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Estate Planning Pitfalls – Navigating the Minefield

The process of estate planning can sometimes seem like tip-toeing through a minefield. Age-old assumptions and planning shortcuts often have the potential to cause liability and tax issues that most people do not know exist, let alone how to avoid them. Below are a few of the most common mistakes that cause more problems than they fix.

Joint Accounts: Possibly the easiest way to transfer assets to heirs and avoid probate proceedings is to name someone as a joint owner of your property, commonly seen on bank and investment accounts. At death, the joint owner will automatically take full ownership of the asset without needing to involve the court. This is usually not a problem when dealing with joint accounts between spouses, but can be problematic with non-spouse owners. Joint owners typically have an unlimited right to manage and withdraw the assets in the accounts without your oversight or permission. Nothing is stopping your joint owner from going down to the bank and withdrawing the total balance for their own purposes. Furthermore, since joint account owners each have unlimited rights to the money in those accounts, if your joint owner ever has any creditor issues, or has an outstanding judgment, those creditors can come forward and confiscate your money to satisfy the joint owner’s debts. Finally, if your joint owner agrees to divide assets they received from a right of survivorship, that person could run into tax issues associated with gifting (described below).

Payable on Death: Another way to avoid the need for probate proceedings is to name a direct beneficiary on your financial accounts. Almost all banks, credit unions, and investment brokers allow you to do this. This can be a viable option to simplify matters, but only if you intend to name only one beneficiary, or are otherwise extremely precise with your beneficiary paperwork. The default rule is that if you make an account payable on death to more than one person, this results in a joint account being created at your death, again inviting the problem that every joint owner has an equal, unlimited right to the assets in the account. For example, if you name three children as equal POD beneficiaries of a CD at the bank, any one of the three can walk into the bank and withdraw the entire amount, with no recourse whatsoever to the other two children.

Failure to Update Other Beneficiaries: In contrast to bank and directly held investment accounts, certain assets are supposed to be distributed via beneficiary designation, such as life insurance policies and retirement accounts like IRAs, 401ks, etc. These assets also avoid probate because the beneficiary designation is a binding contract between yourself and the company that holds the policy. The flip side of this benefit is that if you experience a major life change, or if any of your beneficiaries should predecease you, the insurance proceeds or retirement account could end up in the wrong hands; again because the beneficiary designation is a binding contract and cannot be modified after the fact. All such policies and accounts absolutely must have a contingent beneficiary named, and must be updated as soon as possible when circumstances dictate. This holds particularly true for IRAs and the like, as an incorrect beneficiary designation can easily cause massive tax burdens and penalties if distributed improperly.

Minor Beneficiaries: Leaving assets to minors is particularly complicated since minors are not considered legally competent to manage their own affairs. Absent specific instructions, anything left to a minor beneficiary will be paid into court, invested (poorly at that), and distributed in full to the beneficiary when they reach 18 years of age – usually not a particularly responsible age. A Trustee should be appointed to manage the distribution, and specific instructions should be provided to use the assets for the health, education, and support of the beneficiary until they reach a certain age of your choosing.

Marital Rights: The only person Virginia law does not allow you to disinherit is your spouse. Even if you attempt to leave your estate to someone else, your spouse always has the right to make a claim against your estate to take approximately ⅓ of your assets, plus some additional living allowances. This can become extremely problematic if you have separated from your spouse, but have not signed a separation agreement or completed divorce proceedings. Nothing can extinguish this right except an express waiver signed by the spouse, or an official decree of divorce. Matters of divorce are not to be taken lightly, so if you intend to get divorced, or if you intend to marry and contract around these rules, make sure you follow through and get your divorce decree, or sign a valid Premarital Agreement that waives the rights beforehand.

Gifting: Making gifts in an attempt to short-circuit the probate process is quite possibly the most dangerous move anyone can make. Gifting carries with it some of the nastiest tricks in the government’s arsenal, and can completely destroy an otherwise air-tight estate plan. Some of the reasons for this include:

  1. Under federal law, gifts are taxable to you, the donor. In the vast majority of cases, no actual monetary tax will be owed at the time of the gift, but any gift exceeding $13,000 per person in any given year will automatically reduce the estate tax exemption available to you at death, which can lead to even greater taxation at death at worst, or expensive and time-consuming accounting work at best.
  2. Gifting an asset that has gained in value, or could gain in value in the future, like stocks or mutual funds, uses the “carry-over basis” rule for capital gains tax purposes. If the donee later sells that asset, their capital gains tax liability will be calculated based on the price that you originally paid for the asset. This rule does not apply if you instead pass along an appreciated asset at death, which uses the “step-up basis” rule, giving the donee a tax basis equal to the fair market value of the asset on the date of death.
  3. Giving assets to someone to distribute on your behalf, with the belief that “he/she knows what I want and said they would take care of it,” places you entirely at the mercy of another person who has no legal obligation whatsoever to do as you ask. Furthermore, even if they do agree to do what you ask, depending upon the size of the gift, they could run into the same gift tax consequences listed above when they make the distributions.
  4. Medicaid imposes strict penalties for attempting to gift away assets in an attempt to qualify for financial assistance. The “five year look-back” rule requires disclosure of all gifts made within the five years prior to a Medicaid application, which then imposes a disqualification period based on the value of the gifts divided by a “divestment penalty divisor” which varies from state to state, and sometimes between localities within the same state (for example, the divisor is different in Northern Virginia than it is in the rest of the Commonwealth). This penalty period can expand rapidly, often causing months, if not years, of disqualification for Medicaid benefits.

This is by no means an exhaustive list of mistakes that can cause problems for an otherwise solid estate plan. We can help guide you through this maze to ensure that you and your heirs will face minimum liability and financial distress in the years to come.

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