7 Common Estate Planning Mistakes to Overcome

The simplest acts often turn out to cause the most problematic Estate Planning mistakes.

Beneficiary designations and titles to assets are the most likely sources of estate planning mistakes and problems to address. Though estate planners are aware of the common mistakes and the consequences, many people aren’t. Simple, well-intentioned actions and failures to act often result in major estate planning mistakes.

The mistakes we’re going to cover usually involve assets and ways of holding property that avoid probate. Because the property avoids probate, it often doesn’t receive scrutiny from an estate planner, and a planner might not even be told about the property because the owner believes it is taken care of. Let’s take a look at some widely-committed mistakes that can lead to unintended consequences.

Estate Planning Mistakes: #1

Converting financial accounts to joint ownership.

Often an aging parent will decide to have one or more financial accounts held jointly with an adult child. The simple move is designed to avoid two problems. First, it substitutes for a financial power of attorney. Instead of having a document drafted that gives the adult child the power to manage the accounts when the parent is unable to, the joint title takes care of that. Each owner has authority over the accounts and can make decisions. Second, the accounts avoid probate. One co-owner automatically has full legal title to the account after the other passes away.

The jointly-held account often creates problems. In most states, half the jointly-held account is subject to the claims of creditors of either co-owner. Your assets could end up in someone else’s hands if your adult child divorces, loses a lawsuit, or runs up big debts. Also, it unfortunately isn’t unusual for adult children to start using such joint accounts to fund their own lifestyles.

There also could be tax problems. The IRS is going to consider the creation of the joint account as a gift of half the account from you to the child. You didn’t intend for the child to own the property. It only was a way to help you manage the assets and avoid probate. But the IRS says you made a gift.

When the account has assets other than cash, your heirs could lose a valuable benefit. After assets are inherited, the heirs increase the basis of the assets to their current fair market value. All the appreciation that occurred while you owned the property isn’t subject to capital gains taxes. When the account is owned jointly, however, the increase in basis only occurs for half the account. The other half is treated as a gift from you to the other co-owner, and that co-owner takes the same tax basis you had in the assets.

Estate Planning Mistakes: #2

Naming one child as beneficiary.

Too often a parent decides to keep things simple by naming only one adult child as beneficiary of life insurance or a financial account, including an IRA. The parent’s intent, which often was expressed to the children, is that the child who is named as beneficiary will split the account or insurance evenly with the other children.

The law doesn’t allow you to do things this easily.

Of course, once one child takes title to the property, it is subject to the claims of any of his or her creditors. So, you don’t want to do this with anyone who might have credit problems. Also, there are likely to be tax consequences if that child does split the property with the other children. As new legal owner of the property, anything he distributes to the other siblings is a gift from him tot them. The $14,000 annual gift tax exclusion allows him to give that amount tax free each year to each of the siblings. Any gifts above that amount, however, reduce his lifetime estate and gift tax exclusion. And he has to file a gift tax return reporting the gifts.

If the account is an IRA or other qualified retirement plan, the child has to take a distribution, pay income taxes on it, and give the after-tax amount to the other siblings. There’s no provision in the law for an IRA beneficiary to either split the account with others who also weren’t beneficiaries or to rollover part of the account to non-beneficiaries. The only way to transfer part of the IRA to another sibling is to take a distribution and pay income taxes on it.

Finally, the child has no legal obligation to share the property with the others. There are many instances of one child being given responsibility for an account or an estate and simply claiming that the parents meant for him or her to have all of it.

Estate Planning Mistakes: #3

Failure to name or update.

We’ve covered this many times, but it can’t be repeated too often. Failing to name a beneficiary for an IRA or other retirement plan means the estate will be treated as the beneficiary. That eliminates the potential for having a Stretch IRA in which tax deferral can be maximized. Instead, the entire account must be distributed and subject to income taxes within five years.

Failing to name a beneficiary also means that an asset that normally would avoid probate must go through the probate process. It will be considered part of the estate and be distributed according to the terms of either the will or state law. For financial accounts, the company that holds the account might have its own default rules for determining who is the beneficiary when one isn’t named.

Of course, you need to keep beneficiary designations up to date. Too many people select beneficiaries when they open an account or buy a policy and never review the decision after marriages, divorces, deaths, and other events.

Estate Planning Mistakes: #4

Not having contingent beneficiaries.

The contingent beneficiary receives the property when the primary beneficiary already passed away or declines the property. When there isn’t a contingent beneficiary, then most of the time the consequences are the same as if no beneficiary were named. But sometimes state law or the rules of the account custodian might dictate a strange result.

For example, Max Profits has three adult children and he names them as equal beneficiaries of his IRA. One of the children dies, and then Max dies before updating the beneficiary form. Max didn’t name a contingent beneficiary. Max’s surviving children think they should split the IRA. But the IRA custodian says under its guidelines and state law the children of the deceased child receive one-third of the IRA. That should be your decision and would be if you name contingent beneficiaries.

Estate Planning Mistakes: #5

Naming trusts as IRA beneficiaries.

This is another issue we’ve discussed in the past but that bears repeating. I regularly receive questions from readers asking if they should name one of their estate planning trusts as an IRA beneficiary.

In most cases, when a trust is named IRA beneficiary, required distributions from the IRA are accelerated. The ability to stretch out the distributions and maximize tax deferral is lost. Only certain Types of Trusts can be IRA beneficiaries and maximize tax deferral. We discussed the details in the June 2014 visit.

Estate Planning Mistakes: #6

Naming multiple co-beneficiaries.

This is frequently done with IRAs, financial accounts, and even real estate using a Transfer on Death deed or a similar designation. The arrangement can work well. With an IRA, the beneficiaries can agree to split it into separate IRAs. With other assets, they might work well together making decisions about the asset.

Too often, however, the strategy leads to problems. The beneficiaries can’t agree on how to manage the property or how to split it. It can be a major problem with real estate, because they all have to agree on everything. If they agree to sell, then they must agree on a broker, the offering price, and how to respond to each offer. They also might have to contribute equally to property taxes and other expenses until the property is sold.

A better structure is to split the property now or allow the children to benefit equally from the property but have one person manage it or handle the sale. For example, the property can be inherited by a trust or an LLC. The children receive all the income and gains. But only the trustee or the managing member of the LLC makes decisions about the property. That person can be one of the children or it can be an independent professional.

Estate Planning Mistakes: #7

Naming an inappropriate beneficiary.

This happens more than you would expect. A minor should not be named the direct beneficiary of property or life insurance. If he or she is, then the child will receive full title and control of the property upon turning 18. When minor children are involved, you need to set up a trust that manages the assets and distributes income and principal either on a schedule you set up or at the trustee’s discretion.

Of course, you don’t want to give property directly to someone who might waste it, including someone with a history of financial mismanagement, substance abuse, or gambling issues. Property also probably shouldn’t be given directly to someone who might be divorced, subject to liability lawsuits, or is in a risky business. Such loved ones can benefit from the property if you have it managed and distributed under the terms of a trust.

Finally, special needs individuals shouldn’t receive property directly. This could disqualify them from receiving government benefits or other help. Instead, discuss a special needs trust or supplemental needs trust with an estate planner.