The first assumption that many clients make is that a Will controls the disposition of all assets at death. This is wrong. Assets pass in four distinctly different ways at death. In some estates, few assets pass under a Will. It is important in planning any estate that you understand how property passes at death.
Joint Ownership
The first and most common way that assets pass at death is by joint ownership. There are two types of joint ownership that we commonly see. The first is referred to as a tenancy by the entirety. This is a form of joint ownership between husband and wife. The second is joint tenancy with right of survivorship. This is a form of joint ownership that may exist between anyone, including multiple individuals. For instance, a mother may open a bank account as a joint tenant with right of survivorship with her son or with both her son and daughter.
The effect of joint ownership is to create a dying contest. The person who lives, inherits. Assets held jointly with right of survivorship do not pass under the provisions of a Will. They pass to the surviving joint owner.
It comes as a surprise to many when, at the death of the parent, all of the bank accounts are jointly held with a single child and legally belong to that child. The client’s Will leaves everything equally to the three children. The child who is the joint owner on the bank account, upon realizing that the account legally belongs to him, elects not to share it with his siblings. Family conflict results. The results are never good.
If you desire to place a child or a friend on your bank account or stock brokerage account and do not desire them to inherit the account at death, you should establish a power of attorney account rather than a joint tenancy with right of survivorship account.
Another problem with joint accounts with children is that if a child predeceases you, the child’s interest in the account disappears. The deceased child’s children who might otherwise inherit their deceased parent’s share, are entitled to nothing.
As an example, assume Mom opens a bank account with Daughter and Son. Daughter dies survived by two children. Mom dies shortly thereafter. Son is the sole surviving owner. He inherits the account. Daughter’s children inherit no portion of the account.
Joint ownership is simple. Probate is avoided but joint ownership does not save estate or inheritance tax. Jointly held assets passing to anyone other than a spouse are taxed at death. The assets held jointly with right of survivorship do not pass under a Will. Joint ownership is good, but only if you understand it.
Beneficiary Designations
The second way that assets pass at death is by beneficiary designation. Life insurance, annuities and retirement accounts are all directed by beneficiary designations. These assets are not directed by your Will unless you have named your “estate” as the beneficiary. In many cases, naming the estate the beneficiary, especially with respect to retirement accounts, may cause the beneficiaries to lose certain tax deferral benefits that are otherwise available.
Beneficiary designations, if properly structured, represent an excellent way to distribute assets at death. It is simple. Probate is avoided. However, beneficiary designations need to be reconsidered and updated from time to time. Named beneficiaries die. The relationship with beneficiaries changes.
Assets which pass by beneficiary designation are generally included as a part of your estate for death tax purposes. In addition, these assets often carry with them substantial income tax issues.
Life insurance passes income tax free to the beneficiary. On the other hand, retirement benefits such as IRAs and 401(k) plans are not only part of your estate for death tax purposes, they are also taxable as income when received by the beneficiaries. Thus, in the case of larger estates, up to 50% of the value of a retirement account may be lost to estate taxes. When the retirement account is received, it will be taxed again for income tax purposes. It is not uncommon in the case of larger estates to see up to 75% of the account balance disappearing in the form of death and income taxes.
Annuities are taxed in a similar manner to retirement accounts. They are part of the estate for death tax purposes. The gain, that is the difference between the cost of the annuity and the amount received, is taxed for income tax purposes upon receipt. Thus, annuities are often subject to double taxation in a manner similar to retirement accounts.
A common mistake made in beneficiary designations is to name minor beneficiaries to receive the funds. Naming a minor child as a beneficiary on an insurance policy, annuity or retirement account will require a court guardianship. This will result in unnecessary legal expenses and court costs. The child will likely have unsupervised access to the assets upon attaining age 18. Will an 18 year old invest and manage the money wisely? If you desire to leave assets by beneficiary designation for a minor, they should be payable to a trust for the benefit of a minor.
Distribution by Trust
Assets that are owned by or payable to a trust that you create during your lifetime are distributed at death as provided under the terms of the trust. They are not distributed according to your Will. Probate may be avoided. Depending on whether the trust is revocable or irrevocable and other factors, the trust may or may not be taxed as a part of your estate for death tax purposes at death.
A trust is a legal entity, a personal holding company, if you wish, that is established to hold assets. However, note that in establishing a trust during life, nothing has been accomplished to direct assets at death unless assets are, in fact, transferred into the trust during lifetime or payable by beneficiary designation to the trust at death.
Distribution by Probate
Assets which are not payable to joint owners, by beneficiary designation or through a trust are distributed through probate at death. Probate is a court proceeding designed to see that the provisions of your Will, if you have one, are implemented. If you do not have a Will, the probate process distributes the assets to your heirs as provided by state law.
Probate is not necessarily a bad thing. However, many people seek to avoid probate through utilization of joint ownership, beneficiary designations or a Revocable Living Trust. Probate will be discussed in another article.
Conclusion
Understanding how assets pass at death and making sure that ownership and beneficiary designations are properly structured is perhaps the most important element in any estate plan. For instance, providing in your Will that a specific bequest be made to a named beneficiary, such as “my stock in XYZ Company to son, John” may be defeated if the stock is held jointly with right of survivorship with son, Michael. The joint ownership controls.
Consider the case where mother leaves a Will dividing assets equally among the four children. Mother’s estate at death is made up of a home valued at $200,000 and bank accounts valued at $200,000. One would assume that each of the four children would receive an inheritance equal to $100,000. However, if the bank accounts were jointly held with daughter, by law, the bank accounts would belong to the daughter at death. The only asset to pass under the Will is the home. The home is sold and the proceeds are divided four ways. The end result is that the daughter’s inheritance is $250,000, whereas the three sons each inherit $50,000. Only the decedent knows whether this was the intended result or not.
Understanding how assets pass and structuring ownership and beneficiary designations in a manner consistent with the provisions in the Will is perhaps the most crucial step in the estate planning process.
A. Stephen McDaniel
Williams, McDaniel, Wolfe & Womack, P.C.
5521 Murray Avenue
Memphis, Tennessee 38119
901-767-8200
smcdaniel@wmww.com