Estate planning uses a wide range of terms and definitions. As a result, it is crucial that an individual understand the meanings of these terms and definitions to fully grasp the estate plan that is recommended and what it will do.
An estate plan is created to ensure that you are taken care of the rest of your life and that your wealth is transferred to the people you want to have it. A good estate plan ensures these goals are accomplished with as much efficiency and as little cost as possible.
A good estate plan also can smooth family relationships, while a bad plan makes bad family relationships worse and even turns good relationships into bad ones. An estate plan addresses the management and distribution of an individual’s property and financial obligations after he or she dies with financial tools such as wills, revocable living trusts and power of attorney.
Estate planning is one of the most important actions a person can take to provide for his or her loved ones before dying. Estate planning helps transfer property and provides life insurance, disability income and long-term-care insurance to friends and loved ones with few legal hurdles.
Most of the key terms in estate planning describe documents, because estate planning strategies usually are implemented through legal documents. You don’t have to become an expert in all the different types of documents and their nuances. But you should learn the basics so that you can understand what an estate planner is saying, convey your wishes to an estate planner and understand your estate plan.
The foundation of every estate plan is the will, or last will and testament. The will states a person’s wishes regarding the distribution of his or her assets, payment of debts and other matters. The person whose estate is the subject to the will often is known as the testator.
The last will names the beneficiaries who are to inherit the individual’s assets. It should specifically state who will inherit assets and how much each will inherit. The will might state that specific assets should be transferred to specific individuals. Or it might state that each beneficiary will inherit a named percentage of the estate’s value and empower the executor to determine how the assets are to be divided.
The will usually names an executor or personal representative. This is a person (or persons) who will be appointed by the probate court to carry out the will’s terms and administer the deceased individual’s estate. The executor is responsible to the court, the heirs and any debtors for carrying out the terms of the will and the law.
If parents die before and have minor children, they can use the will to name guardians or custodians for the children. If they don’t name a guardian or custodian, a court will determine who will take that role.
The will also might create a trust (or trusts). It further could provide that assets in the estate are transferred to an existing trust or trusts instead of being bequeathed to individuals.
If a person dies without a will, the person is said to have died intestate. When a person dies intestate, state law determines how the estate will be distributed. Sometimes the estate is distributed the way the deceased individual would have wanted, but sometimes it isn’t. States have very different intestate laws. Some, for example, provide that two-thirds of the estate go to the children instead of to the surviving spouse.
A last will and testament shouldn’t be confused with a living will, which will be discussed later.
A will and any assets owned by a deceased individual go through a process known as probate. The estate of a person who died intestate also goes through probate.
In probate, the will is presented to a court by the executor. The court must determine if the last will is the deceased individual’s final instructions. In the probate process, the executor presents the court with an inventory of the estate’s assets and liabilities and proof that all potential creditors and heirs were notified of the probate process as required by state law. After proving that all known liabilities of the deceased are paid, the executor asks the court for permission to distribute the assets in accordance with the will.
Probate can be a long and expensive process, depending on the state where the deceased was resident. Some states have streamlined probate processes, at least for smaller estates. Others still have longstanding probate laws that make the process long and expensive, even for small estates.
Some assets avoid probate. These include retirement accounts, life insurance, annuities, and jointly owned property. Any assets held in a trust, such as a revocable living trust, also avoid probate.
Probate is where a will can be challenged. When a will is challenged, a potential heir usually argues that the testator lacked the legal mental capacity to make a will or was unduly influenced by someone. Sometimes a potential heir argues that the will submitted by the executor to the court was superseded by another will.
A power of attorney is a document that takes effect while a person is living. It is created to help ensure that the person and his assets are cared for during his lifetime when he is unable to make decisions or take actions. Some powers of attorney (POAs) are directed at medical care while other POAs concern financial and other nonmedical issues.
The person who signs or executes the POA is known as the principal. In the POA, the principal names one or more persons who are authorized to take actions on his behalf. These persons are known as agents or representatives.
A general power of attorney gives the agents broad powers to act for the principal. Using this document, in most states an agent can perform any act, even get married, in the principal’s name. The general POA, however, doesn’t empower the agent to make medical care decisions for the principal.
A limited power of attorney specifies the action an agent can take, or names actions the agent is not empowered to take. While a limited POA seems to protect the principal from an unscrupulous agent or an agent who would take actions the principal would disagree with, it’s usually not the best choice. The limited POA requires the principal to foresee how long he won’t be able to act, the circumstances that will exists at that time, and other factors. It usually is better to execute a general POA and appoint as agents one or more people you trust.
A financial power of attorney is a form of limited power of attorney. This can be a useful document when you work with a financial professional or trust someone primarily to manage your finances. You can execute a financial POA to give an agent the ability to manage your finances and execute a general POA to give another agent the power to act on other matters.
While a POA is meant to be used when the principal is disabled or otherwise unable to act on his behalf, most POAs are what are known as the Durable Power of Attorney. The Durable POA takes effect immediately after it is executed. There is no requirement that the principal be found to be disabled or otherwise unable to act. The durable POA also comes into effect after the principal becomes disabled.
Some states allow a springing power of attorney. The springing POA takes effect when the principal is found to be disabled or otherwise incapacitated. Only a minority of states recognize the springing POA. A problem with the springing POA is that one or more doctors must certify the principal’s incapacity. This requirement could result in expenses and delays and also involve court action. With a durable POA, the agents can take action right away. In the latter instance, the costs and the publicity of court actions aren’t incurred.
A good estate plan also includes one or more medical care documents that take effect during the principal’s lifetime. These documents have different names in different states, such as health care power of attorney, advance medical directive and living will.
In general, these documents appoint one or more agents to make medical care decisions for the principal when he is unable to do so.
A living will is different from a health care POA or advance medical directive. In the living will, a person states the type of care he does or doesn’t want in certain situations. Some living wills are very general. A living will might state that the person doesn’t want extraordinary lifesaving or extended measures used. Or a living will might describe a number of different situations and the care the person would or wouldn’t want. Often, a living will is combined with a health care POA to provide the agent with some guidelines of what the person would want. Sometimes a person executes only a living will and relies on the medical providers to follow it.
Trusts often are used in estate plans.
A trust is a legal agreement between at least three parties. The person who creates the trust is known as a trustor, grantor, or creator of the trust. This person has a legal document drafted known as a trust agreement and signs it. The trust agreement names a trustee who also signs the agreement and agrees to manage any assets transferred to the trust according to the trust terms.
A trust also has one or more beneficiaries. These are the people for whose benefit the trust assets are managed. A trust can have primary or current beneficiaries who are intended beneficiaries when the trust is created. It also can have contingent or secondary beneficiaries. They become the primary beneficiaries of the trust after the primary beneficiaries pass away or their beneficiary period expires.
A trust can be living, or inter vivos, which means it was created during the trustor’s lifetime. Or a trust can be testamentary, in which case it is created in the trustor’s will and doesn’t take effect until after the trustor passes away.
A trust can be revocable, which means the trustor can revoke or change the terms at any time. An irrevocable trust is one in which the trustor gives up the right to revoke the trust or change its terms. Sometimes a trust is fully irrevocable, in which case the trustor can’t make any changes. Sometimes the trustor reserves the right to make limited changes, such as changing a beneficiary.
Irrevocable trusts generally are used to create income or estate tax benefits. Revocable trusts usually have no tax benefits. The trust is created as the owner of the assets for both income and estate tax purposes.
After the trust is created, the trustor or other people transfer legal title to assets to the trust. The trust has no effect until assets are transferred, also known as funding the trust. To fund a trust, deeds to real estate must be changed or titles to other assets must be changed. For financial accounts, the names on the accounts must be changed along with any other steps required by the financial institution sponsoring the account.
Probably the most common type of trust is the irrevocable living trust. It is used primarily to avoid probate and to provide disability planning. All assets owned by a revocable living trust avoid probate. They are managed and distributed after the trustor’s death according to the terms of the trust agreement. That’s why a living trust often is called a will substitute. The terms of the will have no effect on assets held in a living trust.
Initially the trustor has only three roles in a revocable living trust: trustor, trustee and beneficiary. The trust assets are managed much as they were when the trustor owned them in his own name. After the trustor passes away or becomes disabled, a successor trustee or trustees are named according to the terms of the trust agreement and take over management of the trust assets.
Another trust frequently-used in estate planning is known as the bypass trust, marital trust, or A-B trust. The trust is used less now that few estates are subject to the federal estate tax. It was used in most estate plans when most estates were subject to the tax.
A bypass trust can have a wide range of terms. In general, the deceased’s will states that a portion of the estate will be inherited by the surviving spouse and the rest will go into the trust. The trust will be used to provide the needs of the surviving spouse for the rest of his or her life. Whatever remains in the trust goes to the children or other named beneficiaries of the trust after the surviving spouse passes away.
There are many other types of trusts, but these are the main ones used in most estate plans.
A trust can have several benefits in addition to potentially avoiding probate and reducing taxes. A professional or experienced trustee can ensure that the trust assets won’t be poorly invested, wasted, or drained away by scams. A trust also can protect the assets from creditors of the beneficiary, depending on state law.