Estate planning offers many ways to leave your wealth to your children. However, the key is being aware of what not to do. Here are some all-too-common mistakes to avoid:
Joint Tenancy: In lieu of setting up a trust (or, conversely, passing assets under a will), some people avoid a formal document and instead name their children as joint tenants on their real property (or, similarly, co-owners on their bank accounts). The appeal is understandable; listing a child on an account/title while the parent(s) is living should permit that child to smoothly assume full ownership when that parent(s) eventually passes away. After all, joint tenancy property can be structured to pass the asset to the co-owner without necessitating a probate. This strategy, however, often presents more problems than benefits. Namely, it (1) doesn’t insulate the asset from creditors and (2) could easily cause unnecessary taxes.
Imagine if your child has, or will eventually have, financial troubles and/or a rocky marriage. A joint tenancy titling could quickly render your home, investment account, or bank funds an easy target for a creditor or divorcing spouse of your child. Even worse, the child’s debt could potentially result in a forced sale of your jointly-held house!
The second major problem with utilizing joint tenancy ownership involves unnecessary exposure to otherwise avoidable capital gains taxes. As a general rule, when you sell certain assets, the government taxes you if you saw an increase in value on that asset during the ownership period. For example, if you bought vacant land for $200,000 and later sell it for $350,000, you’d likely be assessed capital gains taxes on the $150,000 gain you enjoyed. The good news, though, is the federal government gives your estate an exemption on these taxes if you die owning appreciated assets. Imagine that instead of selling at the $350,000 level you die with the land valued at $350,000. Long ago, lawmakers decided that, under this scenario, favorable public policy should permit your heirs, having just lost a loved one, to be alleviated of this tax burden should they decide to sell the asset. Unfortunately, the government doesn’t treat your child so favorably if he/she was a joint tenancy owner with you at your death. Choosing to rely on joint tenancy, therefore, can easily create a needless tax bill for your co-owning joint tenant! Believe it or not, we see this mistake on a yearly basis from clients trying to “do it themselves”.
Choosing to Gift to the Children During your Life: Some parents entertain the idea of gifting funds to their children early – either outright or incrementally over time. While the strategy sounds appealing, it comes with several pitfalls. First, transferring a smaller, yearly amount is often interpreted by the children as more of an allowance, or “expense money”, than the beginnings of passing them your legacy. As a result, the children are much more likely to spend it mindlessly as opposed to wisely investing the funds. Second, if you want to gift without triggering potentially hefty gift taxes, you are limited to giving each child $14,000/year. Technically, you are able to give more than that figure but you must file a gift tax return with the IRS and the excess amount will begin reducing your lifetime gift tax exemption (not a large issue for most people in today’s estate tax-friendly environment). Thirdly, gifting assets to children or grandchildren is, theoretically, irrevocable. Should your financial situation change and you need to reevaluate your allocation, you don’t want to be dependent on them giving the cash back if you need it for your own needs. While it’s wonderful to provide for loved ones during your own life, we’ve witnessed clients acting too generously and, down the road, they don’t have quite the comfortable nest egg they anticipated having during retirement.
“Oral Wills”: If you feel you have a good rapport with your family and/or don’t have many assets, you might be tempted to simply tell your loved ones how to handle your estate when you’re gone. For example, you may decide to informally instruct one child to carry out your estate in a particular way. However, even if your family member(s) wished to follow your directions, it may not be entirely up to them. Without a written document or proper arrangements, any assets you own individually must go through probate, where “oral wills” have no weight in court. A judge (not your loved ones) would most likely decide how to distribute your assets under state law. Further, it’s irresponsible to burden a particular child with informal instructions regarding your estate; doing so will likely create an undesirable situation for him/her once you are gone (both logistically and related to tax payments, more than likely). This is one strategy to avoid at all costs.
