Popular Strategy Ruins Estate Planning

Many people naively subvert their Estate Planning, creating nightmares for their heirs and bonuses for the taxman. The situation is easy to cause, but also is easy to fix.

The problem is that few people realize the importance of the wording of the legal title to their assets. Yet, this simple decision, often made without much thought when an asset is purchased or an account is opened, can negate all the good features of estate planning.

Most married couples buy assets and open accounts jointly with right of survivorship. It seems fair, is convenient, and gives security to the spouse with lower income. But it can disrupt many of the goals of estate planning.

When a spouse passes away, full legal title to the property automatically goes to the surviving spouse. None of the jointly-titled assets go to any other beneficiaries named in the will. A jointly-titled asset also cannot be transferred to a trust through the will. The result can be both tax and non-tax problems.

There can be estate tax problems for the surviving spouse. He or she will have full title to all the assets. The opportunity to pass up to $1.5 million assets tax free using the first spouse’s lifetime exemption is lost. Instead, only the surviving spouse’s exemption is available to protect the assets when they are passed to the next generation.

The opportunity to increase the tax basis of assets also can be lost. When property was held jointly, the surviving spouse retains his or her original tax basis in half the asset. Only the half that is inherited from the first spouse has its basis increased to fair market value.

On the other hand, if the first spouse to die had sole title to an asset, then the inheriting spouse could increase the basis to its current fair market value. There would be no capital gains taxes imposed on the appreciation during the first spouse’s lifetime.

There also are potential non-tax problems.

If the marriage is a second one, then joint title provides no protection for children of the first marriage. The surviving second spouse will get full ownership of the jointly-held assets. The children of the first marriage might end up with no assets from the estate.

Joint title offers some protection of assets from creditors, making joint title a fairly common asset protection strategy for those in high-risk professions, such as doctors. But the strategy could backfire. Suppose the surviving spouse is the one with the creditors. Then, on the death of the first spouse the creditors can lay claim to all the assets. The opportunity is lost to have the first spouse leave assets in trusts so that they are protected for the next generation.

A better strategy would have been to give the spouse without creditors full title to the assets, then in his or her will they would be transferred to a trust for the benefit of the other spouse, the children, or both.

Another potential problem with joint title of financial accounts is that either owner can empty the account at any time. This frequently happens when a divorce is contemplated. One of the spouses decides to take title to all the assets in the account. It also can happen if one spouse develops a problem such as substance abuse or gambling.

Another common estate planning strategy is for an older person to add an adult child to the account as joint owner with right of survivorship. These arrangements have several virtues. The assets avoid probate and are automatically transferred to the adult child. Also, the adult child is able to write checks and otherwise manage the finances should the older person become unable to.

Again, in these arrangements the joint owner can take the entire account whenever he or she wants. The child really needs to be trustworthy and sensible for this arrangement to work. Another shortcoming of the strategy is that the account is subject to claims of the child’s creditors. The creditors are not a problem in many states when the joint owners are a married couple. But when the joint owners are not married, the rules are different. All or part of the account can be claimed by creditors of one joint owner. The rules vary from state to state.

Also, adding a child’s name to an account or asset could trigger a gift tax liability or use up part of the lifetime gift tax credit. This is especially true if a child’s name is added to the title for a valuable asset such as real estate.

Another titling mistake involves revocable living trusts. These generally are set up to avoid probate and also to provide for management of assets in case of incapacity. The problem is that many people do not transfer title of their assets to the trust. The living trust has no effect unless legal title to assets is shifted to the trust. The trust creator must change the titles on all financial accounts, real estate, automobiles, and other personal property. Many don’t do this.

One reason joint accounts and living trusts are widely used is that people believe these tools will save estate taxes. They will not. One half of assets held jointly with a spouse will be included in the estate of the first spouse to die. When the joint owners are not married, the full value of the property might be included in the estate of the first owner to pass away. With a living trust, all assets in the trust are included in the estate of the trust grantor when he or she dies.

Ensuring the optimum legal title for assets is an important part of estate planning. Failure to properly title assets can result in assets going to the wrong person, inadvertent disinheritance of loved ones, higher estate taxes, unexpected gift taxes, theft, and loss of assets to creditors. Here are some estate planning guidelines to follow:

• Joint title with right of survivorship won’t cause tax problems when a married couple’s total assets are comfortably less than $1.5 million. In that case, there won’t be estate taxes, so it doesn’t matter if the lifetime estate and gift tax credit of the first spouse is lost. In addition, the surviving spouse is likely to need all the assets to meet living expenses, so would inherit them all in a will anyway.
• When there are children from a first marriage, assets that are intended for them should not be held in joint title with the current spouse.
• Married couples with a joint estate greater than $1.5 million should give each spouse full title to either half the assets or $1.5 million, whichever is less. That way, neither spouse’s full lifetime estate tax credit is lost. There are different ways to use the credit. The most common way is for the assets to be left in a trust from which the surviving spouse receives all income and can be paid principal for specific needs, such as education, shelter, medical care, and food. After that, the children or other heirs of the first spouse receive the trust assets.
• A financial power of attorney should be used to name the adult child or other person who will take charge of the finances when the parent is incapable. Joint title often is not a good substitute.
• Joint title should not be used with a spouse or adult child who is at risk to creditors, gambling problems or substance abuse.
• Remember that beneficiary designations on IRAs, qualified pension plans, and other financial accounts supercede anything stated in a will. Whoever is named as beneficiary will inherit the assets.
• Highly appreciated assets probably are best titled in one person’s name, so that whoever inherits can increase the tax basis to current fair market value.