Gifting is good. Gifting to children to lock in the $5.12 million estate planning tax exclusion is very good—except when clients gift away too much.
"We have had clients make such large gifts before they consulted their financial advisor to see if they could 'afford' to make such a gift and still maintain their own standard of living in retirement," says Susan Hartman, a wealth strategist at Raymond James who specializes in retirement and tax and estate planning issues. She and other estate attorneys have seen clients make mistakes in trying to plan for life after their death—and some are doozies. "One of the number one problems with estate planning is when the tax tail has wagged the financial planning dog," Matthew Erskine, an estate planning lawyer in Worcester, Massachusetts, adds. "People go deer-in-headlights, saying 'Oh my God, taxes, taxes, taxes!' That's irrelevant," Erskine says. "There are an enormous amount of techniques for reducing or eliminating taxes. It's not about taxes, it's about wealth transfer."
Sometimes well meaning missteps can be repaired after the client's death, but sometimes not. Here are the top 10 mistakes that can mean your client's wishes will not be followed after their death.
Procrastination. Clients don't like to deal with estate planning because it's an acknowledgment of their mortality, so they put it off and off and off. But lack of action isn't smart. "If you don't have your own [estate plan], state law creates one for you," Marc J. Lane, an estate attorney in Chicago, warns. "In order to have control over what assets go where and over tax consequences and to have the plan be a reflection of your own personal values, it's wise to say to the client: "Okay, we need to do this."
Take a cue from the old Nike ads. Tell the client: "Just do it."
The client takes the previous advice too far and tries to "do it themselves" with online legal form services such as Nolo or LegalZoom. There's nothing inherently wrong with the forms posted by these services, say lawyers. But they're only forms. Without an advisor or lawyer with experience in which forms to use in which situations, or planning for how much money to set aside, it's a recipe for disaster. "If you use one of the online services, you won't have an attorney to represent you at probate; so if there is any concern or lack of clarity, who is there to shine a little light on what the intent was?" Hartman says. Furthermore, without a lawyer, there's no one to tell the client if tax laws have changed, rendering a particular document or strategy useless or less useful, noted Lane.
Guide your clients to use an experienced estate attorney. Tell them to think of the cost as an investment.
Clients latch onto a novel planning idea to lock in a particular gain or credit, and lose sight of the big picture. "They'll peddle it to you, whether it's insurance or estate planning, and never bother to think through the consequences of what could happen," Erskine says. Often the client doesn't ask "what if" questions, such as: "'What happens if I give my kids all this stock, then I get divorced and I need the money? Can I borrow money back from my kid's trust?'" according to Erskine. The answer is the client can, but the legal trust has to be drafted to allow it. Often, the trusts aren't designed with such emergency clauses, and the client is left in the lurch.
Examine every solution carefully, whether it's the flavor of the month or the most traditional, with an eye to what might go wrong. And ask about additional clauses to give the client wiggle room if needed.
Failure to account for potential divorce. Hartman notes that as women's income increases, so does the likelihood she'll divorce her husband. If a client sets up a trust for a child, and fails to account for him getting divorced, the ex-wife could very well tap that trust and get a bigger income stream, for alimony or child support.
Clients could place restrictions on the money in the trust being distributed outside of the family. Or they could use a discretionary distribution standard which gives discretion to the trustees.
Failure to scrutinize documents for vagueness. Tony Guernsey, chief client advocate at Wilmington Trust, cites the classic failure to account for loopholes. The trust document for a wealthy industrialist, written around the 1920s, stated that his son would receive $1 million on the day of his wedding. The son got married 14 times. Each trip down the aisle meant he got another $1 million, because the document did not specify that the gift was to be given on the day of his first marriage.
Hartman has a more recent example. She has seen clients create a spousal lifetime access trust, which gives the husband or wife access to the assets in the trust with certain restrictions during his or her lifetime. At the spouse's death, the assets go to the children. The client gets to put $5.12 million in the trust to lower the tax bill, but the spouse can still access the money. Say the husband sets up the trust, and later the wife leaves him. If he has defined "spouse" very carefully in the document — "Mary Jane Smith" — not just "spouse," — she loses access to the funds in the trust.
Make sure the client and estate planning attorney have dotted every "i" and crossed every "t."
Failure to consider pets. Hartman has had elderly clients who didn't account for a new puppy. After the couple's death, the family didn't want the responsibility of a pet, and had the puppy put to sleep. "These are not pleasant situations," she says. "You need to discuss with the family about the pet and if they are willing to take care of the pet."
Set up a pet trust to care for animals after the client dies. Often, they set aside a certain amount of money to maintain the animal and the trustee—often a corporate trustee, not the person actually caring for the animal—makes distributions to reimburse the animal's caretaker. Hartman had a client-couple with a trust for their horses. The trust stated the farm would be maintained as long as the horses were alive, and they had to be properly cared for. Once the horses died, the farm could be sold and the remaining assets distributed to the children. "In that situation, you had to have a corporate trustee so they didn't put the horse down," she says.
Failure to follow through. The most elegant estate planning documents are no good unless all the client's other documents are titled properly. Lane has seen cases where a client has set up a trust to avoid seeing his assets going through probate. But the client never re-titled the assets in the name of the trust. This omission is called an "unfunded trust" because, essentially, the trust doesn't own anything. Therefore, it has no effect. "They threw away good money," Hartman says.
So now the client's will controls what happens to the assets. Generally the will says the assets will go into the trust, so it's not a disaster. But the will must go through probate first. "So you've lost a benefit of the trust — namely, probate avoidance," Lane says.
A similar problem crops up when clients fail to review beneficiary designations. Say the client's will directs that everything goes to the children, nothing to the ex-wife. But the client never bothered to change the beneficiary designation on his life insurance policy, which was made out to the wife when they were married. That means the ex-wife gets the policy. "The fact that you changed your will is irrelevant," Erskine says. Many contracts, like life insurance policies, 401(k)s, pension plans and IRAs are non-probate assets. That means the beneficiary designations on those documents trump what the will says. As more and more people's wealth is lodged in retirement plans, updating beneficiary designations becomes crucial, Lane said.
Make sure the client re-titles the assets in the name of the trust, not themselves. And check regularly to ensure that beneficiary designations on all retirement documents are up-to-date.
Clients assume trusts are only for minor children. "People think when a child becomes an adult you can make an outright distribution to them, but that misses a significant planning opportunity that could gut the estate plan," Lane says. He noted that if family assets remain in trust, even after the children are adults, the trust can protect the assets from the claims of creditors. "I've seen situations where wealth goes out of the family, and that was avoidable with a trust," Lane says. Now all states allows for dynasty trusts that last for multiple generations.
Explain to clients that trusts are asset protection vehicles for the entire family, rather than simply tools to use to provide for small children.
Failure to even consider—let alone plan for—the disposal of digital assets. "Clients don't recognize there's value they can't get to if they don't have the correct passwords," Sharon Nelson, an attorney in Fairfax, Virginia who specializes in digital forensics, technology and security, says. She tells the story of a woman whose husband handled all their financial affairs online. When he died, she didn't know his user names and passwords. She couldn't get her bills paid on time, and her credit suffered a big hit. Even after she produced paperwork showing that her husband had died and she was his widow, the bank was still uncooperative because she didn't have the passwords. "It was a nightmare scenario," Nelson says. The woman finally hired an estate lawyer who was knowledgeable in the digital arena, and started to repair the damage to her credit. Nelson notes that cases in which the husband is handling all of a couple's financial matters is not unusual in people of a certain age, and that now, there is less room for error. "In the old days, the wife could figure it out by sitting down with someone to go through the paper files," Nelson says. "Now the keys are all electronic."
Separately, what a client wants to do with his or her Facebook account or popular blog may not cost their heirs money, but still needs to be considered. Should the account be closed, or should it stay up as a memorial webpage? Should blogs, websites or other online accounts to stay up?
Make sure clients have a list of all their online user names and passwords, and that the appropriate family member or trustee has access to the information. Nelson recommends having a password manager like software program LastPass, which keeps track of the certifications and encrypts them for safety. Plus, find an estate lawyer who is either up on the evolving law surrounding digital assets, or willing to educate herself on the subject.
Clients assume they can pass their digital libraries and music collections on to their heirs. They can't. Earlier this fall, reports emerged that Bruce Willis was aghast to discover he couldn't leave his iTunes music collection to his children. Nelson says that the terms of service of the major sellers of digital content — Apple, Amazon, Barnes & Noble — all prohibit the owner from passing it on. "You own a license to use it which terminates when you die. You can't do anything with it," says Nelson adding, "I guarantee you there are people all across the country who have left their books and music collections to their kids not realizing it's not legally effective."
There isn't one now. However, Nelson says, because the area is so new, changes are likely. And, as is the case with most things in the digital world, they are likely to happen fast. She suggests that public pressure could force the companies to change the terms of service, or even that Congress might pass a law. "We have very little to go on at this point, but it will amass," she says. "By next year a lot of people will be writing on this."
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