The 4 Greatest Estate Planning Mistakes … And Easy Ways to Avoid Them

Many successful people are often so busy dealing with their businesses, professions, and personal lives that they never take the time to deal with the important challenge of creating a tax-wise estate plan for their families. In fact, a recent survey by Medical Economics showed that less than 5% of all doctors had utilized the proper estate planning documents (those discussed below).  There is no reason for us to think that other successful people are any different from this trend.

In this article, we will examine the 5 most significant mistakes people make when creating (or ignoring) their family’s estate plan.  We’ll also cover simple tools that one can use to avoid such mistakes and allow one’s family to elude the unnecessary delays, legal costs, and taxes which come with poor planning.

———-Mistake #1: Losing Money, Time, Privacy, & Control through Probate———-

One of the most prevalent mistakes that we find in our clients’ estate plans is that their estate will end up in the probate courts after they die.  In many states, probate should be avoided at all costs – as attorneys and courts rack up expensive bills, delaying the transfers which your will covered lucidly (or so you thought).  This ties up funds that your heirs may need to pay federal and state estate tax bills.

• Scope of the Problem: Probate Basics

Probate is the process by which a court administers a will.  There are many problems with probate, including the following:

•  Preventative medicine: Use a Living Trust

A Living Trust is a revocable trust, like a will, which you can change or revoke at any time prior to your death. Also, like a will, it dictates how your property should be distributed at your (and your spouse’s) death. However, unlike a will, a Living Trust is a private document and is not subject to the court’s probate process.  Instead, when you die, the successor trustee of your trust simply distributes the property as you designated in the trust document.  There are no long probate delays, court costs, or publicity.

There are numerous other benefits to the Living Trust (see preventative medicine #2 below) including:

• Avoids the unintentional disinheriting risked by joint tenancy.
• Prevents court control of assets if you become incapacitated.
• Can be changed at any time prior to your incapacity or death.
• Can protect dependents with special needs.

The costs of a Living Trust are extremely low, from $3,000 or more depending on the complexity of the situation.  In states where Living Trusts are not used as often, most attorneys use trust-type provisions within wills. These provide the same planning benefits, but would still require that the estate go through the probate process.

—————Mistake #2: Losing Almost Half of Life Insurance Proceeds to Taxes——-

Life insurance is highly recommended as a tool to pay the estate taxes due when you die because the funds will be available immediately to your survivors, without any delays or expenses involved with liquidating tangible assets.  Further, clients who set up policies in advance of their retirement years enjoy powerful leveraging of today’s dollars.  Nonetheless, most people fail to utilize a simple trust which enables all of the insurance proceeds to be estate tax-exempt.

• Why the IRS May Get More Than Half of Your Policy

The greatest misconception most clients have when it comes to life insurance is that the proceeds are paid estate tax free.  This is absolutely wrong!  The proceeds are income tax free but are subject to both federal and state estate taxes.  As explained above, current federal and state estate taxes can swell to 40%. Why lose potentially hundreds of thousands of dollars of your policy proceeds after you paid those premiums so diligently … especially when a simple trust can take the IRS out of the pictures and provide better protection for your beneficiaries? Ho

• Preventative Medicine: Using Irrevocable Life Insurance Trusts (ILITs)

An irrevocable life insurance trust (ILIT) is simply an irrevocable trust which owns a life insurance policy. The ILIT saves you estate taxes because it, rather than you personally, owns the life insurance policy.  Because the policy is not owned in your name, the policy proceeds will not be part of your net estate when you die (as long as you survive 3 years from the transfer to the trust).  Thus, the proceeds will not be subject to the estate tax.  This can save your family a great deal of money.

• ILITs Give You Control

The ILIT gives you much more control over what happens to the policy proceeds than you would get from a bare insurance policy.  With an insurance policy alone, your only decision is to whom you will leave the proceeds (the beneficiaries) — the insurance company will simply pay these people when you die pursuant to a very limited set of settlement or payment options.

With an ILIT, on the other hand, you can control not only who gets the proceeds and exactly what happens to the funds when you die. You can have the trustee pay the beneficiaries directly or pay them over a period of months or years.  You can incorporate spendthrift provisions and anti-alienation provisions to protect against your beneficiary’s (children’s) financial problems or their spouse’s financial woes.  In fact, an ILIT gives you all of the benefits of a trust arrangement — while allowing you to provide for your family just as you would with a bare insurance policy.

For these reasons, an ILIT should be used to own almost every life insurance policy in a client’s estate plan.

Note:  If you have already purchased a life insurance policy or are presently making payments on an existing policy, it is not too late. You can always transfer a policy to an ILIT.  There may be some gift-tax issues associated with this maneuver, but they will be very minor compared to the large tax savings your family will ultimately enjoy.

———————-Mistake #3: Leaving Property to the IRS———————

While no person leaves property to the IRS intentionally, quite often this is the effect of a person’s estate if he/she has not implemented a gifting program during his or her lifetime.  Simply put, after the exemption amount, any property not given away “in title” during your lifetime will be taken in part by Uncle Sam.  To prevent this – along with the strategies explained above – clients can gift property to family members.

Most clients initially hesitate to begin a gifting program, as they think they will have to give up control of the underlying assets.  As you’ll see below, this is not true.  Instead, one can use legal entities to remove asset values from one’s estate, while maintaining 100% control of the assets while one is alive.

• Preventative Medicine: Gifting Using FLPs and FLLCs

Through entities like family limited partnerships (FLPs) and family limited liability companies (FLLCs), you can share ownership with family members … yet maintain control. In this strategy, you and your spouse gift ownership interests to children over time (using your combined annual $28,000 per donee gift tax exclusion), removing those interests from your estates for tax purposes.  Still, as long as you and your spouse are the FLP general partners or LLC managers, you will maintain control of the underlying assets. Let’s examine a case study:

Case Study: Robert’s Mutual Funds

Robert Jones and his wife, both age 60 and the parents of 5 children, owned $4 million in mutual funds, and $10 million in real estate assets. They set up an FLP to own the mutual funds and real estate, naming themselves the managing general partners. They initially owned 99% of the partnership interests, gifting 1% to their five children. Since the 1% was worth approximately $140,000 ($28,000 per child), the gifts to the children were tax-free.  NOTE: a common practice, known as “discounting,” may allow you to gift up to $20,000/year (possibly more) to each child or beneficiary ($40,000/year if you are married) without having to pay any gift taxes.

Robert can continue to gift these children $140,000 in FLP interests each year, completely tax-free. If Robert lives to age 85, he will give $3,500,000 in FLP interests to his children ($700,000 each), tax-free. This $3,500,000 will no longer be in his estate, and not subject to estate tax. Because Robert’s other assets put him in the 40% estate tax bracket, his estate tax savings using the FLP will be $1,400,000 (40% x $3,500,000). Because he is the FLP’s sole general partner, Robert completely controls the mutual fund and real estate portfolios while alive and can distribute the income to himself or sell some of the funds for his expenses. Robert maintains control of his assets for his lifetime, pays less estate tax, and also provides more for his children.

—-Mistake #4: Losing 80%+ of Pensions, 401(k)s, and IRAs to Taxes Unnecessarily—

Would you be surprised to know that the vast majority of the funds in pensions, 401(k)s, and IRAs will end up with state and federal tax agencies?  Did you think that – after paying taxes for a lifetime of work – your “tax qualified” retirement plans could be taxed at rates from between 60-70%?  Most people – when hearing these facts – are shocked, appalled, and want to learn how to do something about it. While the details of such techniques are beyond the scope of this article, suffice it to so say here that – with advanced planning – the threat of taxes decimating a qualified plan can be eliminated.

Conclusion

Many otherwise-sophisticated clients put their families in an estate planning mess because of the mistakes covered above.  Clients with larger estates have even more potential pitfalls to avoid in their planning.  Thus, this article’s true purpose is to serve as an “eye opener.”  While educating oneself as to the potential errors in the estate planning arena is important – as in medicine – there is no substitute for consults with a licensed professional experienced in these matters.  In this way, an estate planning “physical” is the real first step in any worthwhile estate plan.

Glenn M. Terrones is a Los Angeles attorney who practices in the areas of Estate Planning, Income Tax Planning, and Asset Protection. He is the co-author of Wealth Protection, M.D. and Financial Secrets to Franchising Success, as well as several articles on the topics of asset protection, estate planning, and income tax planning. If you would like to contact him, he can be reached at (818) 649-7673 or by email at glenn@terroneslaw.com.