Retirement Watch : estates

What Your Heirs Should Know About IRAs

Bob Carlson — Thu, 12 Nov 2009 18:28:00 GMT

Heirs routinely lose a large percentage of inherited IRAs to unnecessary taxes. The rules are simple, but they aren't obvious and most heirs don't know about them or to ask about them. If you don't want a large portion or your hard-earned wealth and careful plans wasted, be sure your heirs know how to manage their new IRAs. Here are some key points.

* Spouses vs. non-spouses. A spouse who inherits an IRA has one big advantage over other beneficiaries. He or she can roll over the IRA to an IRA in his or her own name, providing the spouse with a fresh start for the IRA. The beneficiaries and required minimum distribution schedule can be reset. This often is a good idea for an inheriting spouse. But non-spouses who are beneficiaries cannot rollover the IRA to a new IRA.

* Naming the IRA. Other than a spousal rollover, heirs should not make the mistake of changing the IRA to their own names or allow the custodian to do so. That would require a rapid distribution of all the IRA. An inherited IRA needs three things in its title: the name of the deceased owner; the word "IRA"; and the statement that it is "for the benefit of" the beneficiary. An appropriate title is "Max Profits IRA (deceased), F/B/O Hi Profits, beneficiary.

* Deadlines. After inheriting an IRA, beneficiaries have options and reuirements. Required minimum distributions must begin, for example, and joint beneficiaries can split the IRA into separate IRAs for each beneficiary. But these actions must be taken by the end of the year after the year in which the owner died. Failure to act by the deadline ends the right to take an action and can result in higher taxes than would otherwise be paid.

* Splitting the IRA. A single IRA can be left to multiple beneficiaries. For example, Max Profits can name his three children as equal beneficiaries. If they decide to share the IRA, required minimum distributions are based on the age of the oldest beneficiary. The owners also would have to agree on how to invest the IRA and on rules for taking distributions beyond the required minimums. An alternative is to split the IRA into a separate one for each beneficiary. Most IRA custodians allow the IRA to be split in this way. Beneficiaries need to know this option is available and how to exercise it.

* Distributions. Most heirs tend to withdraw all the money from an inherited IRA quickly, pay taxes, and spend the after-tax amount. When beneficiaries prefer to use the IRA’s tax deferral, they should know how to compute required minimum distributions. The amount of the RMDs depends on whether or not the original owner was already taking RMDs, and the beneficiary also has two options in each case.

Suppose the deceased owner was not over age 70½ and had not begun RMDs.

The first option for the beneficiary is to begin taking distributions using the beneficiary's life expectancy. The second option is to distribute 100% of the inherited IRA to the beneficiary by the end of the fifth year following the year of the original owner's death. In the second option, the distributions can be taken on any schedule the heir wants. For example, the entire amount could be left in the IRA until the end of the fifth year. Or roughly equal amounts could be taken each year. Or money could be withdrawn as needed, with whatever is left in the IRA distributed by the end of the fifth year.

The first option is best for an heir who wants to use the IRA's tax deferral for as long as possible. Remember, an amount exceeding the RMD for the year can be withdrawn at any time. The second option is for an heir who doesn't intend to use the long-term tax deferral of the IRA. The five-year period gives the beneficiary time to search for ways to reduce income taxes on the distributions.

The options are a little different when the deceased owner already started RMDs.

The first choice again is for the heir to take annual installments over the beneficiary's life expectancy. The second option does not include a five-year rule. Instead, the heir can continue the RMDs on the schedule begun by the deceased owner, using what would have been the deceased’s age and life expectancy each year. The IRS says that the second method is the default method if the beneficiary does not make a selection or the IRA custodian does not name the other method as the default.

* An overlooked deduction. Most taxpayers and even many tax advisers are unaware of the deduction for "income in respect of a decedent.” Many people who inherit a substantial IRA are eligible for this deduction, which essentially is a deduction for the estate taxes that were paid on the IRA. The deduction is best explained with an example.

Suppose someone left a large estate with an IRA. The estate tax accountant computes that the IRA was responsible for 36.7% of the estate tax paid, and that the IRA's dollar share of the estate tax was $175,000. When the beneficiary takes distributions from the IRA, a miscellaneous itemized deduction (not subject to the 2% floor) of 36.7% of each distribution is allowed. This continues until the beneficiary has deducted a total of $175,000 over the years.

The estate tax accountant should determine the data for the deduction. Details can be found in the IRS Publication 559, Survivors, Executors, and Administrators, available free on the IRS web site, www.irs.gov.

* Disclaimers. The details of who should inherit an IRA can be left to your executor who, along with family members, can determine from both a financial and tax standpoint who should be the Designated Beneficiary. The Designated Beneficiary does not have to be selected until Sept. 30 of the year following the year of the owner's death. The first required distribution does not have to be made until Dec. 31 of that year. But the Designated Beneficiary must be one of a group of primary and contingent beneficiaries named by the account owner.

The way to take advantage of this provision is for you to name both primary and contingent beneficiaries. After your heirs and executor decide who should inherit, those who are ahead of that person in the beneficiary chain can disclaim their interests.

There is a procedure in the tax law for making qualified disclaimers. Your heirs and executor should be aware of your intentions and this process, and you should give the executor guidelines for making the decision and advising the beneficiaries.

All your work of growing and preserving the IRA over the years and planning your estate could come to naught when your heirs mishandle the IRA. Be sure they know their options and obligations and have good advice on how to handle the inherited IRA.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Having the Last Word

Bob Carlson — Thu, 05 Nov 2009 21:49:00 GMT

Most estate plans are missing a key ingredient. Many estate planners don’t recommend it, and it isn't even mentioned in many estate planning discussions. One reason might be that, despite its importance, the document is not legally binding on anyone.

This document can clear up a lot of issues. It can save time and money in processing the estate, answer many questions of loved ones, and prevent the heirs from going to court. The document also can make clear one's final wishes in many areas that are not covered in wills and trusts.

The document often is called a letter of final instructions. That is a bit of a misnomer, because properly done it is more than a letter. It should be several documents contained in a three-ring notebook or other device that makes it easy to update the papers yet keep them together.

The letter of instructions is your last word on a number of issues. It also is a practical guide to handling your estate and managing the property. It can provide advice and guidance. Preparing a letter of instructions also is an excellent way to help do your planning and uncover forgotten information. Let's take a look at the details.

Contacts. Your executor will need to contact your estate planning attorney, accountant or tax preparer, life insurance agent, and any other financial professional who helped you. There also might be investment managers and employers or former employers who are paying benefits. Also include personal contacts: friends, relatives, organizational leaders. Include the name, address, telephone number, and e-mail address of each.

Where to look. Unfortunately, in many cases much of an executor's time is spent looking — for documents, account statements, contact information, personal items, or long-forgotten assets. May you know where everything is (though you probably don't). Make things easy and inexpensive for your executor by leaving behind an inventory of assets that includes where the assets and any documents related to them can be found. If you keep valuables in a safe deposit box or safe, be sure to note this and how the executor can gain entry. Let the executor know where you keep receipts, canceled checks, and any other supporting documents.

How it is divided. Your will, beneficiary designations, trusts and other documents legally determine who gets what. But you can make a plain English explanation of the division in your letter. You might explain why things are divided as they are — especially if you think someone might be surprised, disappointed, or have questions.

If you own a business, be sure to get periodic valuations and asset inventories. The business might own assets your heirs might not be aware of. You should provide separate detailed information about the business, its assets, its operations, and suggested actions to take with it.

You probably have several credit cards and belong to one or more associations, societies, or other groups that offer membership benefits. The benefits might include some kind of life insurance, disability insurance, or medical insurance. Take the time to review your benefits and list them somewhere. Provide full information, such as the brochure received from the provider. Your executor can make claims and boost your estate.

All of these lists can be included as separate statements that are attached to the letter or included in a separate divider in the binder. Also include in the binder copies of recent tax returns for you and your business along with your will and any other estate planning documents. Of course, a copy of your will and any trusts should be included. Recent copies of statements from any financial accounts and employee benefits also should be attached.

In most states, your instructions on funeral arrangements and some other matters are not legally binding even if included in the will. You also don't want to update the will each time a new idea occurs to you. These items can be included in the letter of instructions or notebook. Here are topics to consider:

* Burial, organ donation, and similar preferences. Naturally, if arrangements have been made in advance, these should be explained.

* A suggested obituary or items to include in an obituary.

* Preferences for the funeral, memorial service or other ceremony. You can be as detailed or general as you would like.

* The disposition of special collections or assets, pets, and memorabilia.

* Care for dependents who are incapacitated or for minor children or grandchildren.

Every estate planner with any experience has stories about searches for assets or disputes over seemingly minor matters. You can avoid being part of one of these stories by leaving a letter of instructions.

A letter of instructions has the benefit of being easy to update. You don't need to incur lawyer's fees or have a signature witnessed. Sit down once a year, review it, and determine what needs to be updated. After the revisions, make some copies. Your lawyer and executor each should have a copy, and there should be one in your desk drawer or other place you keep documents.

Preparing a letter of final instructions can provide benefits now. The letter ensures that your financial affairs and documents are organized. It probably will cause you to throw away unneeded items and carefully consider some items that have been put off or neglected. The process will cause you to do things that should have been done some time ago. Make it easy by not trying to do the entire project at once. Break it into manageable pieces and give each the attention it deserves.

When You Don’t Prepare

Without a letter of instructions and good organization, the heirs are forced to engage in the old-fashioned property and document search. Sometimes it is comical. Sometimes things get ugly. Always a lot of time and effort is wasted.

Estate planners tell stories of important documents that never are found and of other documents that are found in the most unlikely places. Cash, jewelry, and other property are found hidden in the backs of closets, in attics, or under floorboards. Sometimes evidence of real estate or stocks is found stuffed where they are discovered only by accident.

When heirs remember seeing property, such as jewelry, or hearing the loved one talk about real estate, suspicions are aroused when the property or documents are not found during the estate settlement process. The results can include accusations, lawsuits, and broken relationships.

Don’t leave your heirs in this position. Prepare a proper letter of instructions and supporting documents. In the process, you probably will re-learn things about the estate you forgot and also realize that some important papers need to be replaced.

The Multi-State Estate Plan

Bob Carlson — Fri, 23 Oct 2009 00:30:00 GMT

Readers with homes or other property in more than one state need to give special attention to their estate plans. Each state has different rules and requirements, and your estate might have to run probate proceedings in each state. There is more work involved for either you or your executor or both.

There are lawyers who advise drafting separate wills and other estate planning documents for each state involved. You shouldn't need to do that much work. The estate plan, however, does need to recognize that multiple states are involved and make appropriate adjustments.

An estate generally must go through the probate process in order for title to the assets to be transferred to the beneficiaries. Real estate is probated in the estate where it is located. Personal property is probated in the deceased's state of residence, even if he or she dies in another state.

Occasionally there is a dispute over a person's state of residence, but that doesn't happen often. When you have houses in more than one state, part of your estate plan should be to clearly establish one state as the legal residence to avoid a dispute over your residence.

When there will be probate in more than one state, the same will can be submitted in probate proceedings in the different states. Each state, however, sets its own qualifications for wills, trusts, powers of attorney, medical directives, and other documents. Some have more requirements than others. For example, some states require only two witnesses to a will while others require three. Louisiana, because it is based on French law, has its own peculiar rules.

Estate planning attorneys, especially when they know that a person spends a significant time in more than one state, will draft a will so that it is valid in every state except Louisiana. The documents are written to comply with the state that has the toughest requirements. Be sure your estate planner knows where your different assets are located and where your time is spent. The planner then should ensure the will is valid at least in the relevant states.

The same strategy should be used with trusts. A trust is resident in and controlled by the law of the state where the trustee is located. A trust should be written, however, so the trustee or the location can be changed. To avoid problems with those changes, a trust should be written to be valid in as many states as possible.

Another way to deal with the potential of estate proceedings in more than one state is to plan your estate to avoid the cost and inconvenience of having the estate probated in two or more states.

One way to minimize probate is to create a revocable trust. The trust can hold a few key assets, such as real estate that is held outside the state of primary residence. Or it can hold title to all your assets. Anything owned in a trust does not have to be probated. The trust agreement should state how a successor trustee is determined and how the assets are managed and distributed. A will still would be needed for assets not held in the trust, but assets in the trust would avoid probate.

Another option to avoid probate for real estate is to own it through a partnership, LLC or trust. The partnership or LLC interests are personal property and could be probated with the rest of your personal property. The real estate would avoid probate.

Another way to avoid the probate problem is to establish joint title with right of survivorship for major properties. There are pitfalls to this, as I have discussed in past issues of Retirement Watch and don’t have space for here, but it might be an appropriate strategy for married couples whose estates are small enough to avoid estate taxes.

Your other estate documents also should be drafted to comply with the requirements of all states you frequent. These could include the general power of attorney, financial power of attorney, health care power of attorney or proxy, health care advanced directive, and living will. The health care documents should be drafted to comply in as many states as possible, because the governing law will be the state in which you need the medical care.

With a financial power of attorney, the key is to make the document acceptable to the financial institutions holding your accounts. Most institutions require that the power be filed with them in advance, and many will acknowledge only powers using their own forms or approved by their attorneys before they are needed.

Spending time or owning assets in multiple states adds a few complications to an estate plan. An experienced estate planner who has all the information can smooth out the complications and make the estate administration process easier. With a little work, you can avoid having probate cost extra time and money.

Why Estate Planning Details are Important

Bob Carlson — Fri, 16 Oct 2009 14:24:00 GMT

In this post we discuss two key issues that don’t draw much attention but are keys to the success or failure of your wealth transfer plans. They probably are not what you’d expect. Meeting a plan’s goals often does not hinge on the “headline issues” of trusts, family limited partnerships, and the like. The nitty gritty details are more important, such as stating who pays debts and taxes, ensuring the estate has enough cash, and choosing executors and trustees. I regularly remind my readers of the details requiring attention and provide recommendations.

Here are a couple of issues that don’t get much attention but deserve more of your time.

A recent court case shows what happens when details are overlooked.

A man owned a farm, sold it, and incurred capital gains taxes. He died before the year ended and before paying the taxes on the sale or filing his tax return for the year. His oldest son was named executor of the estate. It turned out a younger son was a joint owner with right of survivorship with his father of the farm and inherited the rights to the farm's checking account after it was sold. The checking account held the sale proceeds, minus mortgage repayments.

Because the farm and its checking account were held as joint owners with right of survivorship, the younger son automatically became sole owner of the farm business and its assets when the father died. The older son as executor oversaw the probate estate and had control of those assets. But the farm assets never were part of the probate estate, and the executor never had an interest in or control over the farm assets.

Yet, the estate and its executor are responsible for all taxes of the estate and the deceased. In this case, the executor was liable for the father's final income tax return and the taxes due under it. The IRS assessed the executor for the capital gains taxes from the sale of the farm. The executor went to court to challenge this, saying his brother should pay the taxes since he had the money.

The court said it had no choice but to rule for the IRS. The executor is responsible for paying the taxes on the deceased's final income tax return. The brother who served as executor could sue the other brother for the money, but he first had to pay the IRS the money.

Here we have a division within a family and an estate without cash to pay its bills, because the father either didn’t seek advice or received bad advice. The father did not pay estimated taxes that included capital gains taxes on the sale of the farm, and he did not ensure the estate had money to pay the taxes and other bills. He might not have been aware the farm would be included in the taxable estate though the executor had no rights to it.

Several key details were neglected that should be part of every estate plan. Estimate the cash flow for the estate. Be sure there are enough liquid assets to pay its obligations. The will should state who is responsible for paying taxes on the assets. Otherwise, one group of beneficiaries could pay taxes on assets received by another group of beneficiaries.

Otherwise, your estate could end up fighting with the IRS, and your family members fighting with each other. (U.S. v. Guyton, No. 3:07-cv-00273, D.C. Fla, May 7, 2009)

Giving Gifts — and a Lecture

Grandparents are filling only half their roles these days. They are providing financial help to their grandchildren. In fact, they increased their financial aid as the economy worsened. Unfortunately, they are providing financial aid without much advice.

About 63% of grandparents say they provided some form of financial assistance to their grandchildren over the last five years, according to a survey for the MetLife Mature Market Institute, an affiliated organization of MetLife Inc., the insurance company. The assistance over the five years averaged $8,661. The survey was of adults over age 45 who have grandchildren under age 25. About 40% of the gifts went toward "general financial support," while 26% was for educational expenses and 21% was to help grandchildren through major life events. Because of the declining economy, about 26% of grandparents said they increased support for grandchildren.

Despite the generosity with wealth, most grandparents are not generous with their advice and wisdom. About 68% of the grandparents said they provided no financial guidance to their grandchildren. Lower-income grandparents are more likely to give advice, with 83% of those earning $35,000 or less saying they warn their grandchildren to avoid large debts and to maintain financial security. Only 65% of those with incomes between $50,000 and $74,999 talked about finances with their grandchildren.

It is admirable that so many grandparents are willing to give now to help their grandchildren receive educations and establish a firm financial foundation. But it is a mistake to give money or other wealth without some guidance, or ensuring the grandchildren receive good advice elsewhere. Financial literacy is taught in very few schools. Most high school graduates lack basic financial skills such as balancing a checkbook and understanding a mortgage or other debt instrument. If the parents try to provide lessons, the grandchildren are likely to ignore them.

Grandparents are more likely to be listened to, and they can provide a lot of hard-earned wisdom. Grandparents can teach with authority principles such as avoiding debt, starting to save and invest early in life, living within one's income, working hard, and saving both for a rainy day and for specific goals.

Debt management is probably the lesson most grandchildren could benefit from. Their parents, like most of their generation, probably never learned the lessons of how to use credit wisely. Also, the credit picture is much more complicated than it used to be, with many different kinds of debt available but objective information about the credit hard to find.

Grandparents should not give only wealth. They should give lectures and advice. Even a simple request that the grandchild read a basic book, such as The Richest Man in Babylon by George Clason, as a condition of receiving a gift can go a long way. The book is both entertaining and enlightening for most people, regardless of age. But the best advice would be direct from you.

Articles with helpful discussions on my members web site discuss compound returns, mutual funds for small investors, and financial lessons youngsters need to know. Share this and other advice with your grandchildren so they will remember it when key decisions have to be made. It also will make your financial gifts more valuable, making it more likely your wealth is well-used.

Who Will Benefit from Your IRA?

Bob Carlson — Fri, 25 Sep 2009 00:17:00 GMT

One of the most important decisions about an IRA is naming the beneficiary or beneficiaries. There are many candidates for the biggest mistake made by IRA owners, and a leading contender is the failure to name a beneficiary or naming the wrong beneficiary.

If no beneficiary is named, the estate is the beneficiary. When an estate or another non-individual is a primary beneficiary, the entire IRA must be distributed within five years after the original owner's passing. The estate, as the beneficiary, will owe income taxes on the distributions, in addition to any estate taxes due on the value of the IRA. An IRA owner should never fail to designate at least one qualified individual as primary beneficiary and should never name the estate or other non-individual as a primary or contingent beneficiary. The only exceptions are when there is no interest in allowing heirs to use the tax deferral of the IRA and for certain trust that are allowed to defer distributions.

Since new regulations were issued in 2001 and 2002, the choice of beneficiary is not fixed and does not affect required minimum distributions. The major consideration in naming the beneficiary is: Who should receive the IRA in light of the goals, tax issues, and any other factors that are important to the owner?

After deciding on the primary beneficiary or beneficiaries, the owner also should name contingent beneficiaries. These are people who inherit if the primary beneficiaries are not available or disclaim the inheritance. Naming contingent beneficiaries can be part of a good strategy. The estate executor names the Designated Beneficiary of an IRA by the end of September of the year after the owner passed away. The DB's age determines the required minimum distributions for the IRA. The DB must be on the list of primary or contingent beneficiaries.

Naming contingent beneficiaries allows the executor and heirs to adjust the estate plan if circumstances have changed. Primary beneficiaries who believe it is best for the family that someone else inherit the IRA can disclaim their rights. Disclaimers can continue until the "right person" is available to be named DB. That cannot happen unless contingent beneficiaries are named.

Customized Beneficiary Forms

When naming beneficiaries, it often can be best not to use the Beneficiary Designation forms provided by IRA custodians. A number of estate planners draft their own forms and have them reviewed and approved by the custodians.

One value to a custom beneficiary form is it allows the owner to name more than one primary beneficiary and leave them unequal shares, something that often is difficult or not possible with standard forms. A custom form ensures that the form lists all the beneficiaries the owner wants named. Another benefit to a custom form is, if there are disclaimers or premature deaths of beneficiaries, contingent beneficiaries will succeed primary beneficiaries in the desired order and not in an order dictated by the IRA custodian.

While a standard form might work for many people, those with multiple beneficiaries or less-than-standard situations should consider having their estate planners draft custom forms and file them with the IRA custodian.

The IRA owner also should consider who would receive the share of a beneficiary who dies prematurely — either before inheriting a share of the IRA or after distributions to heirs begin. Should the share go to the children of the beneficiary, or should it be shared by the other primary beneficiaries? Or should it go to a different contingent beneficiary?

The choice is up to the IRA owner, but it has to be stated in the designation form. Otherwise, most IRA custodians have a default position they implement absent instructions from the IRA owner. State law also might establish a default position. The IRA owner should consider the issue and make the choice clear in the designation form.

Another issue: Suppose a beneficiary or contingent beneficiary is young or cannot be trusted to handle the IRA properly. Then, it might be appropriate to name a trust as the beneficiary of the IRA. Naming a trust also is appropriate when the intended beneficiary has special needs.

A trust that is an IRA beneficiary must have precise terms in order to take advantage of the IRA’s tax deferral. With the wrong trust terms, the IRA balance must be distributed and taxed on an accelerated schedule. The help of an experienced estate planner is needed to set up the trust properly.

Splitting IRAs

When there are multiple objects of affection, one option is to name them as joint primary beneficiaries. An alternative is for the IRA owner to split the IRA into separate IRAs, naming a separate beneficiary and a group of contingent beneficiaries for each. IRS regulations allow beneficiaries who jointly inherit an IRA to split it. Yet, not all beneficiaries know about this right or are able to agree to execute it. The owner might find it wise to split the IRA now rather than leaving that to the estate administration process.

I frequently emphasize that an estate owner who plans to leave something to charity should consider using the IRA to do so. Unlike other beneficiaries, the charity will fully benefit from the IRA. Charities are tax-exempt. A charity can withdraw the entire IRA balance and not owe income taxes on it. In addition, naming a charity as beneficiary avoids the estate tax. The IRA is included in the estate, but there is an offsetting charitable contribution deduction for the amount left to the charity.

Because non-charitable heirs benefit more by receiving non-IRA assets, leaving the IRA to a charity can be a good deal for all involved. When the estate owner plans to leave part of the estate to charity and there are enough non-IRA assets for other beneficiaries, the owner should consider leaving all or part of the IRA to charity while leaving the other assets to non-charitable beneficiaries.

When considering IRA beneficiaries as part of an estate plan, there are a couple of other strategies I frequently recommend that you should consider as alternatives.

One strategy is to avoid all this by emptying your IRA early. Distribute all or most of the IRA, pay the taxes, and invest the after-tax amount. That gives you more flexibility over how to give away the balance and probably gives the heirs a larger after-tax amount in the long term. This can be appropriate for someone with a large IRA and other income or assets to maintain the standard of living. It also is best if you expect the after-tax account to have 10 years or more to growth and compound before money is withdrawn.

Another strategy is to convert the traditional IRA into a Roth IRA. This does not avoid the choice of beneficiary, but it makes the distributions tax free. Keep in mind it costs money to convert to a Roth IRA.

I have discussed the details of both of these strategies in past issues of Retirement Watch and in my book, The New Rules of Retirement.

Designating IRA beneficiaries is a neglected step in many estates. Take care to designate beneficiaries with care and use a custom beneficiary designation form if necessary. Taking these steps can increase the after-tax wealth of your heirs by tens of thousands of dollars. A will or living trust has no influence on who inherits your IRA or other qualified retirement account. Only the beneficiary designation form counts. Make your designations carefully, update them as needed, keep copies of all forms, and be sure the executor knows where the forms are.

Avoiding Estate Planning Mistakes

Bob Carlson — Thu, 17 Sep 2009 19:40:00 GMT

The success or failure of an estate plan often depends on small details. Amid all the big picture issues (taxes, trusts, gifts, business interests), these matters may seem too small to deserve much time. Don’t have that attitude. It could cost you and your heirs.

Don’t make these very common estate planning mistakes.

* Overlooking non-probate assets. These assets are excluded from the “probate estate” and avoid the probate process, so their disposition is not covered by the will. (They likely are included in the gross estate for tax purposes.) They are covered by law or by contract. These assets include IRAs, employer retirement plans, life insurance, and annuities. Living trusts and all the assets in them also avoid probate.

Retirement plans, annuities, and life insurance have beneficiary designations that must be completed, either as a section of the account application or contract or in a separate document. For each of these non-probate assets, the custodian or account sponsor looks only at the forms in its records. Whoever is listed as beneficiary gets the asset. Often, a beneficiary designation form was completed many years ago, perhaps before the owner was married or had children. In the ensuing years, the owner’s marital or family situation could change. Yet, many people forget about their designation forms and do not update them.

Every estate owner should keep a copy of all beneficiary designation forms and review them every couple of years. More frequent updates are necessary as family situations, goals, and objects of affection change.

A related mistake is not to name contingent beneficiaries. These are needed because a beneficiary might pre-decease the owner or otherwise be unable to inherit. Another reason to have contingent beneficiaries is the primary beneficiaries might realize that due to changed circumstances it would be better for all concerned if someone else inherits the asset. The named beneficiary (or beneficiaries) could file a document known as a disclaimer, refusing the inheritance. The account then would go to the next contingent beneficiary.

* Many people set up living trusts but neglect to fully implement them or update them as needed.

One often overlooked detail with living trusts is that ownership of assets must be transferred to them. Only the assets legally owned by the trust avoid probate and are controlled by the trust’s terms. Too many people do not do the work of transferring the legal title of homes, vehicles, and financial accounts to their trusts, making the trusts useless.

It also is important to check with financial institutions to determine if they need a copy of the trust on file. A number of financial institutions are hesitant to recognize succession clauses in a living trust unless a copy of the trust agreement was filed with them in advance or they have other proof of the initial trustee's intent before transferring power over the accounts.

As with a will, there also might be a need to change trustees and beneficiaries. There should be successor clauses for beneficiaries and trustees that automatically make changes in certain circumstances. The clauses should be carefully written, updated as needed, and the successors made aware of the situation.

* A financial power of attorney is essential to every estate plan. Most estate plans focus on one's demise, but the possibility of disability also must be considered. Someone should have legal authority to manage the finances during a period of disability. If plans haven't been made, loved ones must go to court to have someone appointed. At that point, the owner has no control over the choice.

One reason to get started on the POA is that most financial institutions require that a copy of their own POA form be signed and on record to be effective. They might not accept the form drafted by an attorney or might delay its acceptance for some time. They also might not accept a form that is not filed with them until the principal is disabled.

* There are other details that are part of a complete estate plan. Parents of minor children should designate guardians in case of the demise of both parents. An estate owner also should create a beneficiary book that contains most important financial documents, plus descriptions and locations of other assets and records. There also should be instructions for the estate executor and those who inherit special assets. Funeral, memorial service, and burial instructions can be suggested by the estate owner and should be included in the book. I have discussed all these issues in more detail in regular issues of my newsletter, Retirement Watch.

Over the years estate planning has become synonymous with tax planning. There are other issues that are as least as important as taxes. A goal of estate planning is to manage assets and transfer them as efficiently as possible to the objects of one’s affection. Reducing taxes is part of that process, but there are other aspects that also affect how much of the assets reach loved ones and how efficiently that transfer occurs.

The Four Goals of Legacy Planning

Bob Carlson — Fri, 14 Aug 2009 00:29:00 GMT

Perhaps one of the worst effects of high estate taxes is the way tax planning diverts attention from other important estate planning issues. For many years, I have stressed that estate planning is about much more than taxes, but most people believe estate planning and estate tax planning were the same thing. Though wrong, it was understandable when the lifetime estate tax exemption was $600,000. Many "modest millionaires" who considered themselves middle class would be hit by high estate and gift taxes without planning.

Unfortunately, the idea that estate planning is all about tax reduction still is widely held. With the estate tax exemption at $3.5 million and likely to stay there or higher, many people simply are neglecting estate planning. Since estate taxes are not going to be a problem for them, they see no reason to put together a plan.

One way to avoid falling into this trap is to think about legacy planning instead of estate planning. Everyone needs a legacy plan, even those with less than $1 million in assets. With a new estate tax law likely to come down the pike this year and stabilize the tax picture, 2009 is a good time to put together your legacy plan.

Legacy planning has four key goals. Consider these goals and how to accomplish them. Working with an estate planner will be easier and faster when you understand legacy planning this way, and it will make meeting these goals easier and more likely.

Financial security for you and the objects of your affection is a priority of legacy planning.

Though few people realize it, putting yourself first should come be the priority of legacy planning. Establishing a legacy involves giving to or providing things (not necessarily money) for others. Yet, you are best able to give to others when your own standard of living is secure. You won’t be able to give to or provide for others when your own situation is precarious. As the plan is developed, keep returning to the question of whether a strategy would put your standard of living at risk under some circumstances. The sharp decline in asset prices in 2008 brought that home to many people.

Once comfortable with your financial security, establish goals for the ultimate disposition of your wealth. Often, the spouse is the first beneficiary of the wealth. After that, children, grandchildren, and charities are the usual recipients of the wealth. You need to decide who will benefit from your estate, the order in which they will benefit, and the amount or percentage of your wealth they should receive.

After determining who should benefit from the wealth, the next issue is how they will benefit. That issue often is determined by the other goals of legacy planning.

Continuing the management and caretaking of the estate is the next goal. If you are like most people, you have been calling the shots if not doing all the management. Too many estates, regardless of their size, dwindle rapidly after the first owners pass them on. Often the successors did not understand how the assets were to be managed or did not share the values and outlook of the founder.

This issue is particularly important with small businesses. The founding owner must decide who will own the business, who will benefit from its income, and who will manage the business. Those are three separate categories and do not have to consist of the same person or people. A key to successful legacy planning for a business, however, is to have a succession plan in place and to follow it. Succession planning is an issue we have discussed in my newsletter, Retirement Watch from time to time.

Even estates without businesses need to address the issue of the stewardship transition. It could be that the people you want to benefit from the wealth are not likely to manage it well over the long term. In that case, you want to consider trusts and other arrangements that separate management and ownership. It is important to recognize that those who benefit from the assets do not have to be the managers.

Protecting the estate is another key element of the plan. This goal is particularly important to small business owners and professionals. They feel a greater need to protect assets from potential creditors and lawsuits. But others might need asset protection from those sources as well as disgruntled family members, irresponsible family members, and ex-family members in divorces.

There are simple, low-cost vehicles that will protect assets, including different ways to hold title to assets, IRAs, annuities, and umbrella liability insurance. These work for estates of any size. For larger estates, there are vehicles that can be used to protect assets, including trusts and limited partnerships. Your fears, needs, and the various methods can be discussed with your estate planner. The key is to identify the assets you want protected and the potential harms from which you want protection. Surprisingly, the size of the estate often is not a factor. Many estate planners report that the worst fights are over the smaller estates.

The legacy plan must address the potential tax burden. Once you have established who should benefit from the wealth, you want to transfer the wealth to them in the ways with the lowest possible tax bill that meet your other goals. For many estates, that has become easier each year for about a decade, but easier tax reduction probably won't continue after 2009.

One reason many people do not develop estate plans is they do not realize how valuable the estate is and the potential tax burden. There often are "hidden assets" that are included in the taxable estate such as annuities, life insurance, IRAs, and some trusts. Other people "forget" about some of their assets or do not know their true value.

Even when federal estate taxes are not a problem, state inheritance or estate taxes could be. A number of states have these taxes, and some impose taxes on estates or assets with values as low as $250,000.

Income taxes on beneficiaries also need to be considered in the plan. For example, the beneficiaries of IRAs face an income tax burden many people overlook. That burden is one reason it might benefit you or your heirs to empty an IRA early, pay the taxes, and put the IRA assets in a taxable account to compound over the years. If you do not consider income taxes, your beneficiaries could benefit from far less of your wealth than you expected.

Planning a legacy involves far more than reducing estate taxes. It is time to start determining your goals and putting your plan together. Once the new estate tax law is final, push forward with the final details and implementation.

Better Strategies for Estate Planning Gifts

Bob Carlson — Fri, 10 Jul 2009 15:07:00 GMT

Gift giving is the surest way to help loved ones of all ages, establish a legacy, and reduce estate taxes when the estate is large enough. Yet, many people are hesitant to make significant gifts to loved ones, because of the potential pitfalls. Those pitfalls, however, can be avoided with some shrewd and creative giving strategies.

Potential givers see several risks in making substantial gifts. The wealth could be wasted or spent unwisely by the recipients. Simple mismanagement by an unsophisticated heir might cause the money to disappear in scams or unwise investments or spending. The wealth also could be dissipated though gambling, substance abuse, or bankruptcy. A common concern is that part of the wealth eventually could leave the family in a divorce.

Many of these risks can be reduced by giving through trusts, but there are many reasons why people do not want to give through trusts. It costs money to set up the trusts and keep them going. A trustee must be located to manage the property. It also is a statement to the beneficiary that he or she is not trusted with the money.

While the risks of giving are real, there are ways to give that reduce or eliminate the risks without the expense and inconvenience of trusts. The benefits of making gifts today can be reaped while protecting wealth from the perils.

529 plans. College savings plans authorized under section 529 of the tax code have become one of the best estate planning vehicles in recent years, while tax law changes have diminished the value of other vehicles. Most states now offer multiple 529 plan options, and any person can set up an account for the benefit of someone else and contribute to it. Plan contributions qualify for the annual gift tax exclusion, which is up to $13,000 for 2009. In addition, up to five years' worth of exclusions can be used in one year for a tax free lump sum contribution of up to $65,000. The money given to the account is out of the donor’s estate. Under many state plans the owner has some choice over how the account is invested.

Income and gains in the account compound tax free. Withdrawals are tax free if they are used for qualified education expenses of the beneficiary.

A distinctive advantage of the 529 plan is the owner can retrieve assets from the account for any reason. There is no tax penalty if the owner asks for the return of the assets, though the plan sponsor can impose a penalty of up to 10%. The owner also can change the plan beneficiary at any time.

Some states limit the duration of an account to a number of years or to the 25th or 30th birthday of the initial beneficiary. Others have no time limit.

A 529 college savings plan provides a tax-free way to remove assets from an estate, place them in a tax-free savings vehicle, and benefit an heir. But the beneficiary has no current control of the assets and can be denied future access if the situation changes. The donor can retrieve the assets if his or her needs change.

Bill paying assistance. Many people hesitate to make gifts because they are concerned the gifts will be wasted. They would like to help loved ones but do not want their gifts funding frivolous expenditures or being lost in unwise investments.

One way to prevent that outcome is to make direct payments on behalf of the beneficiary. The beneficiary never touches the money, and the gifts pay for what the donor intended. For example, checks for education or medical expenses can be written and sent directly to the provider. Some people pay directly for vacations, summer camps, furniture, clothing, cars, and whatever other expenses they want to pay.

Direct payment of gifts qualifies for the annual gift tax exclusion. In addition, qualified education and medical expense payments made directly to the provider qualify for an unlimited gift tax exclusion.

Purchasing services is safer than paying for assets. Assets can be divided in a divorce or sold or pawned to fund other spending. A possible disadvantage is that paying for items might put loved ones in the habit of asking for assistance whenever they want something. A better approach is to have a plan in which the amount and object of gifts for the year are discussed and set in advance, or even multi-year plans are developed.

Home equity loan match. Suppose loved ones need an expensive item, but the parents are not able or willing to part with a large lump sum or want to stay within the annual gift tax exclusion limit. A strategy, if the children have adequate home equity and credit, is for the children to make the purchase with a home equity loan. The parents then can agree to make all or part of the loan payments either directly or by sending money to the children. This allows the parents to help the children, stay within the gift tax exemption amount, and spread the payments over time in manageable amounts. The children deduct the interest if they make the payments.

Expense matching. Some donors to charities make challenge matches. They offer to match, up to a maximum amount, whatever amount the charity raises from other donors for a specific purpose. Parents can do the same with children. If the children need or want a car, for example, the parents can offer to match whatever amount the children spend. The match does not have to be dollar for dollar. The parents can offer to pay fifty cents for every dollar the children pay.

Some parents believe it is important the children contribute some of their own earnings to a major expenditure. The cost sharing makes it more likely that the children will choose wisely and take care of the asset. It also makes the children less dependent on the parents.

Marital agreements. When gifts are not made because the parents do not want to risk that they will be divided in a divorce, parents should discuss this with the children. The problem could be remedied with a premarital or postmarital agreement stating any lifetime gifts or estate bequests received by one spouse will not be considered part of the marital estate to be divided in a divorce. Many parents and grandparents will not make estate planning gifts unless there is such a marital agreement.

Maintaining separate accounts. In many states assets owned before a marriage plus gifts and inheritances are not included in the marital estate if they are not commingled with other assets. Parents should check the state's treatment of the gifts, and then can require that their gifts be kept in separate financial accounts

Trusts. Of course, the classic way to protect assets is by placing them in trusts. In this posting I have offered a number of ways to protect assets without the expense and restrictions of a trust. Trusts can be fashioned to accept tax-free gifts, take property out of an estate, protect assets, and provide incentives for the beneficiaries.

Estate owners have legitimate concerns about what might become of their estate planning gifts. These concerns can be resolved with some creative gift giving, enhancing the lives of loved ones while protecting hard-earned wealth.

Avoiding Rags to Riches to Rags

Bob Carlson — Thu, 11 Jun 2009 19:57:00 GMT

The pattern for family wealth seems fixed. Different times and different cultures display the same pattern. The first generation builds wealth, and the second generation shepherds or preserves it. The third and succeeding generations spend until it is dissipated.

There are a few examples of families in which wealth lasted many generations. The fact that people can name these families shows they are exceptions. There are many more families in which little of the wealth makes it past the second generation. The pattern inspired the adages "shirtsleeves to shirtsleeves in three generations" and "rags to riches to rags." These adages have counterparts in other cultures.

After securing their own standard of living, the financial and estate planning concern of most affluent Americans is to provide some financial security for their grandchildren and perhaps later generations. This is possible, but most people try to accomplish it the wrong way.

Estate planning, or wealth transfer planning as some like to call it, tends to focus on the mechanics. Advisors discuss the most efficient ways to transfer assets to the next generations. The emphasis is on reducing taxes and other transfer costs. In recent years, incentives and controls have taken a greater role in many plans. Parents and grandparents seek to transfer wealth in ways that encourage the recipients to develop solid values and a work ethic and protect the wealth if they do not. For example, income or principal might be paid out of trusts only if a beneficiary meets certain goals, such as completing college or holding a job.

The shortcoming of most estate plans is their focus on ways to transfer financial capital. The real, enduring wealth of a family is not financial capital. More important assets to sustaining the family's long-term financial security are intellectual capital and human capital.

Intellectual capital is the accumulated knowledge of the family members. Human capital is the members of the family and their individual qualities and talents.

James Hughes, a semi-retired estate planning attorney, said in Financial Planning that identifying and transferring these non-financial forms of capital between generations is what ensures family wealth will grow through generations. Hughes believes that primitive societies recognize the importance of transferring human and intellectual capital between generations, because they do not have much financial capital to transfer.

Hughes says that primitive societies have formal processes in which older generations initiate younger generations from childhood into adulthood. Older generations seek to identify the gifts of younger members and nurture those gifts. The older members also pass on the knowledge they have acquired. The younger members provide energy to supplement the intellectual capital of the older members.

Hughes believes that estate planning should focus on more than financial capital and the techniques for transferring it. Instead, wealth transfer planning should be values-based and focus on transferring intellectual capital and maximizing human capital. Family mission statements and a governing structure should be established. The governing structure should not be top down or vertical. Instead, it should be more vertical or a combination of horizontal and vertical.

Importantly, there should be a mentoring process in which the older members teach the younger members about the family's values and its techniques for building wealth. Techniques for transferring financial capital, such as trusts, should focus on the very long term, not just the next generation.

Here is an important point that many people get wrong. It is important to transfer principles to the next generation but not necessarily methods of preserving and growing wealth. The methods that will be effective change over time. For wealth to grow over time, strategies must change and adapt. Values can be preserved, but methods might have to change. Each generation needs to do more than preserve and manage what it is given. Instead, it needs to act like the first generation and focus on creating wealth rather than investing and living off the financial capital created by the first generation.

A good example of this process is the Marriott family. The Marriott business empire began as a cafeteria chain, Hot Shoppes. Eventually the company, which was run by the family, invested its earnings in hotels and other real estate. When the cafeteria business seemed mature, it was sold and the family focused on hotels.

After a while, family managers realized that owning hotels was capital intensive and subject to the economic cycle. The hotels were sold. Marriott Corporation now manages hotels under contract from the owners of the properties. Less capital is required; the income stream is more reliable; and the effects of the business cycle are less pronounced. Marriott owns a number of brand names and trademarks it licenses to hotel owners—such as a range of Marriott hotels and Ritz-Carlton. But it does not own many properties.

Marriott Corporation has been controlled by the same family. But it has changed dramatically and continued to grow as each generation has acted as entrepreneurs instead of caretakers.

Each generation must be dynamic if wealth is to be preserved and especially if it to grow. When a generation views wealth or a business as static, the financial capital will begin to decline. That is why it is more important for the first generation to transfer its values and knowledge to the following generations than to transfer financial capital.

There are several ways to do this. In some families the first generation personally transfers the intellectual capital. In other families, formal education and contact with family advisors transfer the values. The transfer process can be informal through daily contact or formally through annual family retreats or other events. In most cases, a combination of these methods should be used.

Few estate planners or other advisors assist in the transfer of nonfinancial capital. Each family must develop a system that works for it.

The real wealth of a family is not its financial capital or its business. Financial capital can be dissipated, and a business must change and evolve to be sustainable. Values and intellectual capital must be transferred from the older generation. The younger generations must add their energy to build on what the earlier generations built. Otherwise the financial capital will dissipate even if the best wealth transfer techniques are used.

The Trickiest Part of Estate Planning

Bob Carlson — Fri, 05 Jun 2009 17:32:00 GMT

ways to efficiently distribute the residuary estate while reducing the probability of a will fight or family dispute. The appropriate method for your estate depends on family dynamics and your understanding of them.

Here are some strategies to consider. You have to decide which works best for your family.

§ If you are confident there won’t be problems, you can leave the residuary estate to the children and let them decide how to divide the items. Or you can name one of the children as executor and let the executor decide how to divide the residuary estate. The will might direct the executor to divide the residuary in equal shares among the children. Or it might direct the children to agree on a division under the executor’s direction. Many families are able to reach an amicable division this way.

If you are afraid emotions might take over, consider one of the other methods.

§ There is one surefire way to avoid conflicts. Direct the executor to sell everything that can be sold and distribute the cash to the heirs. Unsold items would be given to charity. Heirs who want a particular item or items can buy them at the sale. The executor decides on the sale process, and it should be one that does not allow one heir to have an advantage over others in obtaining an item.

§ Instead of listing each item of property and who should get it, you can label items as you decide who should receive them. You might put labels on the backs of artwork and on the bottoms of sculptures and furniture. Though the designations are not legally binding, you can mention them in the will as your preference for the executor to follow, and the executor and heirs usually respect them. Yet, you will have many items that cannot be labeled in this way. Worse, an unhappy family member can switch a label or claim that a label was switched or is not really your handwriting.

§ You can give the heirs an opportunity to agree on a distribution, then provide a back up if they do not agree. For example, the will can state the residuary estate will be distributed as agreed to by the beneficiaries, but if they do not agree within a certain time, the executor will sell or give away the residuary estate.

§ Finally, you can create a lottery system. You can decide on the system yourself or instruct the executor to use a lottery system of his or her own choosing. There are a number of possible lotteries.

The most common lottery probably is for the heirs to draw straws or names to determine the selection order. In the first round, the children each choose an item in the order drawn. In the next round, the selection order is reversed. Then they return to the initial order, and so on. If there are only two heirs, they can flip a coin to determine the first round order. The winner of the flip can be given the choice of either going first and picking one item or going second and picking two items.

Under this system, heirs pick the items that are of most value to them. That might be a problem if you want the heirs to receive equal value, either monetarily or sentimentally. In that case, one suggestion is to have the executor assign a value to each item and keep track of the selections. If heirs end up with unequal monetary values, the difference is made up with cash. Another approach is to allow heirs to choose only from items of relatively equal value in each round. That approach, however, is time-consuming and might not be practical with all estates.

Another lottery strategy is to let the heirs decide how to value items. There are a couple of ways to implement this strategy.

In one approach, each heir can assign a number of points to each item. By giving the items points, they are deciding how important each item is to them. After everything is valued this way, in the first round each person gets one item on which he or she placed more points than anyone else did.

The points assigned to the items are not likely to be equal. The person who assigned the most points to the item that he won doesn't select again. Instead, the others pick one or more items to which they assigned points until the total points of their items equal the total the first person placed on his or her item. For example, the first heir might "win" property to which he assigned 100 points; the second heir might have assigned 70 points to his winning item. The second heir gets to pick one or more items to which he assigned a total of 30 points before the second round begins.

A variation is to give each heir the same number of points as though they were dollars. They use the points to bid for items in the estate. If an item is particularly important to an heir, he might bid all or most of his points to ensure getting it. Under this approach, the heirs might end up with items of unequal economic value. But that should be acceptable because the heirs have determined the personal value of each item. More details on these two approaches are in the book, The Universe and The Teacup by K.C. Cole (Harcourt Brace & Co.; $13.00 paperback).

To make any of these systems work better, most estate planners recommend that in-laws not be involved. They seem to complicate an already complicated process.

If your estate is taxable, you need to keep taxes in mind. Someone must pay taxes on the items in the residuary estate (and the rest of the estate). You need to work with your estate planner to decide where the tax payments will come from.

Distributing the personal items can be the most complicated and difficult process of an estate. That is a reason some people distribute or dispose of many personal items as part of their planning process. One way to improve the results is to prevent surprises. Ask heirs and potential heirs if any of the items are of special value to them. Once you have made a decision, let the heirs know generally how the property will be handled. Estate planners generally believe that estate disputes and hard feelings are triggered more by surprises than anything else.

Your IRA and Your Heirs

Bob Carlson — Fri, 29 May 2009 20:22:00 GMT

The unfortunate fate of many IRAs shows why everyone needs an estate plan, even when the value of the estate is far below the taxable level. Few people are aware of what could happen to their IRAs when the next generation inherits them. Most people, and discussions of IRAs, focus on building the balance through contributions and investments. If your IRA is a meaningful portion of your estate, however, you better consider what will happen to it. Effective estate planning strategies for IRAs tend to be different from the rest of the plan.

An estate plan for IRAs should answer these questions: What will be the bills for estate taxes and income taxes? Who will pay those taxes? Who will receive the IRA? In what form will the IRA be received?

There is a great deal of confusion about how inherited IRAs are taxed. The value of the IRA will be included in the owner's estate. Unlike other assets, ownership of the IRA cannot be given away during life or put into a trust for the benefit of others. If the IRA owner's estate will be large enough to incur estate taxes, the owner has to use other assets to reduce the tax or purchase life insurance to pay the estate tax. Most likely the IRA also will incur any state death or inheritance taxes.

Estate taxes can be avoided when the surviving spouse is the sole primary beneficiary of the IRA. The IRA’s value will be included in the owner’s estate, but there will be an offsetting marital deduction when the spouse inherits.

When estate taxes are incurred on an IRA the next issue is: Who pays the taxes attributable to the IRA?

Most standard wills provide that estate taxes are paid from the residuary estate or from the surviving spouse's share. Other estates apportion the taxes against specific assets or shares of the estate. If the IRA is a large percentage of the estate and taxes are paid from the residuary estate or surviving spouse's share, the taxes attributable to the IRA could really shrink the after-tax value of the shares paying the taxes.

Having the taxes attributable to the IRA paid by the beneficiaries of the IRA could create problems. If the beneficiaries do not have sufficient other assets to pay the taxes, they will have to take a distribution from the IRA to pay the taxes. The distribution will be included in their gross income for income tax purposes, so they will have to take an extra amount to pay the income taxes on the distribution they take to pay the estate taxes.

The best solution depends on the particular estate and the beneficiaries. The IRA owner should take care to consider how much the estate taxes will be and which part of the estate will pay them or whether life insurance should be purchased to pay the taxes.

After the payment of estate taxes isre resolved, or even if estate taxes are not an issue, there are income taxes to consider.

Unlike when other assets are inherited, there also will be income taxes due when the beneficiary takes distributions from the IRA. The beneficiary pays the same income taxes on distributions that the owner would have paid. These taxes cannot be avoided, and the fact of them might influence who is named beneficiary of the IRA or how much is left to different beneficiaries.

A non-IRA asset is more valuable to an heir than an IRA of equal value is, because there will be income taxes due on distributions from the IRA. The heir really inherits only the after-tax value of the IRA. The non-IRA asset, on the other hand, can be sold and no capital gains taxes would be due on the appreciation that occurred during the owner's holding period.

The income taxes due on IRA distributions are a reason to consider making charitable gifts with the IRA instead of other estate assets. The IRA will be included in the estate, but there will be an offsetting charitable contribution deduction, for no net estate tax. In addition, a charity that is named beneficiary of an IRA will not owe income taxes when it takes distributions, so it will benefit from the full value of the IRA. If there is an inclination to make charitable gifts through the estate, it often is better to make the gifts through an IRA and maximize the non-IRA assets left to other heirs.

You do not have to leave the entire IRA to a charity. If the IRA’s value exceeds the amount you want to leave to charity, leave a portion of the IRA to charity and a portion to other heirs. Or split the IRA into two, leaving one entirely to charity and the other to other beneficiaries.

Another issue is the beneficiary selection, if it is not to be a charity. An IRA owner wants to be sure to name one or more beneficiaries. Failure to do so, or naming the estate as beneficiary, removes the tax deferral benefits of the IRA. Distributions will be required from the IRA on an accelerated schedule.

Naming the beneficiary is not as complicated as it used to be. Before 2001 and 2002 regulations, the beneficiary choice greatly influenced the amount of the required minimum distributions during the owner’s lifetime. Now, an IRA owner should consider only which beneficiary he or she really wants to receive the IRA.

In most cases, the surviving spouse is the primary beneficiary and the children are contingent beneficiaries. In larger estates, the owner might name a charity to receive at least some of the IRA as discussed above.

Yet, it makes a lot of sense for an IRA owner to have a back up plan for the beneficiary selection. The regulations allow the estate executor to name the Designated Beneficiary by September 30 of the year after the year of the IRA owner's death. In most cases, there won't be any reason to change from the standard practice of naming the surviving spouse as beneficiary. But circumstances can change, and the regulations allow the executor to adapt to changing circumstances.

For the executor to take advantage of the flexibility, the IRA owner must name contingent beneficiaries on the beneficiary designation form. The Designated Beneficiary named by the executor must be on the list of primary and contingent beneficiaries named by the owner.

When more than one person is beneficiary of an IRA, the beneficiaries can split the IRA into separate ones, but they might not realize this or the IRA custodian might be resistant to it. If the beneficiaries do not split the IRA, the age of the oldest determines the required minimum distributions from the IRA. In addition, the beneficiaries have to agree on management of the IRA and on the policy for taking distributions that exceed the required minimum.

The IRA owner should ensure that the beneficiaries know they can split the IRA. The owner also should check the IRA custodian’s policy for splitting inherited IRAs. Some discourage it or charge fees. Some IRA owners decide to split their IRAs themselves, naming one primary beneficiary for each.

Instead of leaving the IRA directly to individual beneficiaries, the owner might want to name a trust as beneficiary. The trust can control when distributions are made to the beneficiary. This arrangement might increase income taxes, however, and tricky rules must be followed when drafting the trust. Do not name a trust as IRA beneficiary without working with an estate planning attorney who is experienced in this area. The wrong language in the trust can terminate the tax deferral benefits of the IRA and require distributions on an accelerated schedule.

Because of the income and estate taxes and the nuances of naming beneficiaries, some IRA owners choose to empty their IRAs early, pay the taxes, and invest the after-tax assets in taxable accounts. Once out of the IRA, the assets can be given away as part of the estate plan or can be invested for long-term gains.

Emptying the IRA early generally is a strategy for those who have sufficient assets outside the IRA to support their standard of living or have such large IRAs that they consider the IRA primarily a savings account or something to be left to the next generation. If the strategy is used, it is best to empty the IRA as early as possible, because time is needed to make up for paying the income taxes early. I discuss the strategy in detail in my book, The New Rules of Retirement and have discussed it in past issues of Retirement Watch.

For similar reasons, people convert traditional IRAs into Roth IRAs, which also is discussed in those sources.

IRA owners need to know that wills and living trusts have no effect on an IRA. Only the beneficiary designation form on file with the custodian determines who inherits an IRA. IRA owners need to keep copies of the form and review it regularly. They also should check with the IRA custodian to be sure it has the current form on file.

The ABCs and XYZs of Trusts

Bob Carlson — Wed, 06 May 2009 15:17:00 GMT

Trusts are fairly simple. Lawyers and estate planners make them seem more complicated than they are. That’s too bad, because to ensure they have effective estate plans nonlawyers need to understand the different types of trusts and how they work.

Trusts used to be for only the very wealthy or for special situations. But now trusts are included in many estate plans, because they can help achieve so many goals. Almost everyone needs a working knowledge of trusts, and you should brush up on them before the estate tax is changed later in 2009.

A trust is simply a contract with three parties. The parties can be groups, because more than one person can share any of the roles. A person can have more than one role, even all three.

One party to the contract is the grantor or creator. This is the person who wrote the trust agreement and usually puts all the assets in the trust. Another party is the trustee. The trustee agrees to manage the assets according to the terms of the trust agreement and the law. Legally the trustee acts as owner of the assets, but the actions the trustee can take are limited by the trust agreement. In addition, the assets cannot be reached by personal creditors of the trustee.

The third party is the beneficiary. Beneficiaries have rights to receive income or principal or both according to the terms of the trust agreement, and the trust assets are managed for the benefit of the beneficiaries. Sometimes beneficiaries have other rights, such as the ability to change trustees or name who receives their interests after they pass away. Either the beneficiaries or grantor normally can sue the trustee for violating the trust agreement or mismanaging the assets.

Trusts are very flexible. There are few limits to the terms that can be put in the trust agreement. To make their work easier, lawyers have shorthand names for trusts that are designed to achieve specific goals. The tax law also gives names to trusts with certain provisions. The flexibility and different names can make trusts seem confusing.

In general, it is easiest to think of trusts in four categories. In each category there are two possible labels. Most trusts have a label from more than one category and some from each category.

Living vs. post mortem. A living trust simply is a trust created during the grantor's lifetime. A post mortem trust is one created in or as part of the will. A living trust often is given the Latin name inter vivos trust.

Keep in mind a trust can be created but not funded. For example, a grantor and trustee can sign the trust agreement. That creates the trust. But the trust has no effect and there is no business for it to do unless property is transferred to it. It is not unusual for grantors to create trusts then fail to transfer title to any assets to them. Also a trust can be created during life but funded under the will.

When most people hear the phrase "living trust" they actually are thinking of a revocable living trust, which we will discuss next.

Revocable vs. irrevocable. A living trust can be revocable or irrevocable. In a revocable trust, the grantor reserves the right to revoke the trust or change its terms. The right to change might apply to some terms or to all the trust terms. For example, the grantor might reserve only the right to change the beneficiaries but not the rest of the terms. An irrevocable trust is what the name says. Its terms cannot be changed by the grantor after the trust agreement is signed.

A very common trust is the revocable living trust. It is used to avoid probate in states with high probate costs or long probate procedures, especially California and Florida.

Under the revocable living trust the grantor transfers title to almost all his or her property to the trust, including homes, cars, checking accounts, investment accounts, and household furnishings. The grantor and grantor's spouse usually are both the initial trustees and beneficiaries. They generally treat the property the same as they did before the trust was formed, except everything must be in the trust's name, and they manage it as trustees. The trust agreement spells out who succeeds them as trustees and beneficiaries.

Property owned by a trust is transferred to the next generation of beneficiaries under the terms of the trust agreement. A will has no effect, and property owned by a trust avoids the probate process. There is no public recording of the trust, and the trustees do not have to ask a court to transfer title to heirs. Instead, the trust agreement controls. That is why a revocable living trust also is called a will substitute.

There are serious tax differences between revocable and irrevocable trusts. When a grantor creates a revocable trust, the grantor is treated as the owner of the property for tax purposes, and the trust assets are included in the grantor's taxable estate. Income and gains of the revocable trust generally are taxed to the grantor as earned, whether or not money is paid from the trust to the grantor.

Irrevocable trusts can reduce income and estate taxes. When properly structured, irrevocable trust property is not included in the grantor's estate, and trust income and gains are taxed to either the trust or the beneficiary instead of the grantor. While irrevocable trusts can reduce taxes, they really must be irrevocable and the grantor cannot have the right to retrieve the property or be paid the income.

Income vs. total return. The next category refers to how annual payouts to the beneficiary are determined. Traditionally, the income beneficiaries of a trust receive only income earned by the trust's assets. Income generally is defined as interest, dividends, royalties, and rents. Capital gains are not income. They are added to trust principal. A standard trust term is to pay all income to the grantor’s spouse for life. After the spouse's demise, the children receive the remaining trust principal.

The income trust has become less feasible as interest rates declined and the cost of living increased. Income stays the same or declines as the income beneficiary's cost of living rises. The trustee could try to increase income by investing in riskier income vehicles, but that puts the principal at risk. Another tension is the remainder beneficiaries want some of the trust invested for growth. Otherwise, the purchasing power of their remainder interest declines because of inflation. But the needs of the income beneficiary discourage growth investing.

A total return trust solves these problems. The “income beneficiary” is paid either a percentage of the trust assets or a fixed amount. The trustee does not worry about restricting payouts only to income. Instead, the trustee invests for long-term growth with a diversified portfolio. The income beneficiaries can be paid from income, capital gains, or principal. The total return trust is the better way to structure trust payouts today.

Discretionary vs. nondiscretionary. This category refers to the trustee's ability to vary distributions or payouts. In a nondiscretionary trust, the trustee is told in the trust agreement how much to distribute to income beneficiaries each year or how to calculate the distributions. The trustee also is told when to distribute principal and how much to distribute. For example, one third of the principal might be distributed to a beneficiary upon turning age 21, another third at 25, and the remainder at 30.

A discretionary trust allows the trustee to exercise judgment at least part of the time. The trustee might distribute to the surviving spouse all income earned by the trust plus whatever principal or capital gains are needed to maintain the spouse's standard of living in the trustee’s judgment. Or the trustee might be able to withhold any distribution when the trustee believes it is in a beneficiary's best interest, such as when the beneficiary has a substance abuse or gambling problem.

These are the broad ways of categorizing trusts. There are many specialized trusts. There are charitable trusts (several types of them), dynasty trusts, grantor retained annuity trusts, grantor retained income trusts, and many more. These specialized trusts usually are used to accomplish certain goals at a minimum tax cost, and the tax law dictates the details of the trusts. But each of these specialized trusts also can be defined by the categories we discussed. They are specialized trusts within the categories.

Now, you know the basics of trusts. You can intelligently review and discuss estate plan options, know the key questions to ask about a trust and the consequences of the answers. You are ready to put together a more effective estate plan and to avoid having a trust you don't need or that does not meet your goals.

Safe Ways to Give Wealth

Bob Carlson — Fri, 24 Apr 2009 12:49:00 GMT

Gift giving is the surest way to reduce estate taxes, help loved ones of all ages, and establish a legacy. Yet, many people are hesitant to make significant gifts to loved ones, because of some potential pitfalls. Those pitfalls, however, can be avoided with some shrewd and creative giving strategies.

Potential givers see several risks in making substantial gifts. The wealth could be wasted or spent unwisely by the recipients. Simple mismanagement by an unsophisticated heir might cause the money to disappear in scams or unwise investments. The wealth also could be dissipated though gambling, substance abuse, or bankruptcy. A common concern is that part of the wealth eventually could leave the family in a divorce.

While these risks are real, there are ways to give that reduce or eliminate the risks without the expense and inconvenience of trusts. As I have stated in past posts, this is a good time to make estate planning gifts, because asset values are down. Estate and gift taxes are based on the value of property. The lower the value of property is when it leaves your hands, the lower the transfer taxes. The benefits of making gifts today can be reaped while protecting wealth from these and other perils. Consider these strategies for structuring gifts.

529 plans. College savings plans authorized under section 529 of the tax code have become one of the best estate planning vehicles in recent years, while tax law changes have diminished the value of other vehicles. Most states now offer multiple 529 plan options, and any person can set up an account for the benefit of someone else and contribute to it. Contributions qualify for the annual gift tax exclusion, currently up to $13,000 per year. In addition, up to five years' worth of exclusions can be used in one year for a tax free lump sum contribution of up to $65,000. The money given to the account is out of the donor’s estate. Under many state plans the owner has some choices over how the account is invested. The IRS generally restricts investment changes to one per year, though the limit is suspended for 2009.

Income and gains in the account compound tax free. Withdrawals are tax free if they are used for qualified education expenses of the beneficiary.

Some states limit the duration of an account to a number of years or to the 25th or 30th birthday of the initial beneficiary. Others have no time limit.

Direct payment of gifts qualifies for the annual gift tax exclusion. In addition, qualified education and medical expense payments made directly to the provider qualify for unlimited gift tax exclusions.

Purchasing services is safer than paying for assets. Assets can be divided in a divorce or sold or pawned to fund other spending. Another possible disadvantage is that paying for items might put loved ones in the habit of asking for assistance whenever they want something. A better approach is to have a plan in which gifts for the year are discussed and set or even multi-year plans are developed.

Home equity match. Suppose loved ones need an expensive item, but the parents are not able or willing to part with a large lump sum or want to stay within the annual gift tax exclusion limit. A strategy, if the children have adequate home equity and credit, is for the children to make the purchase with a home equity loan. The parents then can agree to make all or part of the loan payments either directly or by sending money to the children. This allows the parents to help the children, stay within the gift tax exemption amount, and spread the payments over time in manageable amounts. The children deduct the interest.

Some parents believe it is important the children have some of their own assets in a major expenditure. The cost sharing makes it more likely that the children will choose wisely and take care of the asset. It also makes the children less dependent on the parents.

Trusts. Of course, the classic way to protect assets is by placing them in trusts. In this post we have offered a number of ways to protect assets without the expense and restrictions of a trust. When the strategies discussed here do not meet the donor’s goals, trusts can be fashioned to accept tax-free gifts, take property out of an estate, protect assets, and provide incentives for the beneficiaries.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of numerous books and reports, including The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

IRA Inheritance Disasters: A Case Study

Bob Carlson — Fri, 10 Apr 2009 20:55:00 GMT

One point I try to emphasize regularly in my newsletter and web site is the importance of the beneficiary designation form for IRAs, pensions, annuities, and a few other assets. Yes, a will or living trust are very important to your estate plan. They do not, however, control the disposition of all your assets. Assets that avoid the probate process are not controlled by your will or trust. Only the beneficiary designation form on file with the IRA sponsor or other custodian of the assets determines who receives the assets after you.

A recent decision from the U.S. Supreme Court shows how important it is to keep your beneficiary forms up to date.

William Kennedy worked at DuPont and had a wife and daughter. He named his wife as beneficiary on the retirement plan's designation form and did not name a contingent beneficiary. Decades later, he and his wife divorced, and Mrs. Kennedy waived her rights to Mr. Kennedy's retirement benefits as part of the settlement. The waiver was not in the form of a qualified domestic relations order as defined in the tax law, which the plan would be required to follow. Since the waiver was not a QDRO, the plan documents controlled the account.

Unfortunately, Mr. Kennedy never changed his beneficiary designation form with DuPont. (He did change the designation form for another retirement plan at DuPont, naming his daughter as beneficiary.) He retired in 1998 and began receiving benefits. He died in 2001. Dupont then paid $402,000 to the former Mrs. Kennedy as beneficiary of the account.

The daughter sued DuPont, saying her father clearly intended that his ex-wife not inherit the retirement benefits. The ex-wife, she said, was compensated by other means and waived any rights to the benefits.

The Supreme Court held DuPont had no responsibility to the daughter. DuPont was bound to follow the employee's instructions on the forms filed with the employer, no matter how old and out-of-date they might seem. The ex-wife's waiver of her rights to the benefits did not amount to an assignment of the rights to the daughter. It was the employee’s job to update the forms if he changed his mind. The plan administrator is not able or required to review anything else to determine who should receive the benefits. Kennedy v. Plan Administrator for DuPont Savings and Investment Plan, US Supreme Court, Jan. 26, 2009.

The bottom line as we have said many times is your beneficiary designation forms control what happens to your retirement benefits, and you need to keep those forms up to date. This is true for retirement plans, annuities, life insurance, and other non-probate assets. You need to review the beneficiary designations at least every couple of years or when there is a major life event. Keep copies of the forms and write “superceded” or something similar on out-of-date forms, in case the custodian loses the forms. Be sure your executor knows where to find your copies of the forms.

How to Revise Your Spending Plan

Bob Carlson — Fri, 27 Mar 2009 15:24:00 GMT

The swift declines in most asset classes in late 2008 and into 2009 damaged many portfolios. For those who are retired or near retirement, one necessary step after such an event is to re-evaluate retirement spending. Specifically you have to check the rate at which you are withdrawing money from the retirement portfolio and decide if it needs to be adjusted to reduce the risk of running out of money.

In the past I have discussed the safe or sustainable withdrawal rate, especially in my newsletter Retirement Watch. The safe withdrawal rate is the percentage of the portfolio you can withdraw the first year, increase by inflation each subsequent year, and have a high probability the portfolio will last at least 30 years. The biggest risk to a retirement portfolio is a bear market or a long-term flat market in the early years of retirement. The second biggest risk is to withdraw money at an unsustainable rate.

Numerous studies have been done. They all indicate that to be safe, the first year withdrawal rate should be between 3% and 4% of the portfolio. The most commonly-cited sustainable rate is 3.6%. This assumes you invest at least 50% of the portfolio in stocks or assets that earn similar returns and the rest in bonds. If you invest a lower percentage in growth assets, the sustainable withdrawal rate is lower.

If you are fortunate enough to retire at the beginning of a bull market, a higher withdrawal rate is safe. But you won't know until after a few years of retirement the type of market that coincided with the beginning of your retirement.

Whatever withdrawal rate you choose the first year, the rate needs to be re-evaluated periodically. Especially with the current bear market, you need to re-examine the decision. Even the 3.6% withdrawal rate does not allow a portfolio to last 30 years 100% of the time. There still is a risk of running out of money in the case of a severe bear market. You want to be sure today’s nasty market environment does not tip you into that small percentage of times when even the historic sustainable withdrawal rate is too high.

Bear markets are followed by bull markets. Bull markets restore the retirement portfolio by accumulating gains faster than you spend. The key is to be sure the combination of the bear market and your spending does not bring the portfolio balance so low the subsequent bull market gains are not enough to sustain the portfolio through retirement.

If you retired a few years ago and still have a portfolio that is worth more than your starting portfolio, you probably are in good shape. The research shows you should be able to continue your planned withdrawal schedule with a very low probability of outliving your money. You might want to reduce spending a bit for the next few years to be on the safe side, but drastic measures should not be needed unless there is another significant downward leg to this bear market.

What if you now have less money than when you first retired? In that case, you need to consider changes. We will review some potential changes shortly. First, let's look at some more objective benchmarks of your spending rate.

One check is to assume an immediate single-premium lifetime annuity is purchased today with your entire retirement portfolio. Is the annual payout from that annuity similar to the amount you are withdrawing now? If you are withdrawing significantly more than the annuity payment, you are likely to have a problem sustaining the withdrawal rate. Insurance companies spend a lot of resources calculating life expectancies, devising investment strategies, and determining how much they can pay a person and still make a profit. If your withdrawals are significantly higher than what the insurers are paying, then you are assuming a significantly higher investment return or shorter life expectancy than the insurers. Keep in mind if you have a spouse you intend to provide for, the portfolio likely will have to last longer than for a single life annuity. Also, insurers usually do not index annuities for inflation. So if you are withdrawing significantly more than annuities are paying and you are increasing that for inflation, you need to re-evaluate the spending rate. Check annuity payout rates at web sites such as www.ImmediateAnnuities.com

Another objective warning sign is a withdrawal rate well above the historic safe rate. Surveys continue to show many people think they safely can withdraw 8% to 10% annually. Research does not back that up, except in strong bull markets.

Here’s another quantitative measure.

One study found a strong correlation between the safe withdrawal rate for the next 30 years and the current price/earnings ratio of the S&P 500. The higher the P/E ratio, the lower the safe withdrawal rate is for the next 30 years. P/E ratios tend to be high at bull market peaks, followed by years of below-average returns.

A simple rule is that when the P/E ratio is above the historic average, the safe withdrawal rate is on the low side. When the P/E ratio is low, withdrawal rates can be higher. When the P/E ratio is below 12, a withdrawal rate of 6% or more generally is safe. At extreme bear market bottoms, a rate of 10% can be sustained going forward. Right now, the P/E ratio is a little below the historic average but not near historic lows.

If your portfolio has declined and you are concerned how long it will last at the current spending rate, there are steps you should consider. One or more of these steps should put you back on the right track.

Drop the inflation bump. Remember the studies all assume that after the first year the amount taken from the portfolio each year increases with inflation. A simple step is to stop the inflation increase for a while. Insurers generally do not increase annuity payouts for inflation because it is very expensive.

Use a market-based formula. Instead of a formula that steadily increases spending, have spending rise and fall with the portfolio, though not by as much. One simple formula is to set your withdrawal rate, but apply it to the average account value at the end of each of the last five years instead of the current value.

Another option is what I call the Yale Endowment formula. Each year 70% of the distribution is the initial spending amount plus inflation. The other 30% is a fixed percentage of the portfolio's value latest year-end value. More details of the formula are in my book The New Rules of Retirement.

Either of these formulas will smooth distributions and their effect on the portfolio. They have the disadvantage of automatically reducing spending when the portfolio declines, but that makes the portfolio last longer. They also have the advantages of increasing spending as investment returns improve and the cuts are not as drastic as the portfolio’s changes.

The safety fund system. Another approach I have recommended is to create a safety fund at the start of retirement. You put an amount equal to the estimated spending for two to five years in safe investments such as money market funds and certificates of deposit. The rest of your portfolio is invested for the long-term. You take money from the safety fund to pay expenses. At the end of each year you rebalance the long-term portfolio by replenishing the safety fund.

The advantage of the safety fund approach is that you do not feel pressured to sell investments after a steep decline, because you know there is enough money in safe assets to get through the two to five year period. Those who do not have large enough portfolios to create a safety fund should consider purchasing an immediate annuity with a portion of their portfolios. The steady annuity income gives your annual income a floor and can prevent you from taking extreme actions with the rest of your portfolio. Because of low interest rates now is not an optimum time to put a lot of money in an immediate annuity, but as rates rise it is a good long-term strategy.

Change allocations and strategies. Retirees whose past investment strategies have let them down should consider changes. Some portfolios were too heavily weighted to equities instead of being diversified (though there were few asset classes that did not lose money in late 2008). Other investors could benefit by shifting from buy-and-hold to the more active strategies of our Retirement Watch Managed Portfolios. A long-term buy-and-hold strategy often is not a good strategy, because it puts you at risk of substantial losses during long-term bear markets.

Another possibility is to try to earn higher returns by taking more risk after the markets decline significantly.

Spending cycles. For many people spending naturally varies during retirement. Spending tends to be relatively high during the early years as people are physically active and have a backlog of things they want to do. After a few years they settle into more of a routine. Spending tends to ratchet down a notch in this second phase because of less traveling and other big ticket activities. In the third phase people generally are less active as they get older and that leads to lower spending. In response to the bear market you might reduce spending a bit now but assume it will decline more later in retirement instead of taking a larger reduction now.

The wild cards in that plan are medical expenses and long-term health care. If you are well-insured these might not be issues. Otherwise, they might keep overall spending from declining in the second and third phases.

Most retirees are able to vary spending. They can postpone travel, spend less on restaurants and entertainment, and replace cars and other items less often. Spending adjustments are the best way to get a retirement portfolio and spending back on track. It is much better than permanently switching to only safe assets, though that is the temptation.

In our portfolios we reduced risk early and will keep it low until the financial crisis seems to be nearing an end. But we are not permanently switching to safe investments. That is a mistake many people make after a market downturn. Retirement lasts a long time, and your income needs to grow to maintain purchasing power.

When secular bear markets strike early in retirement and put the longevity of your portfolio at risk, adjustments are needed. First, adjust spending. You can reduce it for only a year or two or consider making a permanent change to the spending formula. Second, reconsider your investment policy. Do not give up on growth or risk or take too much risk, but be sure your strategy fits today’s markets.