Top Mistakes in Estate Planning: Part I - The Basics
Let’s keep it simple. The most deleterious and shockingly common estate planning mistake is a lack thereof. Seemingly obvious, but nonetheless a dire mistake. Probate is a harsh, costly, and time-consuming process, and happens to come at a time when no one wants to deal with it—immediately after the death of a loved one. Estate taxes that could have been avoided are also a sad burden for the estate to carry, where the oftentimes court-appointed family member that acts as personal representative for the estate has to watch a large chunk of his or her inheritance go to the government.
Perhaps the next most common mistake is exceedingly saddening—having an estate plan paid for, drafted, and handed to you, but not implementing it. Whether that means leaving a will unsigned, or not funding a trust after signing and notarizing the actual trust document, not implementing an estate plan is just as bad as not having one; perhaps even worse, as more often than not you pay a great deal to have the estate plan specifically designed for your particular circumstances.
Take Michael Jackson’s case for example. Ten years after the singer’s death, his estate may be stuck in court for years, all because he failed to fund his trust. An attorney can draft all the perfectly worded and subtly crafted documents in the world, but if you do not actually follow through with your attorney’s instructions, then you might as well use your trust as an uber expensive kindling.
Had it been properly funded, Michael Jackson’s trust would have helped his family members avoid the probate process altogether and allowed for the efficient distribution of hundreds of millions of dollars in assets. Unfortunately, Jackson never transferred the title to his assets over to the trust—a process known as funding a trust. This oversight in failing to fund the trust prevented the instrument from operating entirely, outside of giving the probate court an idea of how he wanted his assets distributed, though in a non-legally binding way. Ten years later, Jackson’s family members, creditors, and the IRS continue to battle over his estate assets in probate.
Both within and outside of proper estate planning, failing to name beneficiaries is another one of the most common and easy to fix planning mistakes. Without any separate legal documents, most bank and investment accounts, as well as insurance policies and certain other assets, can be transferred to others without having to probate the assets through what is known as a beneficiary designation. This designation allows an account holder, for instance, to specify the person or persons to whom the account assets should be distributed in the case of the account holder’s death. The institution at which the assets are held would distribute the assets to the designated beneficiaries upon notification of the account holder’s passing.
Even where beneficiaries have been designated within estate planning, i.e., within a formal trust document or will, a common mistake is the failure to update the beneficiaries. All sorts of major life events can happen after an estate plan is put in place—people have kids, get married, pass away—and they may all effect how you want your assets to be distributed, as well as to whom. Failing to update beneficiaries could mean a younger child gets left out of the picture altogether, or an ex-wife somehow ends up with assets because an estate plan was created during a marriage that ended in divorce.
Another one of the most commonly overlooked tax planning strategies involves one of the oldest and oft heard pieces of tax planning advice, taught in basic business law classes in college—to make use of the annual gift tax exclusion. An individual can currently gift, tax-free, up to $15,000 every year per donee. That means that you can gift $15,000 to as many people as you want every single year without paying any gift tax. On top of that, the annual gift tax exclusion does not eat away at the ever-increasing unified credit amount, currently set to a whopping $11.4 million for a single taxpayer, though due to expire in 2025.
Separately related to the unified credit is a tax planning mistake that is potentially one of the most financially devastating. This blunder involves failing to take advantage of the step-up in basis for inheritances. The way this step-up works is to give property transferred at death a step-up in basis, or cost for tax purposes, to the market value of the property at the time of the transfer. This treatment is different from that provided to property transferred during your lifetime, which receives a carryover basis, meaning the donor’s original basis is carried over to the recipient. The step-up eliminates the heir’s capital gains tax liability on any increase in the asset’s value that occurred during the deceased individual’s lifetime.
This so-called step up allows you to transfer assets to your loved ones when you pass away and provide them with entirely tax-free treatment on potentially millions in income. For instance, say you and your spouse hold assets with a tax basis that is significantly lower than the assets’ current market value. For our purposes, you might have real estate that you purchased for $100,000 in 1960 that is now worth $22.8 million. With proper planning that would allow one spouse to take advantage of the other spouse’s unified tax credit, you can make use of all $22.8 million of the credit to get a basis step up of $22.7 million. When you pass away, if that real estate is inherited by your only son by will or through a probate proceeding, your son will receive the asset and take a tax basis in the asset of the current market value of $22.8 million. All $22.7 million of capital gain can be through proper estate planning and implementation.
As you can see, estate planning mistakes range from those that are quite trivial to some that are more complicated to understand and implement. With the proper advice and follow through, an estate plan can be structured to provide for a myriad of benefits to your loved ones when you pass away. Our next article will take a look at the slightly more intricate world of international estate planning, as it relates to both non-U.S. taxpayers and non-U.S. taxpayers that plan to become U.S. tax residents.