Estate Planning Techniques
That Can Conflict With Retirement Planning
Dianne Reis
Attorney at Law
5904 Pebblestone Lane
Plano, Texas 75093
972-381-8500
www.willsandprobate.com
Turning 65:
What You Need to Know if You or Your Clients are Turning 65
Dallas Bar Association
Solo & Small Firm Section
September 7, 2011
Dianne Reis
Attorney at Law
5904 Pebblestone Lane
Plano, Texas 75093
972-381-8500
www.willsandprobate.com
PRACTICE
Solo practice in Plano, Texas since 1997. Wills, trusts, estate tax planning, probate,
guardianships, and Medicaid planning/eligibility.
EDUCATION
J.D. with Honors, the University of Texas School of Law, 1996.
Associate Editor, Texas Law Review.
A.B. in economics, Harvard University, 1993.
PROFESSIONAL ACTIVITIES AND CERTIFICATIONS
Board Certified in Estate Planning and Probate Law since 2002
Certified in Elder Law by the National Elder Law Foundation since 2003
Board of Directors, National Elder Law Foundation
Board of Directors, Estate Planning and Probate Section, Collin County Bar Association
Author, Texas Estate Planning, James Publishing
MEMBERSHIPS
Estate Planning Council of North Texas
National Academy of Elder Law Attorneys (National and Texas Chapter)
Real Estate, Probate, and Trust Law Section, State Bar of Texas
College of the State Bar of Texas
PRESENTATIONS
“Medicaid Pre-Planning: What Every Traditional Estate Planner Should Know,” Collin
County Bar Association, Estate Planning and Probate Section, co-presented with Lori A.
Leu (April 2011)
“The Substantive Estate Plan: How Hard Can It Be To Give Our Clients What They Want?”
UTCLE Estate Planning, Guardianship, and Elder Law Conference (August 2010)
“Who’s Your Audience? Drafting Wills That The Probate Attorney Will Understand,”
UTCLE Estate Planning, Guardianship, and Elder Law Conference (August 2009)
“Deal or No Deal: Update on Senior Scams,” State Bar of Texas Advanced Elder Law (2008)
Estate Planning Techniques
That Can Conflict With Retirement Planning
For young people who haven’t accumulated much wealth, financial planning and estate planning
are simple. They save as much as they can, they purchase disability, health, and life insurance to
protect against the unexpected, and they execute simple wills leaving everything to their spouses
or children.
By age 65, many things change. The typical middle-class person now has substantial retirement
funds to manage, and needs to withdraw regular payments wisely. Poor health, disability, and
death are no longer completely unexpected, which causes the cost of those insurance policies to
increase significantly. And greater wealth raises the possibility of estate taxes, which require
planning to avoid.
You or your clients may be getting advice from three different sources: a financial planner, a tax
planner, and an estate planner. That advice can point in different directions. Add in Medicaid
planning for those who are relying on government benefits to pay for long term care, and the
landscape becomes truly confusing.
Here are a few common planning strategies that can succeed in one area of planning while
backfiring in another:
1. Deferring Withdrawal of Tax-Deferred Money
If you have a sizable 401(k) balance, you know that it got that way in part because of the tax
deferral. Contributions are deductible, and the money in the plan grows tax-free until
withdrawn.
However, any funds withdrawn are subject to ordinary income tax in the year of withdrawal.
The amount of all withdrawals is added to the participant’s taxable income and taxed at the
participant’s marginal bracket.
The simplistic response to this situation is to defer withdrawals for as long as possible. After all,
a tax dollar not paid today represents money that stays in the market, earning extra returns. A
good spreadsheet can demonstrate the significant costs of premature withdrawal.
However, when you turn 70.5 years old, the federal tax laws require you to start taking minimum
withdrawals from retirement plans and IRAs. The size of each minimum withdrawal is based on
the total balance in the plan or IRA. This can result in a bunching of taxable income that pushes
you into a higher tax bracket than you would otherwise be in. For people at certain income
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levels, this bunching can also increase the percentage of their Social Security income that is
subject to income taxes, which further increases their tax bill.
For some people, it can be wise to make some withdrawals in their 60s, in order to lower the
balance upon which minimum withdrawals are based. The numbers have to be analyzed closely.
If the withdrawals can be done as Roth conversions, some of the deferral can be maintained
while minimum withdrawals and Social Security taxation are reduced. But planning for Roth
conversions adds another layer of complexity to the analysis. A skilled CPA or financial planner
can be valuable here.
Another downside to having a large fund of tax-deferred money is its interaction with the estate
tax. If you withdraw the money and pay the tax before you die, the money used to pay the tax
isn’t subject to estate taxes. But if the money is still in the retirement plan when you die, it is
subject to estate taxes. The recipients of the retirement plan get an income tax deduction that is
intended to compensate them for the estate taxes paid, but this deduction does not completely
make up the difference in many cases. Depending on what the estate tax and income tax rates
are at relevant times, this interaction can affect the overall tax burden on the family.
2. Tax-Deferred Money and Bypass Trusts
The bypass trust is a common strategy for avoiding estate taxes. Married couples create bypass
trusts in order to make use of both of their estate tax exemptions. If the predeceasing spouse
leaves his entire estate to the surviving spouse, both estates wind up being taxed as the surviving
spouse’s estate, and the predeceasing spouse’s estate tax exemption is no longer available to
offset the estate taxes. If the predeceasing spouse instead leaves his estate to a bypass trust, the
assets in the bypass trust will not be included in the surviving spouse’s estate, and can instead be
sheltered by the predeceasing spouse’s exemption.
This strategy doesn’t work as well if the predeceasing spouse has significant assets in an IRA or
retirement plan. An IRA left outright to the surviving spouse receives preferential treatment
under the income tax: The surviving spouse can roll over the IRA and defer all distributions
until age 70.5. And after that, minimum distributions are based on the generous Uniform Life
Expectancy Table, under which a 70-year-old has a remaining life expectancy of 27.4 years.
But an IRA left to a trust must begin making distributions immediately, and those distributions
must be based on the age of the oldest beneficiary using the Single Life Expectancy Table, under
which a 70-year-old has a remaining life expectancy of only 17 years.
Thus, leaving an IRA to a trust can avoid estate taxes on that IRA, but at the cost of accelerating
the income taxes on the IRA. And the income taxes are (a) owed earlier in time, and (b) more
likely to be owed (given the political uncertainty of the estate tax).
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Another factor in the decision is the fact that any extra income taxes generated by leaving the
IRA to the trust would be paid during the lifetime of the surviving spouse, but (thanks to the
unlimited marital deduction) any extra estate taxes generated by leaving the IRA outright to the
spouse would not be paid until after both spouses die. This pits the surviving spouse against the
children: We can either maximize the money for the surviving spouse, or we can maximize the
children’s inheritance, but we cannot do both. The financial planning goal of providing financial
security for the client is at odds with the estate planning goal of providing the largest possible
inheritance to the children.
3. Annual Exclusion Gifts
People with large estates are often advised to make lifetime gifts to reduce the estate taxes they
will ultimately owe. Gifts of up to $13,000 per year per person will not incur gift tax or
generation-skipping tax and will not use up any of the donor’s estate tax exemption amount.
(The gift tax annual exclusion is $13,000 in 2011, but it is indexed to inflation, so it periodically
changes.)
Thus, a person with 2 children and 4 grandchildren can give away $78,000 a year without any
transfer tax consequences. If the children and grandchildren are married, gifts can also be made
to their spouses, which increases the maximum to $156,000. Over five years, a gifting program
to 12 family members could result in $780,000 being removed from the taxable estate, saving
$273,000 in taxes at a 35% rate, or $429,000 at a 55% rate. For minor or irresponsible
beneficiaries, annual exclusion gifts can be made in trust so that the beneficiaries don’t get
control of the money right away, or ever.
The problem is that once the money is given away, it is gone. If the donor retains any legal right
to get the money back, the gift is considered incomplete and will be included in the taxable
estate. And many people who are rich enough to face estate taxes are still not rich enough to
maintain their standard of living and financial security if they give away enough money to make
a meaningful dent in their estate tax bill.
With annual exclusion gifts, the retirement planning goal of preserving financial security is at
odds with the estate planning goal of reducing estate taxes. This is why this loophole in the tax
code exists: The federal government knows that most people will not use it, because of the very
real costs of doing so.
Annual exclusion gifts can also wreak havoc with an application for Medicaid nursing home
benefits. Medicaid rules do not recognize any annual exclusion amount; all gifts made within
five years of the application date have the potential to generate a penalty that could wind up
costing the client more in lost benefits than could have been saved in estate taxes had the estate
been taxable. With the estate tax exemption scheduled to drop to $1,000,000 in 2013, many
people for whom Medicaid eligibility is a meaningful possibility now also face the possibility of
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estate taxes. Yet the planning strategies for one can negate the planning for the other. No one
should make annual exclusion gifts unless they have a plan for paying for their long term care
needs.
4. Life Insurance Trusts
The irrevocable life insurance trust (ILIT) is the classic strategy for avoiding estate tax on life
insurance proceeds. If the insured retains no “incidents of ownership,” the life insurance passes
to the beneficiaries of the trust free of estate or income taxes.
But in order to avoid “incidents of ownership,” the insured has to give up the right to borrow
against the policy or withdraw the cash value. If the insured purchased the policy in order to
invest money tax-free in anticipation of spending that money in retirement, an ILIT will interfere
with that retirement plan.
An ILIT also carries some opportunity costs. The premiums paid to maintain the policy will use
up gift tax annual exclusions. If the insured dies early, this will turn out to be a well-leveraged
use of those annual exclusions. But if the insured lives too long, then those annual exclusions
might have been more efficiently used on outright gifts or on transfers of interests in a family
business.
Some clients are advised to purchase life insurance to provide their estate with liquidity to pay
estate taxes. In that situation, an ILIT will usually be recommended to avoid losing half of the
insurance to taxes. However, life insurance trusts have limitations that can rival the problems
posed by illiquidity. A life insurance trust involves set-up and maintenance costs, in addition to
the premiums for the insurance. Also, the trust must be prohibited from paying the estate taxes
directly, or else it will be included in the insured’s taxable estate. If the estate owns a closelyheld business, a life insurance trust can lend money to the estate and be paid back over time by
the profits from the business, effectively avoiding the need to sell (or strain) a business that the
family may wish to keep. But if the estate owns marketable securities in IRAs, it may be less
onerous to simply incur the tax and transaction costs of liquidating them when the time comes,
since they will have to be liquidated to pay back the trust later anyway.
Also, keep in mind that an irrevocable life insurance trust is irrevocable. A bypass trust can be
changed repeatedly up until you die, but once you set up an ILIT, you cannot take back the cash
value or change the beneficiaries. While creative strategies exist for making certain types of
changes to the trust, as a lawyer you probably are aware that “creative strategies” is Legalese for
“big legal fees.” Any changes you want to make could be expensive.
From a Medicaid planning perspective, both life insurance and irrevocable trusts can be
problematic. Any premium payments made through an ILIT in the five years before a Medicaid
application will be penalized transfers, both for the insured and for any beneficiary who had a
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withdrawal right with respect to the premium payment. It is important to ask whether any
beneficiaries of a proposed ILIT have disabilities that might make them eligible for public
benefits someday.
5. Deferred Annuities
Deferred annuities are pitched as a way to save taxes and get higher returns. The investment
quality of such contracts is beyond the scope of this presentation. The tax savings are often
elusive.
Annuities convert all capital gains into ordinary income. Furthermore, for retirees, the tax
deferral isn’t the same as for young savers. A retiree has much less time for the deferral to work
its magic before it is time to spend the money. And although annuities are compared to IRAs
and Roth IRAs to illustrate the tax benefits, annuities lack the upfront deduction or tax-free
withdrawals that IRAs provide. At the end of the day, deferral on only the income is noticeably
less sexy than deferral on the entire balance.
Aside from the tax problems, annuities can impede flexibility. Many deferred annuities carry
surrender fees during the first five to ten years. And the retirement years are often a time when
people need greater access to their money. Earned income has stopped coming in, and
unexpected medical or long term care expenses are now more likely.
Annuities also complicate Medicaid applications. A deferred annuity owned by the applicant
will usually need to be cashed in: An unmarried applicant will need to spend it down to become
eligible for benefits, and a married applicant will need to transfer it to the applicant’s spouse. A
surrender fee makes the annuity costly to cash in, although some insurance companies waive this
fee if nursing home care is involved. More troubling is the fact that the insurance company may
take several months to complete the process. During those several months, thousands of dollars
in Medicaid benefits can be lost. If you do not have long term care insurance and you cannot
afford to pay out of pocket for your own long term care, do not purchase any annuities.
Annuities do have the advantage of being exempt from creditors in Texas. For doctors and
lawyers and others who are concerned about malpractice liability, this advantage could outweigh
all the costs.
6. Living Trusts
Many people set up revocable inter vivos trusts to avoid probate upon their death. But avoiding
probate is generally not necessary for most Texans, because of our “independent administration”
probate system.
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Living trusts are also recommended as a way to provide for the management of your assets if you
become incapacitated. However, this strategy works only for certain types of assets. Retirement
plans and IRAs cannot be transferred to a living trust, and must be managed using a power of
attorney or guardianship if the owner becomes legally incapacitated. If a significant portion of
your assets are in qualified retirement plans and IRAs, a living trust will not be an effective
strategy for asset management.
Furthermore, a living trust generally cannot be used by somebody who is applying for Medicaid
nursing home benefits. Homesteads become countable resources when transferred into a trust, so
many applicants have to unwind the trust before receiving any of the management or probate
avoidance benefits of having the trust.
Medicaid applicants who are married have an additional reason to avoid living trusts. Federal
law allows spouses to create trusts for each other that are exempt for Medicaid purposes, but the
statutes says that such trusts must be created “by will.” 42 USC 1396p(d)(2)(A).
People who cannot afford to pay out of pocket for their long term care, and who do not have long
term care insurance, should not set up living trusts.
7. Managing Money During Incapacity
Parents will sometimes add an adult child (or other trusted helper) to a checking account so that
the child can pay the parent’s bills. Sometimes the child gets added to all checking, savings, and
brokerage accounts so that the child can manage all of the parent’s affairs.
The problem arises when the parent dies and it turns out that the child was added as a joint tenant
with right of survivorship. This can disinherit other children, or thwart a carefully-designed tax
plan in the parent’s will. If the child decides to follow the terms of the will by giving the money
to the siblings, the child is making a taxable gift. The gift tax consequences can sometimes be
addressed with disclaimers (assuming the child does not have minor children of his or her own),
but hiring an attorney to prepare disclaimers adds expense and hassle to the administration of the
estate.
Adding a child as a joint tenant can have negative consequences during the parent’s lifetime as
well. If the child has money problems, dies, or gets divorced, the money in the account may be
presumed to belong to the child until the parent proves otherwise.
It is better for the parent to rely on a power of attorney, or obtain the necessary legal advice to
make sure the child is added as a convenience signer only. The do-it-yourself approach doesn’t
save money in the long run.
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8. Step-Families
Reconciling all planning goals is an order of magnitude harder in second marriages. And second
marriages become more common as we get older and our spouses die.
Spouses often have joint financial plans. They pool their respective resources in order to
maximize their standard of living. So two homes become one home and a vacation budget.
Assets get combined and commingled in ways that benefit both of them while they are alive.
This can be great from a financial planning perspective, but not necessarily from an estate
planning perspective.
The problems start when one spouse dies. If the predeceasing spouse leaves half of their
combined assets to that spouse’s children, the surviving spouse faces significant disruption in
their joint financial plan. But if the children are disinherited, they will have standing to contest
the will. Many parents optimistically believe that the surviving spouse will take care of the stepchildren and leave them assets upon the surviving spouse’s death. Experienced estate planners
know that this frequently does not happen.
The legal answer to this issue usually involves creating trusts that benefit the surviving spouse as
a life tenant, then pass to the children upon the surviving spouse’s death. However, slicing the
pie differently doesn’t make it any bigger, and may leave heirs disappointed if they were
expecting more. Second marriages involve costs that don’t exist in first marriages. Hard
decisions have to be made about who is going to get what and when. These decisions can be
made early in the process, communicated to all parties, and built into premarital agreements.
Many people think that premarital agreements are for divorce planning, but that is not true.
Premarital agreements arguably accomplish the most in harmonious marriages that end in death
rather than divorce.
9. Timeshares, Mineral Interests, Etc.
Many retired people believe that vacation timeshares are a great investment that will stretch their
travel budget to allow them more vacations. Thus, timeshares are purchased as part of the
financial plan.
But timeshares are bad for the estate plan. Most probate lawyers can tell you that few people
rejoice at inheriting a timeshare interest. The monthly expenses are viewed as a drain on the
estate. Selling the timeshare is usually difficult if not impossible. Many estates struggle just to
give it away in order to be released from the expenses. And if the timeshare is structured as a
real property interest in a state other than the home state, a costly probate procedure may be
necessitated. Overall, the costs to the estate of owning a timeshare could negate any savings the
testator may have received during life. Many people would be better off paying for their
vacations on an as-needed basis, if you factor in the after-death costs.
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Timeshares are even worse from a Medicaid planning perspective. If the applicant is unmarried,
the timeshare will usually have to be sold before Medicaid will grant benefits. Unless the
planning is handled carefully, a family member might spend much more than the value of the
timeshare paying the nursing home bill while trying to sell the timeshare to a third party or
negotiating an alternative with the caseworker.
Mineral interests and other illiquid assets often fall in the same category as timeshares: They
may be valuable to the client, but to the heirs they are often a burden. And they can result in
many months of lost government benefits if they are on hand when a Medicaid application is
filed.
One of the best things a person can do for their estate plan is to clean up their balance sheet. Sell
all of the tiny fractionalized mineral interests, cash in the $1,000 life insurance policies and the
stack of $20 savings bonds, consolidate all the $5,000 IRAs, get the stock certificates into street
name, and leave your heirs a handful of large, easily sold assets. They will thank you. And so
will their probate lawyer.
Conclusions
1.
2.
3.
4.
5.
Don’t let the financial planning needs obscure the estate planning needs.
Don’t let the estate plan compromise the lifetime financial needs.
Don’t let the tax planning tail wag the financial planning dog.
Resist the urge to undo a good plan just to save a few dollars in probate costs.
Don’t ignore Medicaid planning issues.
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