You have just finished reviewing the asset
statements that prospective clients have given to you. Besides seeing
that this married couple's portfolio is heavily allocated in small-cap
stocks, you notice that they hold these positions in separate
individual brokerage accounts and individual retirement accounts.
Many advisors would feel compelled to tell the couple that by holding these assets in joint tenancy with rights of survivorship, the assets will avoid probate and pass to the surviving spouse.
While this may be true, the husband and wife would be prudent in first looking closely at their estate plan before changing the titling of any asset. Many estate plans may end up suffering from the ill effects of incorrectly titled assets, all for the sake of avoiding probate.
So, why is avoiding probate so important? And how can you ensure that your clients' assets will avoid probate without disrupting the flow of those assets under the original estate plan? Let's take a look . . .
Why Avoid Probate?
To appreciate the benefits that result from avoiding probate, you should understand the process, at least in some general way. Probate is a court-supervised process to identify the property and living heirs of a decedent. It allows the decedent's property to be distributed according to a will, or under state laws of intestacy if a will does not exist.
Without the probate process, determining who owns what property and who has the authority to act on behalf of the decedent's property would be confusing. The will names an executor or personal representative, or the court appoints one, to inventory the decedent's property and to distribute the property in accordance with the decedent's will or under the state's intestacy laws.
While the probate process is certainly effective in ultimately disposing of an estate's property, it has its problems. Administrative and attorney's fees can be expensive. Probate also is generally time consuming and may ultimately put property into the hands of heirs without any consideration for the decedent's wishes (as when an individual dies without a will). Identifying and locating an estate's rightful heirs can significantly delay making the distributions to heirs who already have been identified and are entitled to receive their share.
Probate has another downside: The proceeding is a matter of public record. Given a choice, most families would opt for privacy when dealing with the financial matters of a deceased family member. These factors make it clear why most planning addresses the transfer of wealth to heirs without involving a probate proceeding.
How To Avoid Probate And The Issues To Consider
Avoiding probate is easy enough. You simply title property in such a way that the interests in the decedent's property pass automatically to co-tenants named to the account or instrument that holds the property. It seems simple enough. But is there a catch?
Before changing a property title, you must consider all the issues involved in making such a change. A review of some common probate avoidance devices will help in highlighting the pros and cons of each strategy.
Joint tenancy with rights of survivorship. A very common way for clients to hold title to many types of property, such as brokerage and bank accounts, mutual funds and their personal residence, is joint tenancy with rights of survivorship (JTWROS). The popularity of JTWROS stems from the way that the interests in the property pass automatically from the deceased tenant to the surviving tenant without the interference of a court proceeding.
The effectiveness of JTWROS in transferring ownership upon death is unquestionable. But the transfer's effectiveness will sometimes disrupt the estate plan. The automatic transfer of property to a joint tenant may not have been the client's intent, as spelled out in the estate plan. Issues generally arise when tenants use JTWROS to deal with needs that other forms of titling would better address.
One scenario many clients find popular is to name an adult child as the second tenant to an elderly parent on a JTWROS account or residence title. Clients primarily do this to allow the child to exercise control over the account or to act as a will substitute in transferring the property upon death. Using JTWROS to meet these goals presents some glaring problems, however.
Adding an adult child (or someone other than a spouse) as a joint tenant may expose the original property owner to gift-tax liability. There is an exception for bank and brokerage accounts, so long as the noncontributing tenant only draws against account assets to benefit the contributing tenant.
The exception does not apply when a joint tenant is added to real property title, such as the parent's primary residence. Adding a tenant to real property title will immediately expose the original property owner to gift tax. In addition, the gift of real property interest during life will remove the possibility that the heirs will receive a full step-up in income tax basis upon the property owner's death, since the recipient of a lifetime gift assumes the same basis as the original property owner.
Finally, the addition of a joint tenant may expose those joint assets to the creditors of the recently added tenant.
Many clients would find it beneficial to name the proposed tenant as their power of attorney over financial matters if they are concerned about the management of their property in their later years. The drafting of a power of attorney would provide clients with the peace of mind that someone they trust is managing their finances on their behalf without exposing the assets to another party's creditors.
Revocable trusts. The most efficient instrument for the management of assets during life and the transfer of those assets to heirs at death is the revocable trust. It is an entity through which individuals can hold title to their assets.
A revocable trust manages the assets of the grantor (the person who creates the trust) during his or her lifetime while also passing the assets along to named beneficiaries without the requirement of a probate proceeding. If the client becomes incapacitated, the trust, through the trustee's direction, will continue to manage the assets without needing a power of attorney.
The revocable trust will protect the privacy of the grantor and beneficiaries while effectively meshing with the estate plan. The revocable trust allows for distributions to heirs, beneficiaries and other estate planning vehicles based upon the trust's language and the trustee's direction.
Revocable trusts don't have much of a downside, but establishing them can be expensive. That expense may vary depending on the attorney and the provisions of the trust in accordance with a larger estate plan.
Another problem is that the trust will be worthless unless it is properly funded after being created. Many revocable trusts are ineffective because the trust was never funded with the property it was created to manage. It is not uncommon for assets to be subject to a probate proceeding due to an oversight in funding the trust.
Transfer-on-death. Transfer-on-death (TOD) accounts allow individuals or joint tenants to pass securities upon their death to named beneficiaries without exposing the assets to probate.
You can set up TOD in states that have enacted the Uniform Transfer on Death Security Registration Act. Currently only Louisiana and Texas have not adopted the Act (although Texas does have similar provisions for the transfer of securities in the Texas probate code).
Securities titled as TOD will automatically transfer to the named beneficiaries of the securities upon the owner's death. TOD is an efficient way of transferring assets to beneficiaries as an automatic operation of law that avoids the time and expense of a probate proceeding.
Prior to titling any clients' securities as TOD, you must be sure that those securities are not earmarked for distribution to another heir or beneficiary of other estate planning instruments.
Many clients who have smaller estates use JTWROS and TOD as will and trust substitutes. That may be fine for their particular circumstances, but it does not diminish the importance of carefully reviewing the titling of all assets the clients own.
To coordinate financial and estate plans, higher-net-worth clients may require a more thorough review than their lower-net-worth counterparts, as assets may be titled to address specific needs of their overall plans. Avoiding probate isn't difficult, but you must consult the existing estate plan and the estate planning attorney before making any changes to how assets are titled.
Gavin Morrissey is an advanced
planning consultant at Commonwealth Financial Network in San Diego. He
is available at firstname.lastname@example.org.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Clients should consult a professional tax advisor or lawyer.
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