Everything You Need to Know About Estate Planning

• Why Plan Your Estate?
• Your Durable Power of Attorney
• Your Will
• Your Medical Directive
• Trusts
• Capacity Requirements
• Estate Taxation
• Estate Administration
• Guardianship and Conservatorship

Why Plan Your Estate?

The knowledge that we will eventually die is one of the things that seems to distinguish humans from other living beings. At the same time, no one likes to dwell on the prospect of their own death. But if you postpone planning for your demise until it is too late, you run the risk that your intended beneficiaries – those you love the most – may not receive what you would want them to receive whether due to extra administration costs, unnecessary taxes or squabbling among your heirs.

This is why estate planning is so important, no matter how small your estate may be. It allows you, while you are still living, to ensure that your property will go to the people you want, in the way you want, and when you want. It permits you to save as much as possible on taxes, court costs and attorneys' fees; and it affords the comfort that your loved ones can mourn your loss without being simultaneously burdened with unnecessary red tape and financial confusion.

All estate plans should include, at minimum, two important estate planning instruments: a durable power of attorney and a will.

The first is for managing your property during your life, in case you are ever unable to do so yourself. The second is for the management and distribution of your property after death. In addition, more and more, Americans also are using revocable (or "living") trusts to avoid probate and to manage their estates both during their lives and after they're gone.

TOP

Your Durable Power of Attorney

For most people, the durable power of attorney is the most important estate planning instrument available – even more useful than a will. A power of attorney allows a person you appoint – your "attorney-in-fact" – to act in your place for financial purposes when and if you ever become incapacitated.

In that case, the person you choose will be able to step in and take care of your financial affairs. Without a durable power of attorney, no one can represent you unless a court appoints a conservator or guardian. That court process takes time, costs money, and the judge may not choose the person you would prefer. In addition, under a guardianship or conservatorship, your representative may have to seek court permission to take planning steps that they could implement immediately under a simple durable power of attorney.

A power of attorney may be limited or general. A limited power of attorney may give someone the right to sign a deed to property on a day when you are out of town. Or it may allow someone to sign checks for you. A general power is comprehensive and gives your attorney-in-fact all the powers and rights that you have yourself.

A power of attorney may also be either current or "springing." Most powers of attorney take effect immediately upon their execution, even if the understanding is that they will not be used until and unless the grantor becomes incapacitated. However, the document can also be written so that it does not become effective until such incapacity occurs. In such cases, it is very important that the standard for determining incapacity and triggering the power of attorney be clearly laid out in the document itself.

However, attorneys report that their clients are experiencing increasing difficulty in getting banks or other financial institutions to recognize the authority of an agent under a durable power of attorney. A certain amount of caution on the part of financial institutions is understandable: When someone steps forward claiming to represent the account holder, the financial institution wants to verify that the attorney-in-fact indeed has the authority to act for the principal. Still, some institutions go overboard: for example requiring that the attorney-in-fact indemnify them against any loss.

Many banks or other financial institutions have their own standard power of attorney forms. To avoid problems, you may want to execute such forms offered by the institutions with which you have accounts. In addition, many attorneys counsel their clients to create living trusts in part to avoid this sort of problem with powers of attorney.

While you should seriously consider executing a durable power of attorney, if you do not have someone you trust to appoint, it may be more appropriate to have the probate court look over the shoulder of the person who is handling your affairs through a guardianship or conservatorship. In that case, you may execute a limited durable power of attorney, simply nominating the person you want to serve as your conservator or guardian. Most states require the court to respect your nomination "except for good cause or disqualification."

TOP

Your Will

Your will is a legally binding statement directing who will receive your property at your death. It also appoints a legal representative to carry out your wishes. However, the will covers only probate property. Many types of property or forms of ownership pass outside of probate. Jointly owned property, property in trust, life insurance proceeds, and property with a named beneficiary, such as IRAs or 401(k) plans, all pass outside of probate.

Why Should You Have a Will?

Here are five reasons:

1. First, with a will you can direct where and to whom your estate (what you own) will go after your death. If you died intestate (without a will), your estate would be distributed according to your state's law. Such distribution may or may not accord with your wishes.
   
   Many people try to avoid probate and the need for a will by holding all of their property jointly with their children. This can work, but often people spend unnecessary effort trying to make sure all the joint accounts remain equally distributed among their children. These efforts can be defeated by a long-term illness of the parent or the death of a child. A will can be a much simpler means of effecting one's wishes about how assets should be distributed.
    
2. The second reason to have a will is to make the administration of your estate run smoothly. Often the probate process can be completed more quickly and at less expense to your estate if there is a will. With a clear expression of your wishes, there are unlikely to be any costly, time-consuming disputes over who gets what.
    
3. Third, only with a will can you choose the person to administer your estate and distribute it according to your instructions. This person is called your "executor" (or "executrix" if you appoint a woman) or "personal representative," depending on your state's statute. If you do not have a will naming him or her, the court will make the choice for you. Usually the court appoints the first person to ask for the post, whoever that may be.
    
4. Fourth, for larger estates, a well-planned will can help reduce estate taxes.
    
5. Fifth, and most important, through a will you can appoint who will take your place as guardian of your minor children should both you and their other parent both pass away.

Preparing a checklist will help you make decisions about what to put in your will. Bring it and any additional notes to your lawyer and they will be able to efficiently draft a will that meets your needs and desires. 

TOP

Your Medical Directive

Any complete estate plan should include a medical directive. This term may encompass a number of different documents, including a health care proxy, a durable power of attorney for health care, a living will, and medical instructions. The exact document or documents will depend on your state's laws and the choices you make.

Both a health care proxy and a durable power of attorney for health care designate someone you choose to make health care decisions for you if you are unable to do so yourself. A living will instructs your health care provider to withdraw life support if you are terminally ill or in a vegetative state. A broader medical directive may include the terms of a living will, but will also provide instructions if you are in a less severe state of health, but are still unable to direct your health care yourself.

For more information, review an article on Health Care Decisions.

TOP

Trusts

A trust is a legal arrangement through which one person (or an institution, such as a bank or law firm), called a "trustee," holds legal title to property for another person, called a "beneficiary."

The rules or instructions under which the trustee operates are set out in the trust instrument. Trusts have one set of beneficiaries during their lives and another set – often their children – who begin to benefit only after the first group has died. The first are often called "life beneficiaries" and the second "remaindermen." (Get more information on the duties of a trustee.)

Uses of Trusts

There can be several advantages to establishing a trust, depending on your situation. Best-known is the advantage of avoiding probate. In a trust that terminates with the death of the donor, any property in the trust prior to the donor's death passes immediately to the beneficiaries by the terms of the trust without requiring probate. This can save time and money for the beneficiaries.

Certain trusts can also result in tax advantages both for the donor and the beneficiary. These are often referred to as "credit shelter" or "life insurance" trusts. Other trusts may be used to protect property from creditors or to help the donor qualify for Medicaid.

Unlike wills, trusts are private documents and only those individuals with a direct interest in the trust need know of trust assets and distribution. Provided they are well drafted, another advantage of trusts is their continuing effectiveness even if the donor dies or becomes incapacitated.

Types of Trusts

Trusts fall into two basic categories: testamentary and inter vivos.

A testamentary trust is one created by your will, and it does not come into existence until you die. In contrast, an inter vivos trust starts during your lifetime. You create it now, and it exists during your life.

There are two kinds of inter vivos trusts: revocable and irrevocable.

Revocable Trusts

Revocable trusts are often referred to as "living" trusts. With a revocable trust, the donor maintains complete control over the trust and may amend, revoke, or terminate the trust at any time. This means that you, the donor, can take back the funds you put in the trust or change the trust's terms. Thus, the donor is able to reap the benefits of the trust arrangement while maintaining the ability to change the trust at any time prior to death.

Revocable trusts are generally used for the following purposes:

1. Asset management. They permit the named trustee to administer and invest the trust property for the benefit of one or more beneficiaries.
2. Probate avoidance. At the death of the person who created the trust, the "grantor" or "donor," the trust property passes to whoever is named in the trust. It does not come under the jurisdiction of the probate court, and its distribution need not be held up by the probate process. However, the property of a revocable trust will be included in the grantor's estate for tax purposes.
3. Tax planning. While the assets of a revocable trust will be included in the grantor's taxable estate, the trust can be drafted so that the assets will not be included in the estates of the beneficiaries, thus avoiding taxes when the beneficiaries die.

Irrevocable Trusts

An irrevocable trust cannot be changed or amended by the donor. Any property placed into the trust may only be distributed by the trustee as provided for in the trust document itself. For instance, the donor may set up a trust under which they will receive income earned on the trust property, but that bars access to the trust principal. This type of irrevocable trust is a popular tool for Medicaid planning.

Testamentary Trusts

As noted above, a testamentary trust is a trust created by a will. Such a trust has no power or effect until the will of the donor is probated.

Although a testamentary trust will not avoid the need for probate and will become a public document as it is a part of the will, it can be useful in accomplishing other estate planning goals. For instance, the testamentary trust can be used to reduce estate taxes on the death of a spouse or provide for the care of a disabled child.

Supplemental Needs Trusts

The purpose of a supplemental needs trust is to enable the donor to provide for the continuing care of a disabled spouse, child, relative or friend. The beneficiary of a well drafted supplemental needs trust will have access to the trust assets for purposes other than those provided by public benefits programs. In this way, the beneficiary will not lose eligibility for benefits such as Supplemental Security Income, Medicaid and low-income housing. A supplemental needs trust can be created by the donor during life or be part of a will.

Credit Shelter Trusts

Credit shelter trusts are a way to take full advantage of the estate tax exemption. The first $5.34 million (in 2014) of an estate are exempt from federal estate taxes, so theoretically a couple would have no estate tax if their estate is less than $10.68 million.

As explained in the section below on Estate Taxation, the law makes the estate tax exemption "portable" between spouses. This means that if the first spouse to die does not use all of their $5.34 million exemption, the estate of the surviving spouse may use it. However, if one spouse dies and leaves everything to the surviving spouse, the surviving spouse may have an estate that is greater than $5.34 million, plus whatever is left over from the deceased spouse's exemption, or an estate that is higher than the applicable threshold in their state (assuming the state has an estate or inheritance tax). When the surviving spouse dies, any part of the estate over that threshold will be subject to estate tax.

To avoid this problem, the spouses can create a credit shelter trust as part of their estate plan. When one spouse passes away, an amount up to the applicable exclusion threshold of that spouse's estate is put into a trust. The surviving spouse can receive income from the trust, but as long as they do not control the principal, the money will not be included in the surviving spouse's estate when they pass away.

TOP

Capacity Requirements

Proper execution of a legal instrument requires that the person signing have sufficient mental "capacity" to understand the implications of the document. While most people speak of legal "capacity" or "competence" as a rigid black line – either the person has it or doesn't – in fact it can be quite variable depending on the person's abilities and the function for which capacity is required.

One side of the capacity equation involves the client's abilities, which may change from day to day (or even during the day), depending on the course of the illness, fatigue, and the effects of medication. On the other side, greater understanding is required for some legal activities than for others. For instance, the capacity required for entering into a contract is higher than that required to execute a will.

The standard definition of capacity for wills has been aptly summed up by the Massachusetts Supreme Judicial Court:

Testamentary capacity requires ability on the part of the testator to understand and carry in mind, in a general way, the nature and situation of [their] property and [their] relations to those persons who would naturally have some claim to [their] remembrance. It requires freedom from delusion which is the effect of disease or weakness and which might influence the disposition of [their] property. And it requires ability at the time of execution of the alleged will to comprehend the nature of the act of making a will.

This is a relatively "low threshold," meaning that signing a will does not require a great deal of capacity. The fact that the next day the testator does not remember the will signing and is not sufficiently "with it" to execute a will then does not invalidate the will if they understood it when they signed it.

The standard of capacity with espect to durable powers of attorney varies from jurisdiction to jurisdiction. Some courts and practitioners argue that this threshold can be quite low. The client need only know that they trust the attorney-in-fact to manage their financial affairs. Others argue that since the attorney-in-fact generally has the right to enter into contracts on behalf of the principal, the principal should have capacity to enter into contracts as well. The threshold for entering into contracts is fairly high.

The standards for entering into a contract are different because the individual must know not only the nature of their property and the person with whom they are dealing, but also the broader context of the market in which they are agreeing to buy or sell services or property. In Farnum v. Silvano in 1989, the Massachusetts Appeals Court reversed the sale of a home by a 90-year-old woman suffering from organic brain disease. The sale was for half of the house's market value. The court contrasted competency to sell property with the capacity to make a will, the latter requiring only understanding at the time of executing the will:

Competency to enter into a contract presupposes something more than a transient surge of lucidity. It requires the ability to comprehend the nature and quality of the transaction, together with an understanding of what is "going on," but an ability to comprehend the nature and quality of the transaction, together with an understanding of its significance and consequences.

As a practical matter, in assessing a client's capacity to execute a legal document, attorneys generally ask the question, "Is anyone going to challenge this transaction?" If a client of questionable capacity executes a will giving their estate to their spouse, and then to their children if their spouse does not survive them, it's unlikely to be challenged. If, on the other hand, they execute a will giving their estate entirely to one daughter with nothing passing to their other children, the attorney must be more certain of being able to prove the client's capacity.

While the standards may seem clear, applying them to particular clients may be difficult. The fact that a client does not know the year or the name of the President may mean they do not have capacity to enter into a contract, but not necessarily that they can't execute a will or durable power of attorney. The determination mixes medical, psychological, and legal judgments. It must be made by the attorney (or a judge, in the case of guardianship and conservatorship determinations) based on information gleaned by the attorney in interactions with the client, from other sources such as family members and social workers, and, if necessary, from medical personnel. Doctors and psychiatrists cannot themselves make a determination as to whether an individual has capacity to undertake a legal commitment. But they can provide a professional evaluation of the person that will help an attorney make this decision.

Because you need a third party to assess capacity and because you need to be certain that the formal legal requirements are followed, it can be risky to prepare and execute legal documents on your own without representation by an attorney.

TOP

Estate Taxation

Ever since the estate tax was instituted in 1916, whatever an individual owns has been subject to the federal estate tax upon their death – until 2010, that is. The estates of those dying during that year were entirely free from federal taxation because Congress could not reach an agreement extending the federal estate tax in some form. An agreement was finally reached at the end of 2010 that cemented the federal estate tax rules for 2011 and 2012. If Congress fails to act before the end of 2012, the rules for 2013 will revert to the provisions prevailing in 2001. For 2011 and 2012, the tax rate on estates is 35 percent (see chart below).

That said, not all estates will be taxed. First, spouses can leave any amount of property to their spouses, if the spouses are U.S. citizens, free of federal estate tax. Second, the estate tax applies only to individual estates valued at more than $5.12 million ($10.24 million for couples) in 2012 (see chart). The federal government allows you this tax credit for gifts made during your life or for your estate upon your death. Third, gifts to charities are not taxed.

The heirs of those dying in 2010 will have a choice between applying the new rules for 2011 and 2012 or electing to be covered under the rules that applied in 2010 – no estate tax but only a limited step-up in the cost basis of inherited assets. (Get a more detailed explanation on step-up in basis and why it matters in estate planning.) The law for 2011 and 2012 also makes the estate tax exemption "portable" between spouses. This means that if the first spouse to die does not use all of their $5 million or $5.12 million exemption, the estate of the surviving spouse may use it. So, for example, John dies in 2011 and passes on $3 million. He has no taxable estate and his wife, Mary, can pass on $7 million (her own $5 million exclusion, plus her husband's unused $2 million exclusion) free of federal tax. (However, to take advantage of this Mary must make an "election" on John's estate tax return. Check with your attorney.)

The currently high federal estate tax exemption, coupled with the portability feature, might suggest that "credit shelter trusts" (also called AB trusts) and other forms of estate tax planning are needless for other than multi-millionaires. But there are still reasons for those of more modest means to do planning, and one of the main ones is state taxes.

Nearly half the states also have an estate or inheritance tax and in many cases the thresholds are far lower than the current federal one. Many states used to take advantage of what was known as a "sponge" tax, which ultimately didn't cost your estate. The way this worked was that the states took advantage of a provision in the federal estate tax law permitting a deduction for taxes paid to the state up to certain limits. The states simply took the full amount of what you were allowed to deduct off the federal taxes.

However, the allowable state deduction was phased out under the Bush tax cuts enacted in 2001, and it disappeared entirely in 2005. This means that many states are changing their estate tax laws to make up the difference, and more changes at the state level can be expected as state politicians react to the new federal estate tax landscape. These changes may call for a restructuring of your estate plan; check with your attorney.

Making Gifts: The $14,000 Rule

One simple way you can reduce estate taxes or shelter assets in order to achieve Medicaid eligibility is to give some or all of your estate to your children (or anyone else) during their lives in the form of gifts. Certain rules apply, however.

There is no actual limit on how much you may give during your lifetime. But if you give any individual more than $14,000 (in 2014), you must file a gift tax return reporting the gift to the IRS. Also, the amount above $14,000 will be counted against a $5.34 million lifetime tax exclusion for gifts. (This exclusion was $1 million for many years but was raised to $5 million in 2011 and $5.34 million in 2014.) Each dollar of gift above that threshold reduces the amount that can be transferred tax-free in your estate.

The $14,000 figure is an exclusion from the gift tax reporting requirement. You may give $14,000 to each of your children, their spouses, and your grandchildren (or to anyone else you choose) each year without reporting these gifts to the IRS.

In addition, if you're married, your spouse can duplicate these gifts. For example, a married couple with four children can give away up to $112,000 in 2014 with no gift tax implications. In addition, the gifts will not count as taxable income to your children (although the earnings on the gifts if they are invested will be taxed). For more on gifting, see Gifts to Grandchildren.

Charitable Gift Annuities

Another way to remove assets from an estate is to make a contribution to a charitable gift annuity, or CGA. A CGA enables you to transfer cash or marketable securities to a charitable organization or foundation in exchange for an income tax deduction and the organization's promise to make fixed annual payments to you (and to a second beneficiary, if you choose) for life. A portion of the income will be tax-free. Learn more about CGAs.

TOP

Estate Administration

Probate is the process by which a deceased person's property, known as the "estate," is passed to their heirs and legatees (people named in the will). The entire process, supervised by the probate court, usually takes about a year. However, substantial distributions from the estate can be made in the interim.

The emotional trauma brought on by the death of a close family member often is accompanied by bewilderment about the financial and legal steps the survivors must take. The spouse who passed away may have handled all of the couple's finances. Or perhaps a child must begin taking care of probating an estate about which they know little. And this task may come on top of commitments to family and work that can't be set aside. Finally, the estate itself may be in disarray or scattered among many accounts, which is not unusual with a generation that saw banks collapse during the Depression.

Read more about the steps the surviving family members should take when administering an estate. Note that these responsibilities ultimately fall on whoever was appointed executor or personal representative in the deceased family member's will. Matters can be a bit more complicated in the absence of a will, because it may not be clear who has the responsibility of carrying out these steps.

Consult With a Professional

Estate planning can be complex, with certain regulations varying by state. Be sure to work with a qualified estate planning attorney in preparing estate planning documents for your family; find an attorney in your area.