbows though. First, this works for many mainstream assets like bank accounts, investment accounts, retirement accounts and life insurance. It does not work so well for assets like small business/partnership interests, most personal property, and real estate in many states/instances. This type of plan probably does not work well for parents with ankle-biters as they may receive their “inheritance” at the age of majority in your state. Please note that to the extent you have (or later create) a Will, your POD/TOD/Beneficiary designations will take precedence over anything you say in that Will.
Also, you must be very careful about your financial institution’s default rules for what happens if a beneficiary (perhaps one of your children) does not survive you. Does your institution pay to the surviving beneficiary or do they pay to the deceased beneficiary’s descendants? If you plan this way, you must review the plan if a beneficiary dies before you.
A significant problem with this type of planning is that it does not deal with your incapacity. If you become incapacitated while using this planning method you are stuck with the default (i.e. guardianship) rules we already covered.
For those of you with an estate large enough to trigger federal or state estate tax, this type of planning will do nothing to reduce that burden on your beneficiaries.
3. Joint Ownership (with right of survivorship).
Owning assets jointly with someone else is another way to informally plan an estate. Many of you probably already engage in this sort of planning by owning assets jointly with your spouse. For jointly owned accounts, the death of one owner will automatically make the other person the sole owner – the Last Will and Testament of the first to die is irrelevant as to jointly owned assets. Further, incapacity of one joint owner will allow the other joint owner to have full access. Planning this way works well for real estate, financial institution accounts (except qualified accounts like IRA’s and 401k’s), and many forms of personal property.
While this works well for married couples, most people are reluctant to name their children as joint owners of their property (privacy and being subject to their children’s creditors are big reasons). As a result, the death of the second joint owner will result in probate unless other steps are taken. If you have an estate tax problem, planning this way may not be your best bet. Of course, this planning method needs to be combined with something more to deal with incapacity of both owners or the surviving owner.
Formal Estate Planning
While informal planning may work in some cases, it comes with gaps that need to be filled. That’s where formal estate planning comes in. Every plan should consist of a minimum set of documents**. Here they are and what they do (at a very basic level):
A. Last Will and Testament.
Although a Will can accomplish many tasks, the primary one is to direct the disposition of your assets at your death. For parents with underage children, Wills can often be used to designate who will raise your children and how/when their inheritance will be distributed. The issue of guardianship for minors is probably the most common reason I see for people making their first estate plan.
Although a Will is an essential component of every formal estate plan, it not the most effective tool for dealing with two of the other very common reasons people make a plan – probate avoidance and estate tax reduction/elimination. Since the term “probate” is such a big concern for many people, let’s take a minute to discuss what it is and why a Will can’t help you avoid it.
Probate is the process of validating your Will at your death, ensuring your valid debts and expenses are paid and distributing your net estate in the manner you direct (with limitations). While many people believe having a Will avoids the probate process, quite the opposite is true. In order for your Will to be validated, it must be filed in court and a judge must say it meets all the technical requirements in your state – an essential element of the probate process. If it fails to meet those requirements, your Will is invalid and your estate will be administered in accordance with the state default rules mentioned above.
There are many reasons people don’t want their estates to go through probate. The three most common are: 1. the probate process is very public – your Will, heirs, asset information, etc. are all open to inspection by anyone who wants to look; 2. the probate process takes a relatively long time to complete (varies by state) which tends to tie up your assets; and 3. the probate process can be expensive. If you want to know more about probate, this should get you started: http://legal-dictionary.thefreedictionary.com/probate
You should note that only those assets owned by you in your individual name are subject to probate. Anything with a beneficiary, TOD/POD or jointly owned (with right of survivorship) will bypass the probate process. Further, small estates may not need to be probated. The definition of a small estate varies across the country – see here to check your state’s rules. (http://www.nolo.com/legal-encyclopedia/free-books/avoid-probate-book/chapter8-2.html)
B. Power of Attorney for Healthcare.
This document is primarily designed to appoint an agent to make medical decisions on your behalf if you are incapacitated. Without this document, a court proceeding will typically be required to give someone the legal authority to act on your behalf. This document typically begins upon signing and terminates at your death. If your state requires certain language to be “durable” (i.e. survives your incapacity), you must make sure that language is incorporated.
C. Power of Attorney for Property.
This document allows an agent to manage your business and financial affairs. As with the healthcare power of attorney, failing to have this document will likely result in a court proceeding to allow someone to pay your bills, manage investments, and do all things asset related. Your agent’s powers typically begin upon signing and end at your death. If you are uncomfortable giving your agent that level of immediate power, you may want to consider making the document effective upon the happening of some future event (e.g. your incapacity). Again, don’t forget to include durability language if required by your state.
D. Living Will.
Although included in the basic set of documents list, this document is considered optional to many people. The document is designed to deal with the specific issue of end-of-life care (e.g. life support machines). If your healthcare power of attorney is broad enough to adequately cover life support machines and end-of-life care, you can consider skipping this document. However, if you would like to give your agent and family specific instructions for end-of-life care a living will should be considered. If you aren’t sure whether to include it, do a little research on living wills in your state. Here is Illinois’ form document to give you a flavor for what one says. http://www.state.il.us/aging/1news_pubs/publications/poa_will.pdf
As mentioned, using a Will as your primary post-death planning tool will leave a couple significant gaps – requiring probate and failing to efficiently deal with estate tax. If these issues are a concern for you, the following additional document should be considered:
E. Revocable Living Trust.
A revocable living trust is a document you create during your lifetime to hold your assets. You are typically the trustee of the trust during your lifetime which ensures that you maintain full control of the trust assets. If properly used, this document will become the primary vehicle to manage your assets both during your lifetime (even during incapacity) and at your death. Once an asset is transferred to your trust, you technically no longer own it. Instead, your trust owns the asset and you are merely the trustee. This is the reason any assets transferred to your trust avoid probate – remember, only assets you own in your individual name at death are subject to probate. If you own real estate in multiple states, a trust is a great way to avoid having to probate your estate in each jurisdiction.
If you are married, a properly prepared estate plan using trusts can reduce and often eliminate the need for your heirs to pay estate tax. Before you prepare a plan to deal with estate tax issues, you must first determine if you have an estate tax problem – most people don’t. If your estate is less than $5,250,000 (2013 exemption amount which will adjust over time), no federal estate tax will be due at your death. If you are married, you can pass up to $10,500,000 to the next generation without triggering estate tax by filing the proper documents at the first spouse’s death. Please note, your “estate” consists of anything in which you had an ownership interest at the time of your death including jointly owned accounts, accounts where you’ve named a beneficiary, IRA’s, 401k’s, life insurance, etc. I bet life insurance surprised you. Although the benefits are generally not income taxable to the beneficiary, they are counted in your gross estate for estate tax purposes. For more detail, see here http://www.investopedia.com/ask/answers/09/life-insurance-tax.asp
Even if you don’t have a federal estate tax problem, you must also determine whether you have a state estate tax issue. Some states collect estate tax while others don’t. If your state collects the tax, the exemption amounts are going to be lower than the federal government. To see your state’s rules, start your research here http://wills.about.com/od/stateestatetaxes/qt/nostateestatetaxes.htm
A final note on estate tax . . . you can pass an unlimited amount to your spouse at death. If you are single with an estate above the state or federal exemption amounts, there are solutions but you’ll need to get more creative.
I suspect many of you are like me and enjoy doing things yourself – both for the joy of accomplishment and for the money savings. If you plan on doing your own estate plan be very careful. I have been practicing law for more than a decade – in the estate planning arena for most of that time. In that time, I have administered several DIY Wills. None of them accomplished what the testator intended. Many had fatal flaws leading to their outright rejection in court. All of them led to above-normal administration costs.
This biggest problem I have with DIY planning is that problems are often not discovered until it’s too late. It’s not like improperly fixing a leaking faucet. If you mess that up, you’ll know. You can always try again or call a professional. Estate planning documents are a bit different. You may not know there’s a problem. If there is a problem, you’re probably already dead or incapacitated and can’t fix it.
If you decide to write your own, please at least consider having them reviewed by a professional.
* Bonus points if you know who that is without looking it up.
** Special circumstances may require additional documents. Those circumstances and documents are beyond the scope of this post.
Note from jlc:
Prob8 practices law in Illinois. If you would like to talk to him about engaging his services, say so in the comments and I’ll connect you thru email.
My pal Darrow just put up an excellent post on this stuff, too. It is especially worth reading if you are considering doing this as a DIY project: Do it yourself Estate Planning.
Addendum 2: Curious as to what your taxes might look like in retirement? While everybody’s situation will vary, here are two excellent posts from my pal Jeremy detailing his own tax strategy as he travels the world as an early retiree: Never pay taxes again and his actual 2013 tax return.