Planning—the Key

Update your estate plan—right now

Here are the three steps you need to take.

By Robert Lowes
Midwest Editor

In this world," wrote Benjamin Franklin, "nothing is certain but death and taxes."

Ironically, nothing's more uncertain than that juncture of death and taxes called estate planning. You need look no further for proof than the tax law that Congress passed this year. The legislation progressively shrinks the estate tax and hikes the tax-sheltered amount through 2009, then repeals the tax entirely in 2010—but just for one year. In 2011, the estate tax will return with the top rate again at 55 percent, unless in the meantime Congress decides to make the repeal permanent.

However, a new president and new Congress in 2005 might undo what President Bush and his congressional allies have wrought. "You don't know how the political winds will blow," says Pittsburgh estate-planning attorney Robert B. Wolf. "That makes it difficult for people to make short- or long-term plans."

All this goes to show that nothing in estate planning is certain except flux. Not only do tax laws continually change; so do personal circumstances. A grandchild comes along. An adult child gets divorced. A spouse dies. Since you can't count on life to stand still, you need to review your estate plan regularly to ensure it stays current. And it's also wise to have an estate plan that can roll with the punches.

Here are three things you need to do now to stay flexible—and to ride out the Dubya tax revolution.

1. Make sure your plan reflects your life today

A banker—who should have known better—left his will and trust documents untouched from the late 1960s until his death 30 years later. "During that time, there had been many changes in the tax code, as well as new grandchildren," says Wolf. Because his plan was seriously outdated, the heirs feared they'd be assessed a huge estate tax. They dodged that bullet, but only after legal scrambling that cost them thousands of dollars.

Yes, highly educated people, including doctors, are that careless about freshening their estate plans. "Sometimes, people will set up a trust for their first child, but not for their second or third," notes David Rubinowitz, who heads estate-planning services for Morgan Stanley Investment Management in New York.

Rubinowitz and others suggest that at the very least, you revisit your estate plan every three to five years to avoid such lapses. That's not counting automatic reviews at important milestones in your life: Marriage. The births of children and grandchildren. Divorce. A career change. A move to another state that has different estate-planning laws. Retirement. Death, including that of a trustee or executor.

Trigger points for a review also include events in your children's lives. "You may have intended to will assets to a son or daughter outright, but that may not always be helpful," says New York estate-planning attorney Gideon Rothschild. "Maybe they're going through a nasty divorce or having business problems. Putting their inheritance in a trust can protect it from an ex-spouse or creditors."

When you examine your estate plans, make sure beneficiary designations on financial instruments are up to date. If they're not, the results may be disastrous. Maybe you designated your spouse as the beneficiary of your IRA and life insurance policy, for example. Then you divorce. If you don't remove the ex-spouse as a beneficiary, he or she may be entitled to those assets when you die, depending on what state you live in, says Rothschild.

Don't forget to add grandchildren as secondary beneficiaries on 401(k)s and other retirement accounts, says Robert Wolf. "I've seen plenty of 401(k)s where the children are listed as secondary beneficiaries, but not the grandchildren. However, if the owner outlives his spouse and children, who gets the 401(k) when he finally dies? The grandchildren could inherit it through probate, but that route would likely generate a lot of unnecessary income tax."

2. Adapt your plan to the new tax code

St. Louis financial planner Richard Feldmann recalls how one client overreacted when Congress approved this year's new tax revisions. "The estate tax is dead," the client crowed, overlooking that the law repealed it for only one year. He promptly dropped an insurance policy designed to pay his estate taxes. If he wants another policy to cover his estate-tax derriere, he'll have to pay a higher premium, because he's older.

Feldmann is telling other clients not to get carried away. "The tax changes don't have a huge effect on most people when it comes to estate planning," says Feldmann. Still, some tweaking may be in order.

Take the matter of the estate tax's disappearance in 2010 (and possibly beyond, although few experts are betting on an extension). "If you have an irrevocable trust, you might want to word it so that if the estate tax truly goes away, the trustee can collapse the trust and pay out all the assets," says Feldmann. However, Feldmann and others caution that there are plenty of good reasons to maintain a trust regardless of the tax climate—shielding assets from creditors, for instance.

The growth of the estate-tax exclusion from $675,000 in 2001 to $1 million in 2002 and $3.5 million in 2009 is a boon, but you won't fully exploit it if your trust documents are poorly drafted. A common blunder: Some people have living trusts stipulating that, upon their death, $675,000 in assets will flow into a credit shelter trust that eventually will pass on to their children tax-free under the exclusion. Remaining assets are to flow into a marital trust for the surviving spouse, who can receive any of her deceased spouse's assets tax-free.

The trouble with such trust language, says Gideon Rothschild, is that if the person dies in 2002, only $675,000 lands in the credit shelter trust, even though the amount that can be protected by the exclusion will then be $1 million. The solution: Avoid naming a specific number, and instead state that the maximum amount excluded from estate taxes goes into the credit shelter trust, says Rothschild. That way, you'll keep pace with the changing amount.

Even such wording could backfire if you're not careful, however. Let's say you die in 2009 with a $3.5 million estate, and you have both a credit shelter trust and a marital trust. Your will states that the maximum amount excluded from estate tax—in this case, $3.5 million—goes into the credit shelter trust. The children are taken care of in grand fashion, but nothing is left to fund the marital trust. If you were expecting your spouse to live primarily off the marital trust, she's out of luck.

One way you can avoid that snafu, says Robert Wolf, is to treat the credit shelter and marital trusts together as a total return unitrust.¹ The idea is to distribute a fixed percentage of the two trusts' combined value annually to the spouse—enough so he or she is well supported, but not so much that the overall value shrinks rather than grows.

Under this arrangement, it doesn't matter what percentage of assets—if any—wind up in the marital trust, according to Wolf. If the marital trust does get funded, the spouse draws that down first. After it's depleted, distributions come from the credit shelter trust. All along, assets in the credit shelter trust grow in value for the children's sake.

Like the estate-tax exclusion, the lifetime amount you can exclude from the federal gift tax—levied on assets you dole out while you're alive—has been hiked, from $675,000 to $1 million. That also should prompt a look at your estate planning. "You have the opportunity to reduce your taxable estate by an additional $325,000," says David Rubinowitz. "And assets that you gift appreciate outside your estate." You can leverage your gifts through a family limited partnership or a qualified personal residence trust, both of which allow you to discount the gifts for tax purposes. That way, you might be able to report a $1.5 million gift as only $1 million—and avoid the gift tax.

One nasty feature of the recent tax law change is the new method of calculating the cost basis of inherited stocks, real estate, and other appreciated assets in 2010. Right now, their cost basis is whatever their fair market value was when the previous owner died—not the amount that person originally paid for them. That spares the heirs from paying capital gains tax on any prior appreciation if they sell the assets. But beginning in 2010, the cost basis of all the appreciated assets in an estate will be what the previous owner originally paid for them, plus a "step up" amount of no more than $1.3 million ($4.3 million in the case of a spouse) for the estate overall. If the step-up doesn't wipe out all the appreciation, the heirs will pay tax on the remaining gain.

Given all the new complexities, make sure you keep careful records of assets that you purchased so heirs can establish their cost basis and stay in the good graces of the IRS.

3. Find out who's in your corner

If the new tax law makes you dizzy, get used to this feeling. "These days, the tax law changes every time the balance of power in Washington changes," says Stephan R. Leimberg, an estate planning attorney in Bryn Mawr, PA, and co-author of The New Book of Trusts (Leimberg Associates, 1997). "It no longer happens just once every 15 years, or even every seven."

This constant state of flux underlines the importance of flexibility in estate planning. The plan you drafted this year may need a substantial overhaul in 2005. And the longevity of trusts—think of multigenerational "dynasty" trusts—means that they're more liable to get out of whack with succeeding tax revisions and changing personal circumstances, says Kyra Morris, a financial planner in Mount Pleasant, SC.

Accordingly, Morris and some other estate-planning pros suggest appointing someone as a guardian angel over trusts. They go by such names as trust protector, trust adviser, and special trustee, but they share a common mission—riding herd on regular trustees and bank trust departments and ensuring that what you wanted to achieve through estate planning comes to pass.² They can be invested with certain powers, such as modifying trusts to keep them in sync with tax laws, or dissolving trusts if the estate tax ever dies for good.

These guardian angels watch out for your heirs after you're gone. But while you're alive, you need topnotch legal advice to continually fine-tune your plan. Here's a test: Did the attorney who drafted your will and trust documents send you any sort of communique about the impact of the new tax law? If he didn't, that's a bad sign, according to Stephan Leimberg. Adds Kyra Morris: "Most good estate-planning attorneys will write their clients once a year about tax code changes and provide a checklist of life changes that require a revision of their estate planning."

¹See "Will your trusts keep your heirs poor—and fighting?" Sept. 18, 2000.

²See "The best estate-planning tool you've never heard of," March 5, 2001.

 

Robert Lowes. Update your estate plan--right now. Medical Economics 2001;21:21.