The Myths and Fables of Estate Planning

January 18, 2007

Published in the AICPA Wealth Management Insider 

How you can debunk your clients' misconceptions about estate planning. 

It's the beginning of a new year.  Your clients are calling to set appointments for their annual income tax reviews.  During those annual meetings, you may ask your clients:  Do you have an estate plan in place?  You may be surprised at some of the responses you will hear. 

While most of our clients have a fairly good understanding of estate planning, others may not.  Some clients have perceptions about estate planning that are based not on the facts, but rather on the myths and fables of the estate planning world.  So let's explore just a few of the responses that you may hear which are based on those myths and fables.

The estate tax was repealed, so I don't need an estate plan.

Well, yes and no.  Yes, under current, federal estate tax laws, the federal estate tax is scheduled for repeal during a one year period in 2010.  But very few practitioners believe that the repeal will actually take place, even for that one year period.  Besides, who can guarantee that he or she will die during that year?   In addition, many states have their own inheritance or death tax, which is completely separate from the federal estate tax.   Therefore, even if the federal estate tax is repealed, there may still be a state inheritance or death tax due. 

And no, even if there is no estate tax due at death, you still need an estate plan.  An estate plan is simply a set of directions for the distribution of your assets at death, and for the payments of any expenses and taxes.  You have the power to distribute your assets to anyone, and subject to the terms and conditions that you desire.  If you don't have an estate plan in place when you die, you may want to read the next section. 

If I die without a will, the government will take all of my assets and my family will get nothing.

A decedent's estate is distributed at death according to the laws of the state in which the decedent was a resident.  If a decedent has no will, or an alternative estate plan such as a living trust, then the decedent is deemed to have died "intestate", and the assets that he or she owns at death will pass according to the default intestacy rules for his or her state of residence.   For instance, under California's intestacy rules and in general terms, a decedent's community property passes to the surviving spouse, and any separate property is allocated between the surviving spouse and children.  Under California's intestacy rules, children inherit assets outright if they are over the age of 18. That alone can be a scary thought for many parents.  The assets don't "escheat", or pass, to the state unless no family members can be found. 

Certain assets pass by "operation of law" at death, meaning that they are not distributed according to a decedent's will or trust, or under the intestacy rules.  Joint tenancy bank accounts, for example, pass to the surviving joint tenant, regardless of whether the decedent had a will, a trust, or died intestate.  Other assets that pass by operation of law are retirement accounts and life insurance proceeds which pass to the named beneficiary for that account or policy, not according to the terms of a decedent's will or trust.

No living trust for me!  If I have a trust, the trustee will take all of my money and I won't have anything to live on.

If a person creates a revocable or living trust, and then transfers his or her assets into that trust, the trustee of the trust becomes the manager and custodian of the trust assets.   The trustee has the fiduciary duty to make distributions from the trust according to the terms of the trust document.   Most often, the person who creates a revocable or living trust serves as the initial trustee, and so retains control over all investment and management decisions, as well as all distributions from the trust.  If another trustee is serving (either because they were named as initial trustee, or because the initial trustee became incapacitated), then that trustee has the fiduciary duty to manage the trust and to make the same trust distributions. 

I have a revocable trust, so when I die nothing will need to be done to administer my estate.  It's already taken care of.

A trust, much like a will, is a set of directions for the administration and distribution of an estate at death.  In most cases, the assets held in a revocable or living trust are not subject to a court-supervised probate process.  But this doesn't mean that nothing happens.  A trustee must (a) determine the extent of assets held in the trust at death, (b) determine the value of all of the trust assets, (c) provide for the preparation and filing of a federal (and perhaps state) estate tax return if the estate reaches a certain value, (d) insure that any estate taxes are paid, (e) pay all outstanding and legitimate debts and other expenses, and (f) distribute the trust assets as described in the trust.

I have a revocable trust, so no matter what I'm worth when I die, there won't be any estate tax due.

Or:  I have plenty of life insurance, which isn't subject estate tax, so I'm set. 

Or:  My assets are all in my IRA, which isn't subject to estate tax, so no problem.

It's surprising how often we hear these comments!  Of course, everything a person owns and controls at death will be included in his or her taxable estate.  This includes assets that pass under a will or trust, assets held in joint tenancy with others, life insurance, retirement accounts, etc.  Once the value of the taxable estate has been determined, there are deductions, exemptions and exclusions to apply which may reduce or eliminate any estate tax liability.

Life insurance proceeds are generally not subject to income tax, but if your client owns or controls a life insurance policy on his or her life, then the proceeds of the policy will be part of the taxable estate, subject to estate tax.  Any person who receives the insurance proceeds will likely receive those proceeds without incurring any income tax liability.

Retirement accounts are sometimes more confusing to understand from a tax perspective.  Withdrawals from traditional retirement accounts such as IRAs or 401(k)s, whether made by the person who created an account or by the beneficiary who inherits an account, are subject to income tax at ordinary income tax rates.  Withdrawals from Roth IRAs are not subject to these income tax rules.

On top of that, when a person dies owning a retirement account, the value of the account at death is added to that person's taxable estate.   This means that an inherited retirement account is subject to (a) estate tax in the decedent's estate (taking into account the total size of the estate) and (b) income tax in the hands of the person who inherits it.

It can be a confusing world for our clients, with federal and state income tax, federal (and perhaps state) estate tax, wills, intestacy, probate, trusts, etc.  It's our job to guide them through the maze, and explain away their misperceptions.