When Should I Update My Estate Plans?

During the process of gathering information from my estate planning clients, I provide a questionnaire that asks questions on goals, financial situations, family relationships and the like. One of the questions asks the client to list the designated beneficiary and contingent beneficiaries on their financial accounts like IRAs, 401(k)s, brokerage accounts, etc. Many times the client says, "Well, it should be my spouse, but right now it is my parents because I didn't update it when I got married." I also commonly hear clients state that they have never updated their contingent beneficiary designations when a child was born.

Forgetting to update designations as their family structure changes is very common. A person should adjust their beneficiary designations when certain life changing events take place, most commonly:

• when a person gets married,
• when a person purchases a home,
• when a child is born,
• when a married couple gets divorced, or
• when a spouse dies.

With Americans getting married later in life, many single people now acquire assets prior to getting married. For example, if a non-married person purchases a house and subsequently gets married, there could be an issue with respect to ownership of the home in the event the purchaser spouse dies. More than likely, the non-married purchaser bought the house without any joint tenants or tenants in common (See January 2010 Newsletter.). If the deed is updated to reflect the change in the purchaser's marital status, the house will have to enter probate. It might not be a huge issue. For example, Virginia's transfer of ownership during probate moves quickly. However, other states are not as accommodating. But a more complicated situation may occur. For instance, if the non-married purchaser listed one or more parents on the deed as joint tenants, the house could go to the deceased's parents under joint tenancy with the right of survivorship rules. Or, the lack of joint tenancy of the home could create an estate tax issue for the deceased. (See August 2010 Newsletter).

Another issue that impacts beneficiary updates is divorce and remarriage. A divorce will normally negate the ability of the divorced spouse to collect as a beneficiary on their ex-spouse’s death. But, each state is different and varies their laws as to how far the ex-spouse can reach into the estate of the deceased as a beneficiary. Barring a contradictory provision in the divorce decree, some states automatically cut-off the ex-spouse from collecting on all beneficiary designations. Other states will permit a divorced spouse to collect on non-probate assets that still list the divorced spouse as beneficiary. If the decedent/spouse has remarried or there are children from different marriages involved that are potential beneficiaries, it can be a real mess. If the estate is large enough, litigation is very likely.

Naturally, there are several caveats for qualified plans, i.e., profit sharing plans and 401(k)s. For 401(k)s, generally federal regulation, automatically dictate that a spouse is the primary beneficiary without the spouse’s signature stating otherwise. Beneficiary designations with respect to IRAs are governed by state law, and each state has different protections for ex-spouses. Instead of dealing with the messiness that arises from incorrectly listed designated beneficiaries, it is much easier to make the necessary changes near the time of the life changing event.

For other types of financial accounts, like a life insurance or a brokerage account, typically all a person needs to update their designations is to use the forms provided by the company managing the account when a life changing event occurs. Many companies even have on-line forms to update beneficiaries or will accept as adequate a simple letter informing the institution of the changes.

So after the joy or pain of a life changing event has subsided, take a few minutes to think about how the event will impact your life, and review your financial and legal documents. Five minutes of time updating the beneficiary designation on a company’s internet website can potentially save months of anguish for your loved ones.

Basics of Estate Planning: Are Life Insurance Benefits Taxed?

Most people assume that a life insurance death benefit is not taxed in any situation, confusing income tax and the estate tax. Since life insurance death benefits are not taxed as income, it seems to reason that benefits also escape the clutches of the estate taxes¹. This is not the case.

Generally, a beneficiary does not have to pay income taxes on a life insurance death benefit when those payments are made in a lump sum or regular intervals, but would pay income tax on any post-death interest earned prior to the payment to the beneficiary. However, as I demonstrated in (See August 2010 Newsletter), life insurance death benefits can elevate a decedent’s estate above the estate tax exemption level, and any amount over the exemption level would be taxed.

The decisions a decedent makes prior to dying with respect to ownership of the life insurance policy, the relationship of the beneficiaries to the decedent and the estate planning steps taken to mitigate the taxability of the life insurance death benefits all could impact whether or not benefits are included in the taxable estate.

To avoid including life insurance death benefit in your estate, two factors must be addressed. The first factor deals with making sure the estate is not named as the beneficiary of the life insurance death benefit. That is not as easy as it sounds. For example, a husband and wife each set up life insurance policies only listing the other spouse as the beneficiary and does not list any contingent beneficiaries. The husband dies and wife receives the death benefits from the husband’s policy. The wife continues to pay the premiums on her life insurance policy and never updates her beneficiaries on the policy. The wife eventually passes away and the life insurance death benefit folds back into her estate because her beneficiary, her husband, has already died. The wife has unknowingly increased the size of her taxable estate by failing to update her beneficiaries.

The other factor that determines if a life insurance death benefit is included in the estate is whether the insured demonstrates any incidents of ownership with respect to the life insurance policy. Examples of incidents of ownership would include:

• If an individual has the right to change the beneficiary,
• If an individual can transfer ownership of the policy,
• If an individual can use the policy value as collateral for a loan, or
• If an individual has any other traditional rights of ownership.

I know you are all rushing to scan your policies right now, if you can find them. No need; I have some good news. First, the policy’s death benefit, along with value of the person’s other taxable estate would need to exceed the federal exemption for a person to pay estate taxes on any life insurance death benefit. Right now, the federal estate tax exemption is projected to be around $1.0 million in 2011. Maryland and D.C. also have state estate taxes which could be applicable. Second, if your spouse, as primary beneficiary, inherits the death benefit, the money paid out would be protected under the unlimited marital deduction. However, the example I gave above could come into play, if the surviving spouse had no contingent beneficiaries listed. Further, if the insured spouse dies after the beneficiary spouse and the proceeds are paid to non-spouse beneficiaries, then no marital deduction will be available.

Eliminating a person’s incidents of ownership over a life insurance policy can be accomplished in two ways. The first way is to transfer ownership to another individual following life insurance company and IRS guidelines. Many times that other person is a spouse or a child of the insured. One draw back is the insured loses control of the policy because it must be a permanent transfer, and, if a divorce occurs, that policy is outside the control of the insured. Also, the cash value of the insurance policy would be included in the gross estate of the new owner of the policy and, thus, might create estate tax issues for the new owner of the policy.

The second option is to create an irrevocable life insurance trust, or “ILIT.” An ILIT is a specially designed trust that acts as the owner of the life insurance policy. As an irrevocable trust, the assets held in that trust are not part of the insured estate for estate tax purposes. ILITs are complex tools that I will describe in the future. If you are interested in an ILIT, given the 2011 estate tax issues, you should talk with an attorney.

While the conventional wisdom that life insurance death benefits are essentially income tax free is correct, make sure you have taken the steps to ensure they are also estate tax free.

Estate of the Month: A Jurassic Father

If you have been reading my newsletters you will notice I attempt to link a general theme through the articles to demonstrate practice and theory. In this estate of the month, I demonstrate how Michael Crichton’s delay in updating his estate plan resulted in larger legal bills than necessary for his heirs.

Crichton, the author of novels including Jurassic Park and Disclosure, died of throat cancer on November 4, 2008, at the age of sixty-six. It was estimated that his annual earnings in 2008 approached $100 million mostly generated from writing novels, screenplays and television shows. He married actress Sherri Alexander in 2005 but also had 4 ex-wives. His obituary listed only being survived by Alexander and a daughter from a previous marriage. But it gets very interesting from there. Alexander was six months pregnant at the time of Crichton’s death and gave birth to Crichton’s son several months after his death in February. As someone in his mid-30’s who chases a three year old around, I could not imagine chasing one in my 60’s around but that is another issue.

Given his convoluted family relationships, Crichton did take several steps to organize his estate to provide his heirs and charities upon his death. He had a will, executed in 2007, and a trust in place to manage his assets and distribute his assets to his beneficiaries. He also had a prenuptial agreement with Alexander alleged to be $9 million dollars over a period of 9 years that limited what she would receive from his estate and would impact her ability to inherit upon his death.

But, he made one crucial flaw. He did not update his will to account for his unborn son. Most states have “pretermitted heir” laws to protect children that are accidentally omitted, if other children are accounted for in the will, so that they can still receive a portion of the estate. The “pretermitted heir” law is not a rigid, however, since an estate plan can work around the law to “disinherit” a child. In fact, Crichton did take steps to limit the ability of omitted children to inherit parts of his estate in his 2007 will. Crichton did this for a precise reason. He was rumored to be somewhat of a ladies’ man. Crichton had a restrictive clause inserted into his will to block surprise offspring from appearing at his death. His will stated:

"I have intentionally made no provision in this will for any of my heirs or relatives who are not herein mentioned or designated, and I hereby generally and specifically disinherit every person claiming to be or who may be determined to be my heir-at-law, except as otherwise mentioned in this will."

Words have meaning and he never did update his 2007 will. Crichton demonstrated the intent that he did not want anyone not expressly mentioned to inherit. Thus, by the letter of the will, his son should not be a beneficiary. One could argue that given his daughter is an heir, he would want to include his son. Alexander did make this claim and contended that Crichton was in the process of updating his estate plan to account for his son. She also petitioned a California court to be appointed the guardian of her son and to have access to her son’s inheritance to raise him. A very nice upgrade for Alexander from the $9 million she was due under the pre-nuptial contract to hundreds of millions she would have access to while raising her infant son. Not bad.

The clause in Crichton’s will would pit his daughter against his son for inheriting his estate. In fact, that is exactly what happened. Alexander petitions the court to designate her as guardian and Crichton’s son as an heir. Crichton’s daughter fought the move. In October 2009, a Superior Court judge of California rejected Crichton’s daughter’s argument and ruled that her infant half-brother was entitled to a one-third of Crichton's estate. Eventually, the estate distribution was reworked to include Crichton’s son as beneficiary, but not without Crichton’s estate accruing legal and professional fees from both sides of the case².

How does this apply to the everyday man who does not have millions of dollars in assets? Fighting over control of estates and trusts doesn’t just happen to the wealthy. In fact, estate litigation is very common in second-marriage situations. By simply taking the time to make the necessary changes to your estate plan after those life changing events, or immediately upon notification of a life threatening illness as in Crichton’s case, a person can save a great deal of loved one’s time, heartache and money.

¹ As most who read my newsletters know, I am firmly in the camp that the federal estate tax is coming back in 2011. Regardless, Maryland and D.C. apply a state estate tax to a decedent's taxable estate.

² It is likely that Alexander, the petitioner in the matter, and Crichton's daughter, respondent in the matter, used assets distributed from Crichton's estate to pay the legal and professional fees accrued in the matter.