As most of us are aware, smart estate planning includes avoiding probate. Avoiding probate doesn’t have to be difficult, yet, many people fail to take the simple steps to do so. Taking these simple steps can help ensure that all, or some, of your property will pass directly to your heirs, without having to be subject to probate.
What is Probate?
Probate is the legal process to officially prove and record one’s will, or if one has not created a will, determine who the heirs are. Depending on the size and complexity of the estate, assets could be tied up in the court system for several months, and the attorney and court fees will reduce the overall estate transferred to the heirs. Probate attorney fees for “routine” services can easily reach 4%, 5%, or more, of the total estate asset value. For an estate with a gross value of $500,000, that’s $25,000 or more, that the heirs will not receive.
Gift it.
The best way to make certain that your assets avoid probate is to not have any assets when you die. Of course, gifting away everything is rather extreme and isn’t very practical since you will need money while you are alive. In some cases though, it may make sense to gift some of the assets away while you are living in order to ensure that the proper beneficiary receives it. Provided your gift to an individual is not more than the annual exclusion for the calendar year, it should not be taxable. To be certain though, you should check the IRS website on estate and gift tax rules, or contact your accountant.
Joint Ownership
There are several forms of joint ownership and they do vary somewhat depending on what state you are in, but overall it is a pretty simple way to avoid probate. When property (including taxable accounts such as checking, saving, investment, etc.) is held in joint tenancy with rights of survivorship, that property will automatically transfer to the surviving owner(s) upon the death of another owner, no court proceeding required. For married couples, tenancy by the entirety or community property with right of survivorship may be an option in your state.
While joint ownership has been a rather popular way of avoiding probate, there are some downsides that should be considered before implementing this strategy.
Gift Taxes – Many parents add an adult child to one, or all, of their asset accounts with the understanding that the child will distribute the money equally to their siblings upon the death of the parent. In most instances this works just fine, but when there is a relatively descent amount of money or value involved, the use of a trust would likely be a better option.
Capital Gains Taxes – When someone becomes a joint owner of an asset, they assume the original cost basis of that asset. However, when they inherit and asset, they receive the stepped up cost basis, which is the value of the asset at the time of the owners death.
For example, let’s say you have an investment account and you own stock that you purchased years ago for a total of $50,000. Today, the account value is $200,000. In order to avoid probate and allow for the quick access to the funds in the event of your death, you add one of your children as a joint owner. A few years later, when you pass away, the account has grown to $300,000. When your child elects to sell the stock his/her cost basis will be $50,000 and therefore would have a potential capital gain of $250,000 that would be subject to taxation. Had the child inherited the account instead, he/she the cost basis would have been the $300,000 that the account was valued at on the day of your death.
Judgments Against Joint Owner – If the joint owner gets a divorce, is sued, files for bankruptcy, etc., a creditor or divorcing spouse could go after some or all of the assets in the joint account(s). After all, the counterparty is considered an owner of those assets.
Payable on Death
If you have life insurance, an annuity, or hold assets in a retirement account such as an IRA, 401(k), etc., then you have probably already specified one or more beneficiaries of those assets. While a beneficiary designation is rarely offered when you open a taxable account (such as a checking, savings, brokerage, etc.) you can easily convert the account to a POD “Payable on Death” or TOD “Transfer on Death” by filling out a simple form where you list the beneficiary. Some states even allow you to designate beneficiaries for your autos and real estate. Designating beneficiaries retains your control over the assets during your living years, avoids probate and provides the beneficiary with a stepped up cost basis.
Revocable Living Trust
A revocable living trust is simply a trust set up by a person during their life that lists what happens to the property in the trust after death. Having a living trust established is not enough to avoid probate of your assets when you pass. After the trust agreement has been established and signed, you will need to “move” the assets into the trust. This can be accomplished by simply designating the trust as the beneficiary of life insurance proceeds, annuities, retirement accounts, etc., as well as, a Payable on Death for non-retirement accounts. Real estate can also be held in a trust.
If you create a living trust but do not transfer a particular asset into it, (like a new vehicle that was purchased after the trust was created) that particular asset would be subject to probate. For these circumstances, it is wise to create a "pour-over" will when you create your trust. A pour-over will directs that any assets you own outside the trust should move into the trust at the time of your death to be administered to your trust's beneficiaries under the terms of your trust agreement. Again though, any property left outside your trust will still require probate, but the pour-over will would ensure that the property is moved to your trust after your death and therefore be distributed in accordance with the trust agreement.
As you can see, there are only a limited number of ways to avoid probate. What will actually work for you will depend on your own unique family and financial situations, but the bottom line is that by using one or more of the techniques described above to avoid the probate of your property, you will be creating peace of mind for you as well as peace of mind for your loved ones during a difficult time.
Kevin Warman, CIMA®, RMA®
Last Updated 10/12/12016