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Meador: Now, basically, we're talking about estate planning options.
What are some of the options in terms of estate planning at this point?
Peterson: Well, there's basically seven basic types of estate plans.
So, the first one is to have no plan whatsoever, which is actually
having a plan, whether you realize that or not. The second is to gift
away your property. The third is to jointly own your property with
someone. The fourth is to pass your property through a beneficiary
designation, like in a life insurance, or a retirement plan. The fifth
is to pass through a will, and then the sixth is basically revocable
trust planning. So, that's typically what we see as the six major ones,
and then the seventh is to do a combination of one of those six, or
multiple of those six, I should say.
Meador: So, let's talk about the do nothing approach, first of all,
because I've got a lot of clients that just want to put everything off
until they're dead basically, and that happens more times than you would
know. So, in any event...
Peterson: We also have a lot of clients that want to do nothing...
[Both Laughing]
Peterson: And you know, in our office we refer to that as the ostrich
approach. What I'd rather do is stick my head in the sand, and just not
worry about it, and let my kids worry about it. That is potentially the
worst plan you could ever make. And here's the reason why. All 50states
have an intestacy statute. Dying intestate means that you've died
without a will. So, if you die without a will, there's a statute that
says who's going to inherit your stuff. And I don't know about your
experience, Jay, with legislatures, but sometimes, they don't make the
best decisions, and they don't always do what I would want them to do.
And so what we find a lot of times is for folks who die without a will,
there's a lot of unintended consequences, and it doesn't pass the way
they want it to pass or the way they think it will pass. And so by doing
nothing, you've defaulted to whatever that state statute says, and every
state is different about what their state statute says.
Meador: Well, not only that, but just from an emotional standpoint for
that clients beneficiaries, it's horrible because those beneficiaries
are in a situation where it's a highly emotional situation anyway, and
they don't have clear direction in terms of what they're supposed to do
with things, and it is a chaotic mess, and it is just absolutely a
crumbling emotional experience for those beneficiaries. So, yeah, it's
a horrible thing. So, then of course, let's go into problems and
examples.
Peterson: Okay. Let's start with kind of the pros and cons of doing the
no will approach. The pro is that you don't have to do anything. That
you literally do nothing, and so it takes none of your time. You don't
have to think about it, and you don't have to worry about it, and that
is the only pro for the approach because everything else is a con. So,
the first con is that the statutory scheme is generally not what clients
want it to be, and so who they want to end up with their stuff usually
is not the case. The second is that they have abdicated control over
their assets and control over the executor of their estate would be, and
they've given that power to the probate court.
So, the probate court judge has all the power and no direction, and so
now, they, without really any limits whatsoever, can do whatever they
want. And so we've seen, in situations like this, kids who would never
give your checkbook to have control of every one of your assets, or
maybe an extended family member that is the one that steps up, but is
also the one that you wouldn't trust with two nickels, much less your
entire estate, and they're the ones that gets appointed. The third
typical con to this approach is when you described it as a mess, it's
not just a mess for the beneficiaries of the estate. It's a mess for the
attorney.
Meador: Yeah.
Peterson: So, when you make things a mess for the attorney and the court, what you make
them is expensive for your heirs. And so if you
want someone else to be in total control, if you want somebody else to
decide who your beneficiaries are, and you want to make it as expensive
as possible, then you should definitely recommend that you have no will
because you're going to do that. You're going to fulfill all of those
objectives.
Meador: Right.
Peterson: And there are a lot of problems that come up with intestacy
because of the statutory scheme. So, we have a lot of people who end up
with those unintended consequences. So, let me tell you about one
client that we had. So, Irv and Sylvia are married, and it is the
second marriage for both of them. They don't have children together,
but he had children from a previous marriage. So, he passes away. Now,
they've been married for a long time. They've been married for close to
twenty years, and they have a house, but it was Irv's house before they
got married. So, it's Irv's separate property, okay? So, let's talk
about what Texas law does because like I said, every states' intestacy
law is different, but if we were to bring Irv out of the grave and we
were to ask Irv, "What is it that you want to have happen with your
house?", I would bet dollars to donuts that Irv would say, "I want
Sylvia to have the house. I want the house to be hers." Under Texas'
intestacy law, guess who inherits the house?
Meador: The kids.
Peterson: Not quite. Sylvia gets a third of the house and the kids get
two thirds of the house. Now, Sylvia gets a life estate in the house,
and so she gets to stay there as long as she's living. But let me tell
you what the kids get to do. The kids get to drive by the house and
look at the condition of the roof, and see the gutters kind of falling
down and the paint's kind of peeling, and so they get to call Sylvia
whenever they want and hassle her about the condition of the house.
That's really what the net result is, and so what it's become is the
house has become a source of conflict between Irv's kids and Irv's wife,
and that is the enduring legacy that he left in that situation. That's
not the legacy that I would want to leave, and that's not the legacy
that any CFP should want their clients to have.
Meador: Exactly, exactly. Well, and then of course, the next step is
gift the property away. So, tell us about that.
Peterson: So, lots of people think, "Well, what I'm going to do is I'm
going to get to the end of my life and I'm just going to give everything
away, and so I won't own anything and so we won't have to go through
probate." So, this is a strategy that can work. I've seen it work, but
it's, in general, not a good strategy. So, the pro of the strategy is
its quick and it easy. If you give something to someone and it gets out
of your hands and into their hands, there's no probate that's required
for that.
Meador: Right.
Peterson: You don't have to write anything necessarily down. I mean,
if you gifted a piece of real estate away, you might have to do a deed
or something like that, but if you gave, you know, all of your household
furnishings to your child, you wouldn't necessarily have to paper that
in some way. Gifting is a good strategy when you do it underneath the
gift tax annual exclusion limit. Everyone has the ability right now
under current IRS regulation or code to give up to $14,000 a year to
anyone that they want without paying gift taxes on it. So, gifting can
be a very effective way of passing money to kids or grandkids, and doing
it in a tax free way. And so those are the two pros about it. Now,
there's several cons. One is it has to be done during your lifetime.
You can't gift after your death. Once you die, anything you have left
becomes the subject of your estate. So, gifting works really well if
you own a crystal ball and you can tell me exactly when you're going to
die, and if you don't have a crystal ball, and you can't tell me exactly
when you're going to die, then it's really hard to ensure that you're
going to gift everything away during your lifetime, at least, I find
that hard to do. Another con is that once you gift something away, it's
not yours anymore. You have no rights over it, and you don't have any
control over it. So, if I decide I want to get rid of my estate, and so
what I want to do is I want to write a check for everything that I own
to Jay. Well, if I need something in the future, do I have control over
all of my money? No, Jay, you've got it.
Meador: Right.
Peterson: Let's say I get sick, and I have to go into long-term care,
and I need that money back so I can get it paid for so I can pay for my
nursing home care. Jay, you might want to go buy a Lamborghini with the
money that I gave you. You may not want to buy my nursing home care
anymore, but I am totally dependent and reliant on you to give what I
gave you back in order to provide for myself in the future. I love you
Jay, but I'm not doing that...
Meador: Yeah. [Laughing]
Peterson: The other problem with gift is that anything over that
$14,000 limit is subject to gift tax. So, if you give something over
the gift tax annual exclusion, the amount that is over that gift tax is
going to be subject to gift taxes, and gift taxes are at a really high
rate. So, for most people, the gifts that they give end up being, you
know, 40% gift tax, and that's a pretty onerous rate, compared to what
most people are paying in income tax. Kind of the unintended
consequence of gift taxes or making gifts is that often, the gift end up
in a very unexpected hand, and this is what we see a lot of times when
people are giving gifts as, kind of, their estate plan. They don't
think multigenerationally. They just think about the person that
they're giving it to, but they don't think about who that's ultimately
going to end up in. So, those tend to all be problems. You want to
hear an example of a problem that happened with gifting?
Meador: Always. I love examples.
Peterson: So, we had a client who bought a house and the house was
worth...Well, he bought it a long time ago, 34 years ago, and so the
house at that time was worth $50,000, I think is what he paid for it.
Well, now, the house is worth about $300,000. So, what he does is he
says. . .This is not in consultation with me, but he says," I'm just
going to give it all away, and I'm going to give it to my daughter
because my daughter will take care of me in the future, and so I don't
have any problems. I'm just going to give it to her." Well, Robert
gives the house away to his daughter, Judy. So, the first unintended
consequence, which Robert didn't find out about for several years is
that because he was over the gift tax annual exclusion, which, at that
time, was $10,000, he owes gift taxes on everything above that $10,000
limit.
Now, that's not judged at his basis in the house. It's not judged at
what he bought the house for. It's judged at what the fair market value
of the house was at the time that the gift was made. So, Robert, the
giver of the gift, not Judy, the recipient of the gift, but the giver of
the gift is the one that owes gift taxes. Robert's gift tax was based
on $250,000. So he owes gift taxes on $250,000. Now, if Robert was
really wealthy, that might not necessarily be a problem except for a
couple of things. One, he didn't fill out any gift tax returns so now,
there's penalties and interest that have to be applied to that. The
second is the house was pretty much what he owned and so now, Robert
doesn't really pay the gift taxes with. So, you've got that problem.
So, it gets kind of worse.
So, the next year, Judy decides that she's going to sell the house. So,
she sells the house for $310,000. Now, if Robert had passed away and
Judy had inherited the house, she would've gotten what's called the
step-up in basis.
Meador: Right.
Peterson: So, when Judy went to sell the house for $310,000, her basis
in the house, had it gone passed through a will or trust after Robert's
death, would've been $300,000 because that was the fair market value at
the time of death. So, Judy's capital gains on the house would've only
been $10,000. $310,000 minus $300,000, and so she would've owed a very,
very, very small portion of taxes. In fact, I think it would have come
out to about $1800 or so. Because of the way that she obtained the
house during his lifetime as a gift, when she goes to sell the house,
her basis is the same as his basis. So, when she sold the house for
$310,000...
Meador: Double taxes.
Peterson: She got taxed for capital gains...
Meador: ...On the basis...
Peterson: ...On the difference between...
Meador: ...On the original basis...
Peterson: ...310,000 and 50,000...
Meador: Wow.
Peterson: And so she owes capital gains taxes on $260,000.
Meador: The government loves that family.
Peterson: The government loves that family because Robert got nailed
for the gift taxes on the, pretty much the full amount, and then Judy
got nailed for capital gains taxes on, pretty much, the full amount.
Meador: Wow.
Peterson: So, it was a great day if you were the IRS. It was a bad day
if you were Robert and Judy. And so we see that a lot when people are
doing gifts. They don't think-they don't know about the gift tax annual
exclusion amount so they don't know about the $14,000 limit, and they're
just giving stuff away, and they think, "Well, if I give it to the kids,
there's nothing owed," and so the lack of knowledge is a real problem.
The second is the unintended consequences, and then the third is they
don't think about the loss and step-up in basis if they had passed it at
death.
Meador: Huge red flag. Anytime, one of your clients says, I'm going to
gift something to one of my kids or to whomever, make sure that before
they do that, they check with their CPA or their Estate Planning
Attorney. Big, big red flag right there gang, just to let you know.
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