15 PRESERVING YOUR ESTATE Keeping It All in the Family Learning Objectives Upon reading this chapter, students should: Be able to begin planning the key elements of your estate plan. Know how to prepare to draw up, with an attorney’s help, a valid will to benefit your heirs. Understand and estimate the size of your estate and the taxes that would be owed upon your death. Recognize how to choose trusts, gifts, and charitable contributions to minimize estate taxes. Chapter Summary Estate planning is the process of planning for the distribution of your assets and the care of your dependents after your death. Your estate is your net worth at the time of your death, less the payment of any debts and funeral payments. The legal process of settling your estate—paying your debts and distributing your assets according to your wishes—is called probate. One of the purposes of planning for the distribution of your estate is to avoid probate and other potential problems. For example, if you fail to adequately plan your estate could be subject to additional federal and state estate taxes and additional probate costs. In addition, your heirs could incur significant personal costs, disagreement over the disbursement of funds and distress over funeral arrangements. Estate planning should be done on a regular basis and reevaluated as an individual’s life cycle changes. Although estate plans can be very different from one another, most share certain key components. These may include a will, a living will, a letter of last instruction, and any trust instruments deemed necessary. A will is a legal document that specifies how you want your property to be distributed upon your death. A person or entity designated to receive something from your estate after your death is called your heir. A durable power of attorney is similar to a living will but should be used in conjunction with one. In it, you designate a person to make decisions on your behalf in case you are temporarily or permanently unable to do so. A trust is a legal entity that holds and manages assets on behalf of someone else. Trusts are commonly used in estate planning for a variety of purposes. A will enables the person writing it, the testator, to direct the disposition of his or her assets to specific beneficiaries, those who will receive the assets. Wills can be very simple or very complicated but must satisfy certain legal requirements to be valid. The will must name an executor, and should in all cases name a standby executor in the event of the death of the other person. After a will has been executed someone may decide to change the provisions of the will. These changes are executed by completing a document known as a codicil. Assets can be owned in various ways. When two people own property in a joint tenancy with right of survivorship, the ownership of the property automatically passes to the surviving owner upon the death of the other without going through probate. The property will also be free of claims from creditors, other heirs, or executors. In some states, tenancy by the entirety, the same as joint tenancy with right of survivorship, allows the property to pass outside of probate, normally going to the surviving spouse. These are the most common forms of ownership, but they do come with several disadvantages. For example, you lose complete control over the property after you die and you lose the ability to have the property pass to a trust. An alternative to this form of ownership is tenancy in common. In this ownership scheme, each tenant retains the right to transfer his or her ownership interest independently. An individual’s portion of their property can pass by will. Some states also are community property states whereby any property acquired during the marriage is community property. Under federal law, you may be subject to a tax on gifts if they exceed a certain amount. Currently, you and your spouse can give $12,000 per person per year tax free. Any amount in excess of this requires filing certain forms and paying taxes. Under current estate tax law, the amount of your estate that exceeds the allowed exclusions may be taxed around 47%. It is due to be repealed in 2010, but will be reinstated in 2011 if Congress does not pass any additional laws. To estimate the amount of your estate that could be subject to estate tax at your death you can use the following steps: calculate your gross estate, calculate your adjusted gross estate and calculate your taxable estate. The best way to understand these calculations is to use the sample calculation provided in the text. However, the larger an individual’s taxable estate is the more likely their heirs are going to have to pay estate tax. There are two general ways to reduce the size of your taxable estate: first you can move money into legal vehicles called trusts and you can give away your assets before you die as gifts. A trust is a legal entity that holds and manages assets on behalf of someone else. The grantor, the person putting aside the assets in the trust, transfers the assets to the trust. Trusts are used to bypass probate, to remove property from the taxable estate and to ensure the estate achieves the grantor’s intent. If the primary purpose of the trust is to avoid estate taxes than you have to set up an irrevocable trust. This means you cannot change the terms of the trust once it has been established. Under a revocable trust, the grantor retains the right to change the trust. A grantor may also establish a trust while they are living known as an inter-vivos trust or one established through the terms of the will known as a testamentary trust. Some common types of living trusts are to establish a revocable trust that becomes irrevocable upon your death. This type of arrangement does not reduce taxes, but does avoid probate. An individual could also execute a pourover will. This is a legal document simply stating that any of your assets which have not been transferred to your trust, should do so at your death. There are also two important types of testamentary trusts that may be created known as a standard family trust and a qualified terminable interest property trust. Key Terms Beneficiaries The individuals or entities receiving a distribution under the terms of a will. Capacity The mental competence to make a will, including understanding the nature and content of the document and not acting under threat or coercion from anyone. Codicil A legal amendment to a will. Community property A property law in some states by which any property acquired during a marriage is considered to be jointly owned by both spouses. Durable power of attorney A legal document in which a person designates another to make decisions on his or her behalf if incapacity. Escheat The legal process by which the state government acquires the estate of a person who dies without a will and has no living relatives. Estate A person’s net worth at death. Estate planning The development of a plan for what will happen to your wealth and dependents when you die. Executor/executrix A person designated to carry out the provisions of a will. Grantor A person or entity who legally passes ownership to another person or entity. Heir Person or entity designated to receive something from your estate after your death. Intestate Without a valid will. Estate planning is the most neglected component of financial plans. Irrevocable trust A trust that the grantor cannot revoke; it is not subject to probate or estate taxes. Joint tenancy with right of survivorship A form of property ownership in which, after the death of one owner, the property passes to the surviving owner without going through probate. Letter of last instruction A nonbinding document that provides helpful information to survivors after the writer’s death. Living trust A trust established during the grantor’s lifetime. Living will A legal document that specifies a person’s preferences as to medical care in the event that he or she becomes unable to make decisions because of illness or disability. Pourover will A will that leaves a person’s remaining assets to a trust. Probate The legal process of settling an estate. Qualified terminable interest property (Q-TIP) trust A trust for married couples in which the grantor retains control over the ultimate beneficiaries of the estate. Revocable trust A trust whose terms the grantor can change during his or her lifetime; it bypasses probate but is still subject to estate taxes. Standard family trust A trust for married couples designed to avoid estate taxes on the estate of the surviving spouse. Tenancy in common A type of ownership in which each person owns his or her share independently and retains the right to transfer that share by sale or will. Testamentary trust A trust established by the terms of a will. Testator The writer of a will. Trust A legal entity that holds and manages assets on behalf of someone else. Trustee A person or entity who manages assets on behalf of another. Will A legal document that transfers property upon the death of the property owner. Lecture Notes 1. This chapter is extremely difficult because it is filled with a tremendous amount of legal terminology. One useful lecture tool would be to obtain a sample will from an online site and go through the document with students using the terms in the chapter. Samples can be obtained from the website www.findlaw.com. After going through some the basic definitions with the students ask them some of the following questions: What happens if someone wants to make a change to their will? Do they need to execute a new will? What happens if a will is not properly executed? 2. Using a legal database at your school, or through Lexis One which is available online free of charge find a case relating to wills. Give students the case to read and ask them to discuss the case in relation to the chapter. Using a true factual scenario will assist the students in relating to the terms in the chapter. 3. Students may have difficulty understanding the concept of estate taxes. Using the worksheet in the Personal Financial Planner, the calculation could be done in class with students to assist them in understanding, each of the relevant values in addition to the impact the calculation will have on determining the portion of an estate which is taxable. Suggestions for Learning Activities 1. Invite an elder law attorney to the class to speak with the students. 2. Invite an employee from the trust section of a bank to discuss trusts in more detail with the students. 3. Invite an accountant to the class to discuss federal and state estate taxes and the impact they have on the value of someone’s estate. 4. Give students the task of interviewing at least three people. Ask the students to elicit the following information from the people they interview: a. Do you have a will? b. Do you have a durable power of attorney? c. Do you have a living will? d. Do you have a health care proxy? e. If you do not have any of these documents, when will you execute them? After the students have completed their interviews, ask them to compare the results in groups. Ask each group to prepare a table and analyze the data. How many people had wills? How many thought about doing a will? At the conclusion of the exercise, ask the students to discuss some of the implications of not having a will. 5. Ask students to write a one page essay on why people do not engage in estate planning. The information for the essay can come from personal interviews or articles they find through conducting research. Suggestions for Additional Resources 1. www.findlaw.com 2. www.lexisone.com 3. www.lexisnexis.com 4. www.westlaw.com 5. www.forbes.com/finance/taxesestates 6. http://www.nolo.com/resource.cfm/catID/FD1795A9-8049-422C-9087838F86A2BC2B/309/ 7. http://www.estateplanning.com/ 8. http://www.aarp.org/money/financial_planning/ 9. State Bar Association for the state in which you are located Answers to Self-check Questions 15.1 1. Define estate and estate planning. Estate: A person’s net worth at death. Estate planning: The development of a plan for what will happen to your wealth and dependents when you die. 2. What’s the purpose of estate planning? To have control over your assets and guardianship, reduce family discord over your assets, and minimize costs of settling your estate. 3. List three potential financial costs of not planning. Federal estate taxes, state inheritance taxes, probate costs. 15.2 1. What document designates somebody to make financial decisions on your behalf. Power of attorney. 2. What should be included in a living will? Your decisions about what medical care you wish to receive if you are incapacitated. 3. Define intestate, trust, and letter of last instruction. Intestate: Without a valid will. Trust: A legal entity that holds and manages assets on behalf of someone else. Letter of last instruction: A nonbinding document that provides helpful information to survivors after the writer’s death. 15.3 1.Define testator, beneficiaries, execution, and codicil. Testator: the writer of a will Beneficiaries: The individuals or entities receiving a distribution under the terms of a will. Execution: carrying out the provisions of a will Codicil: A legal amendment to a will. 2. List five requirements for a valid will. You must be of legal age (usually 18). You must have the mental capacity to make a will: You must understand the nature and extent of your assets. You must understand whom you intend your assets to be distributed to. You must understand how you are distributing your assets. You must intend for the document to be your will. The will must be in writing and, with some limited exceptions, typed or printed. The will must be dated. The will must be signed in the presence of two witnesses who are not your relatives or named beneficiaries in the will. The will must name an executor. 3. Name three types of ownership of property. Joint tenancy with right of survivorship, tenancy in common, community property. 15.4 1.What is the lifetime limit on tax-free gifts? $1 million. 2. List three exceptions to the limit on gifts. Gifting your spouse, gifts for the payment of medical expenses, gifts for educational costs. 3. Give the three steps used to calculate your taxable estate. Start with your adjusted gross estate, subtract marital and charitable bequests, and add any taxable gifts. Your spouse can inherit an unlimited estate without being taxed; the deduction for charitable giving is also unlimited. You may also need to make adjustments for gifts made during your lifetime that exceeded the allowed exclusion, as discussed. Thus, if you gave more than $12,000 per year to someone or if you’ve exceeded the $1 million lifetime exclusion, you add the excess to your taxable estate. Finally, you subtract the applicable exemption amount. The amount you end up with—the remainder of your estate—will be taxed if the total exceeds the allowed exemption amount for that year. Although prior law allowed a tax credit for state estate taxes paid, this credit was repealed as of 2005. 15.5 1. List two ways to reduce your taxable estate. Setting up a trust, and giving away your assets. 2. Define grantor, Q-TIP trust, and testamentary trust. Grantor: A person or an entity who legally passes ownership to another person or entity. Q-TIP trust: A trust for married couples in which the grantor retains control over the ultimate beneficiaries of the estate. Stands for qualified terminable interest property trust. Testamentary trust: A trust established by the terms of a will. 3. Which type of trust can be changed during your lifetime? Revocable trust. Answers to Summary Questions 1. The process of developing a plan for what will happen to your wealth and dependents when you die is known as probate planning. True or false? 2. The legal process of settling an estate is known as: a.liquidation. b.trust management. c.a will. d.probate 3. If you die without a valid will, this is known as: a.contested. b.intestate. c.escheat. d.interred. 4.A legal document that designates another to make decisions on your behalf in the event of incapacity is a: a.living will. b.trust. c.durable power of attorney. d.escheating. 5. A person designated to carry out the provisions of a will is called: a.a guardian. b.an executor. c.a trustee. d.a beneficiary. 6.The major purpose of having witnesses sign the will is: a.to make sure there is no case of forgery. b.to make sure the testator is actually who he says he is. c.to make sure the testator had the capacity to make the will. d.to make sure the distribution of assets is done fairly. 7. Under 2007 tax law, you and your spouse can give up to $10,000 per person per year tax-free with no limits on the number of people you gift. True or false? 8. Which of the following is the formula for adjusted gross estate? a.gross estate - marital and charitable bequests + taxable gifts. b.gross estate - funeral costs and marital and charitable bequests. c.gross estate - funeral costs and settlement expenses. d.gross estate - marital and charitable bequests. 9. If your primary purpose in setting up a trust is to reduce estate taxes, then you should set up: a.a revocable trust. b.an irrevocable trust. c.a living trust. d.a testamentary trust. 10.A trust that is established by a will is called: a.a revocable trust. b.an irrevocable trust. c.an inter vivos trust. d.a testamentary trust. Answers to “Applying this Chapter” Questions 1. For a single college student, age 20, with negative net worth, identify estate-planning goals that would be appropriate. What about a 30-year-old married couple with 2 children and $150,000 net worth? No estate planning goals at this life cycle stage. The student is just trying to finish college without too much debt. Provide for children’s guardianship and support until age 18 (or older); Plan for college funding; Provide for spouse’s well-being for a few years after death, at least until youngest child goes to school and spouse can work full-time; Possibly fund education for spouse; Replace home services provided by non-working spouse; Have valid wills in place. 2. Eva is about to take a trip away from her family, and she’s concerned that she doesn’t have a will. Because she left the task of writing one to the last minute, she doesn’t have time to consult an attorney. So she decides to write up a simple will on her own and take care of the details when she returns from her trip. After writing her will and signing it, Eva gets two of her neighbors to witness it. Her will is as follows: I, Eva Malone, being of sound mind, declare this to be my last will. I give all that I have to my beloved husband James Malone. I nominate my daughter Katie Malone to be the Executrix of my estate, because she is the only one in the family with any sense. _______________________ Eva Malone Do you think Eva’s will is valid? Why or why not? Eva’s will doesn’t meet the requirements for a valid will because she didn’t date it and she didn’t sign it in front of witnesses. 3. Your adjusted gross estate is worth $5 million. If you leave everything to your husband, will any estate taxes be payable at your death in 2007? No estate taxes are due because a wife can leave as much as she wants to her husband. 4. You’d like to leave all your wealth to your grandchildren when you die, but you want to be sure that you and your wife will have enough to live on in the meantime. What type of trust could you use to accomplish this? Establish a Q-TIP trust to help you and your spouse use the assets and income while you’re alive. When you both die, the trust’s remaining assets go to the beneficiaries, your grandchildren. 5. You have a portfolio of bonds that generate substantial income annually. You’ve heard that your alma mater is having some current cash flow problems. How can you help out your alma mater but still leave all your assets to your children when you die? Does this strategy offer any current tax advantages to you? Use a charitable trust. The charity will receive the trust’s income during your lifetime. When you die, your beneficiaries will receive the trust’s assets. You’ll get a current tax deduction for the income stream. 6. Which estate planning tool would you use to ensure that your daughter ends up with the family china (instead of your sister who lives closer and will likely clean out your belongings after you die)? Specific bequest in a will 7. Which estate planning tool would you use to ensure that you aren’t kept alive by artificial means when there’s no chance of your recovery from a terminal illness? Living will or durable power of attorney 8. Which estate planning tool would you use to provide for your children’s college education after you die? Testamentary trust Answers to “You Try It!” Questions Where There’s a Will There’s a Way Mina is a successful entrepreneur. She started a small bakery when she graduated from college and has turned it into a multi-million-dollar business. Mina is divorced and has had sole custody of her daughter Naitra, age 10, since her ex-husband left them six years ago. He provides no financial support for Naitra. Mina has spent a great deal of time running her business—so much that she has sometimes neglected her financial plan. Recently, though, she consulted a financial planner, who was adamant that she immediately take care of a few very important elements of her financial plan. First and foremost, he wants her to make a will right away. Mina and her ex-husband had made wills many years ago, but they predated Naitra’s birth. In her old will, Mina left all her wealth to her husband. Mina’s current assets are as follows: Equity in family home $100,000 Business assets $250,000 Retirement account $200,000 Other investments $50,000 Total net worth $600,000 In the event of her death, Mina would want her sister Janna to be Naitra’s guardian. Janna is aware of Mina’s wish and has agreed to act in this capacity. Mina’s brother Sanjay was named as the executor in her prior will and will probably be willing to continue in that role. 1. Does Mina need a will? What would happen if she died today (before drafting a new will)? Yes. She needs a will. If she dies before a new will is written, her ex-husband could inherit. Note that in some states, the divorce would nullify the previous will, but Mina’s estate would be treated as if she had died intestate. In either case, the guardianship of her daughter is uncertain. 2. What features should Mina incorporate in her will? Naming Janna as Naitra’s guardian and a contingent guardian; Naming Sanjay as the executor for the will and specifying the payment he will receive; Designating Naitra as beneficiary of the will, perhaps putting the assets in trust for her care until she reaches the age of 18 (or older). 3. Does she need to include a trust in her will? Why or why not? Since her estate is less than the unified exemption, a trust isn’t needed at this time. However, if her assets continue to grow, she should reconsider this decision at a later date. She could name Naitra as the beneficiary of the trust and she can also hold some of her assets jointly with her daughter. 4. If Mina names Janna as Naitra’s guardian but Janna dies before she does, who will end up being guardian? This is the reason that Mina needs to name a contingent guardian. If Janna has since died, the guardianship will be decided by the courts. 5. What duties will Sanjay have to perform as executor of the estate? The executor will: document and value all of Mina’s assets and liabilities, pay off all debts that have verified claims, file income and estate tax forms and pay all taxes owed, manage any assets in Mina’s estate until they are completely distributed. This could take up to 8 years (until Naitra is 18). If all assets are placed in a trust, then the trustee would manage the assets.