Creating an Estate Plan that includes a Revocable Trust, pour-over Will, Property Power of Attorney, Health Care Power of Attorney, Living Will, and Health Insurance Portability and Accountability Act Authorization provides numerous benefits during life and at death. During life, the plan provides directions to your family regarding your medical care and finances if you become incapacitated or are otherwise unable to articulate your wishes. At death, the plan acts as a set of instructions to your fiduciaries regarding distribution of your assets. Unfortunately, as seasoned Estate Planning practitioners know, signing the documents alone does not solve every problem or guarantee that the plan will work as intended. Sometimes, mistakes occur that undermine an Estate Plan.
An Estate Plan involves more than just the documents evidencing the plan. Effective estate planning requires an understanding of an individual’s assets and how the plan will work for those assets. It also involves knowing what assets the plan won’t cover. Under normal circumstances, any asset that passes pursuant to a beneficiary designation, such as a retirement plan, life insurance, or an annuity passes outside the Estate Plan. Sometimes, these assets make up the bulk of an individual’s wealth. Thus, coordinating beneficiary designations for those assets constitutes an integral part of comprehensive Estate Planning. For example, assume that while single, Don named his brother as the beneficiary on his life insurance policy. Upon Don’s later marriage, he updates his Estate Plan leaving all his assets to his wife but fails to update the beneficiary designation for his life insurance. Upon Don’s death some years later, his life insurance passes to his brother, rather than his wife as was his stated intent. Simply put, Don could have avoided this result by updating his beneficiary designation upon his marriage.
In addition to considering beneficiary-designated assets, it’s important to consider the overall impact that taxes will have on the plan as well as the beneficiaries themselves. Obviously, it is important to understand whether the estate exceeds the Applicable Exclusion Amount ($12.06 million in 2022) which includes determining whether lifetime gifts reduced that amount. Further, if the estate will have an estate tax liability, then it’s important to consider which assets the estate will use to pay such liability. In a situation in which the client has children from a prior relationship, this matters a great deal. While assets passing to a surviving spouse do not incur an estate tax because of the unlimited marital deduction under Internal Revenue Code Section 2056, when those assets pass from the surviving spouse to the children of the first deceased spouse, a tax liability may occur and determine which party ultimately bears the taxes matters.
Finally, it is important for the client to understand the potential income tax consequences of the plan. For example, if the client has designated a beneficiary on an Individual Retirement Account (“IRA”), that beneficiary will have to pay income taxes on the distributions from the IRA unless it’s a ROTH IRA. The income tax consequences of receiving these assets may influence the client to structure their plan another way. Perhaps they intended to make a charitable bequest and after discussing the income tax consequences of distributions from an IRA decide that using a portion of the IRA to fund that charitable bequest makes more sense for their plan.
Beneficiary-designated assets and taxes make up an important part of any estate plan. As part of the complete Estate Plan, any time a birth, death, marriage, divorce, or change in financial situation or the law occurs, we need to update the beneficiary designations and consider anew the tax implications. Mistakes happen in many ways and lead to various unintended and potentially catastrophic consequences for the loved ones of those who fail to plan. These mistakes may make an impact during the life of the individual who failed to plan, and they certainly cause problems at death. Making matters worse, these mistakes may cause lasting trouble after an individual’s death either through an unnecessary (and possibly expensive or time-consuming) probate process or by improper planning for the intended beneficiary which takes numerous forms.