The first sentence in this blog is necessary to mention that I’m not a lawyer. And this isn’t any type of legal advice. That said, much like tax planning, estate planning is one of those things that intersects with many of the different areas of financial planning. And it’s something that can directly affect other areas of the financial plan. We’re going to take a look at some of the common estate planning mistakes I see retirees make in my practice and some general advice on how to get your estate plan in order.

Key Takeaways

• Beneficiary designations override your Will. If they’re outdated, your Will won’t save you.
• A trust only works if it’s funded. Many aren’t.
• A complete estate plan is more than a Will. Powers of Attorney and healthcare directives matter just as much.
• Estate planning and tax planning are linked. Roth conversions and gifting can keep more of your money in the family.

Beneficiary Planning

The lowest hanging fruit in estate planning in my mind has to do with beneficiaries. Why? If you have a retirement account, you need to address beneficiaries. All retirement accounts are subject to certain rules within the tax code. Some of those rules are age based, which is why a retirement account can only be titled in one person’s name or tax ID number. A good example of one of those rules is Required Minimum Distributions (the rule about minimum distributions starting once you reach age 73). That exists so there is no deferral of growth in perpetuity.

When someone dies with a retirement account, who the beneficiary is depends on how those rules are applied. We’re not going to get sidetracked here reviewing all of the RMD rules as there is another blog for that. But what happens if you don’t have a beneficiary? The rules can change. As an example, a spouse can re-title the retirement account in their own name. This is beneficial as the RMDs will be based on their own life. A child can re-title the account into an Inherited IRA and have to take the funds out over 10 years. If there is no beneficiary, the retirement account may be payable to the estate, which causes the account to be paid out over 5 years (or the decedent’s remaining life expectancy if they had already started RMDs) at trust and estate tax rates!

That’s just one example of how “forgetting” to list a beneficiary can be punitive from a tax standpoint. Condensing the length of the payout along with the potential tax rate can be extremely punitive.

I also ask new clients I meet all the time if they have their estate planning complete. Many will let me know they just updated their Will, so they believe they are good to go. An issue with that is that beneficiary designations “trump” a Will. A Will is designed to instruct probate proceedings. But beneficiary designations allow financial assets to pass without going through probate. So if your beneficiary designations aren’t updated, but your Will is, your money may still go to the wrong place.

Trust Planning

A popular question I get is on having a “trust”. There are many good reasons to have a trust. The most popular type of trust our clients have is what is called a “Revocable Trust”. In the case of a revocable trust, you are the trust and the trust is you. It doesn’t have a tax number. I like to think of it as a giant beneficiary designation around any assets you’ve put into the trust. I should emphasize the last sentence because you actually have to put assets in the trust for it to work.

As we talked about above, beneficiary designations circumvent an asset from the probate process. Which is most people’s goal. Probate can be time consuming, there can be costs and fees, and it’s public. As an example, in Sussex County, Delaware the probate cost is 1.25% of the net estate. That’s $6,250 on a $500,000 estate, the approximate value of a home in the area. The last bit is in my experience the biggest reason people opt for beneficiary designations on many assets as well as the use of a revocable trust. To avoid the public process of a probate proceeding.

When you have assets in a revocable trust, any income, capital gains, and interest all pass through to your personal return. You can move money in and out of the trust, amend its terms, and really retain all the flexibility of the assets put into the trust. As such, there aren’t any protections or shielding assets from say, the Medicaid qualification process.

So if privacy and timely settlement of your financial assets via probate avoidance is your goal, a trust may be an appropriate tool. The same can be said if you have any specific bequests or limitations on financial assets. Say if you have children who you’d be uncomfortable leaving your $2,000,000 IRA to outright. A trust may be a better tool to have some oversight in how those funds are passed to that individual. It can be good protection for all involved.

The mistake I see the most often is the “funding” of the trust. An estate planning attorney will often draft a trust, provide a letter of instruction to the client, and then things can sit. Until someone like me finds out a trust actually exists, people automatically assume their assets are in it. That isn’t the case. If you want to put your “joint” brokerage account, or bank account, or vehicle inside the trust, those assets will need to be re-titled. That isn’t a huge deal, but it does need to be completed. Without it, the assets may still go through the probate process and the entire money you spent on the trust is for naught.

It’s Not Just About the Will

As I stated, a previous familiar refrain when I ask if someone’s estate plan is complete is that they have an updated Will. That is only one piece of the puzzle. While everyone needs a Will as a clean up for any assets without beneficiary designations or that make their way into probate, it is only one piece of the puzzle.

From an importance standpoint, a durable Power of Attorney and Advanced Medical Directive/Living Will hold equal levels of importance. One major concern for retirees as they age is cognitive decline. What happens if you’re unable to handle your own financial affairs?

A Durable Power of Attorney is a document appointing an agent to handle your financial affairs on your behalf. Great care should be taken in selecting this individual as they are often put into effect immediately, though some are drafted as “springing” and only take effect upon incapacity. Sometimes we’ll see clients re-title certain accounts jointly in the name of their children. I’m not going to say that is a mistake per se, but it involves other complications from a tax and gifting standpoint. Most importantly, it can mean the loss of a step-up in basis on a portion of the asset, losing significant tax benefits.

The word durable might seem curious to you if it’s your first time hearing of it. Durable means the Power of Attorney survives your incapacity. Most General Powers of Attorney will cease to hold their power upon the incapacity of the client. All Powers of Attorney cease power upon someone’s death.

An Advanced Healthcare Directive also appoints an agent to make healthcare decisions on your behalf. A Living Will helps the individual make those decisions following your preferences for extending life and so on. The biggest thing in obtaining these documents is doing so when you are of sound mind. So there is no question as to your wishes or capacity when making such decisions. This really applies to the entirety of the estate plan. However, with a Power of Attorney, questions can come up due to the significant powers granted for an agent to handle your financial affairs. It is often broad, as someone handling your financial affairs will need that to complete the duties adequately.

Integrating Tax Planning Today

As we previously stated with regard to beneficiary planning, there can be significant tax consequences when it pertains to estate planning decisions. We’ve written at length in previous blogs on optimizing tax planning during your lifetime. Another opportunity to do so is on the transition of assets.

The delta, or difference, between marginal and effective income tax rates can provide an opportunity to keep more money in your family. This is where I stick in the “My kids are lucky to be getting an inheritance” line that sometimes comes up. And optimizing the amount of assets for an inheritance isn’t necessarily everyone’s goal. And that’s OK. It’s an opportunity nonetheless.

First, upon the death of a spouse, tax brackets do compress as a spouse will suddenly be filing single instead of married filing jointly. However, the assets, and the Required Minimum Distributions, don’t get cut in half. So a “widow’s penalty” can occur, where retirement assets can be taxed at a higher effective marginal rate than previously when there were two spouses. The opportunity here can be to convert assets to a Roth IRA in anticipation of such a situation occurring. Statistically speaking, it’s likely one spouse will predecease the other.

The same “delta” can occur when financial assets are passed to children. As mentioned previously, retirement assets will need to be distributed over a 10 year period for most non-spouse beneficiaries. Those “Required Distributions” will be significantly larger and likely taxed at a higher rate given that the children will also have employment income that the decedent did not. All else being equal, in the love triangle with the government, more money goes to them and less in your family.

Partial Roth IRA conversions and accelerated gifting can be prudent tools to minimize the amount of income tax paid on the transition of these assets. Like many things in retirement tax planning, just continuing to defer into the future often results in the largest tax bill being paid. Though in fairness, it isn’t usually by the decedent.

In Summary

These are some of the “low hanging fruit” we discuss with clients when thinking about the basics of examining an estate plan. There are significant planning opportunities to make sure there aren’t gaps in your wishes being fulfilled, but also eliminating unnecessary costs and frictions as assets pass from one generation to the next.

If you’d like a second set of eyes on how your estate plan fits with your overall retirement and tax picture, we’d be happy to take a look as part of a free retirement review.