First, the nuts and bolts. A trust is an arrangement where a trustee holds the right to property for the benefit of a beneficiary. The person who establishes and funds the trust is the grantor (also called the “trustor” or “settlor”). The person who controls the property in the trust for the benefit of a beneficiary is the trustee. The trustee has a fiduciary duty to always act in the grantor’s best interest. The person who the grantor appoints to manage the trust assets during their lifetime or distribute the trust assets after their death is the successor trustee. Commonly in a living trust, the grantor, trustee, and beneficiary are all the same person.
Probate is the legal process that takes places after someone dies. It includes validating the will, identifying, inventorying, and valuing the decedent’s property, paying debts and taxes, and distributing the remaining property as the will or state law directs. If the decedent had a will, then the will determines the transfer of property; if the decedent didn’t have a will, then the laws of intestate succession determine the transfer of property. In California, intestate succession is determined by the state legislature and set forth in the Probate Code. As such, the decedent has no choice but to leave their property to the persons in the order listed in the Probate Code, even if it’s not what they would have wanted.
Enter the living trust. A living trust is a type of trust that the grantor establishes during their lifetime (as opposed to a testamentary trust which takes effect at the grantor’s death) and one that they may amend, revoke, or terminate at any time (as opposed to an irrevocable trust). A living trust essentially acts in place of a will, and trust assets pass to beneficiaries outside the probate process. This works because probate only includes property held in the decedent’s name, whereas property in the living trust is held in the trust’s name. The number one reason people create living trusts is to avoid probate.
Probate fees are a significant concern. As of April 1, 2022 in California, probate is required if someone dies owning $184,500 or more worth of assets. Excluded from this $184,500 are financial accounts with designated beneficiaries, transfer-on-death (TOD) accounts, or any assets owned in joint tenancy or as community property with the right of survivorship. California has the following statutory fee schedule set forth in the Probate Code for the attorneys and executors representing the estate, which cover the probate duties mentioned above.
- 4% of the first $100,000
- 3% of the next $100,000
- 2% of the next $800,000
- 1% of the next $9,000,000
- 0.5% of the next $15,000,000
The probate fee calculations may have to be done twice, once to calculate the attorney’s fee and once to calculate the executor’s fee. Here are example probate fee calculations based on the gross value of an estate.
- $500,000 $13,000 x 2 = $26,000
- $600,000 $15,000 x 2 = $30,000
- $700,000 $17,000 x 2 = $34,000
- $800,000 $19,000 x 2 = $38,000
- $900,000 $21,000 x 2 = $42,000
- $1 Million $23,000 x 2 = $46,000
- $5 Million $61,000 x 2 = $122,000
The gross value of the estate is the full market value of the assets of the estate, and the probate court does not use debts or encumbrances to offset this. For example, if a house is appraised at $900,000 but has an outstanding mortgage of $400,000, the house is still valued at $900,000 for the purposes of calculating probate fees. Furthermore, if the house is sold during probate, the attorney and the executor may be entitled to receive extra compensation for their time and the costs incurred in the sale.
The probate process is slow and can drag out the distribution of the estate, which is undesirable for obvious reasons. Probate can easily take a few years and most beneficiaries would prefer not to wait that long. By contrast, a living trust can be distributed in accordance with trust instructions at any time after the grantor’s death, without having to get permission from the probate court. This is a much more expedient and straightforward process.
Privacy may be an additional worry. All documents related to the transfer of the decedent’s property must be filed with the probate court and as such become a matter of public record. This includes assets and their values, identification of beneficiaries, and any conditions on the receipt of assets. By contrast, a living trust is a private document, and nothing becomes part of the public record. This is how a living trust can protect the decedent’s privacy and the privacy of their beneficiaries.
Outside of avoiding probate, there are ancillary benefits of a living trust. A living trust can protect the grantor if they become incapacitated, as the successor trustee can step in and manage or distribute the trust assets for the grantor’s benefit. This is particularly important for people who are single or who don’t have children. A living trust can also provide management of property for young beneficiaries by naming custodians and including instructions for the creation of subtrusts. These provisions can protect minor children until they are old enough to manage their inheritance themselves, or protect adult children who are not responsible from themselves.
If you live in California and own a home, the math is irrefutable. As of August 31, 2022, Zillow lists the typical home value in California as over $775,000. If a living trust costs approximately $3,000, then establishing one will save you over $30,000 based on that asset alone. While talking about estate planning with an estate attorney may be a gloomy prospect, paving the way for beneficiaries to receive more of their inheritances efficiently, privately, and responsibly makes complete sense.
Life insurance is not a topic that the vast majority of people want to think about, but it’s an essential piece of the financial planning puzzle. Purchasing a life insurance policy can significantly ease the way for your heirs. While there are umpteen types of life insurance products on the market, there is generally only one kind that I advocate, where you are not being sold something with bells and whistles that you don’t need, and that is a term life insurance policy.
What is term life insurance? Term life insurance is exactly what it sounds like, a policy that you purchase for a certain period of time, commonly 10, 15, 20 or 30 years. There are several types of term – for example where the premiums start low but increase annually (annual renewable term) or where you pay higher premiums for the chance of outliving your policy and being refunded some of the premiums at the end of the term (return premium term). But the type that I’ve found to be most appropriate for most people is level premium term, where the premiums are fixed over the life of the policy. When any of these terms expire, the policyholder can restart coverage at a higher rate or give up coverage altogether. In essence, you are renting a life insurance policy instead of owning it, meaning there are no accumulated cash benefits that need to be paid out at the end of the term.
Life insurance policies that do have the benefit of a guaranteed payout are called permanent life insurance, and this is like being a homeowner instead of a renter. Permanent life insurance comes in several basic types, whole life, universal life, and variable universal life, and all build up a cash value and last for your lifetime.
On first glance permanent life insurance sure sounds better than term life insurance. Why rent when you can build equity as an owner? Well, permanent life insurance definitely has a place in complex estate plans or charitable giving strategies, but for most of the population, term is the best option. This is because term is by far the least expensive option as you get the most death benefit per dollar paid. While term does not bank your cash in an investment account, the money that you are not spending on more expensive permanent life insurance premiums can be invested more competitively, which means you should expect higher returns. Furthermore, in most cases I think of life insurance as an income replacement strategy, and so I advise clients to match their term policies as closely as possible to their retirement dates. Once their income turns off, so does their life insurance policy. As that point, clients should have pension, portfolio, or other supplemental income to provide for their needs comfortably in retirement.
For people with children and/or mortgages, term life insurance is a necessary consideration. To throw out some ballpark numbers – if you are in your late 30s or early 40s you should be able to get a policy for between $10-80 a month that will give you between $100,000 and $1 million in coverage. That’s a small price to pay for a big relief should the need arise.
You are likely familiar with the concept of a power of attorney, a legal document that allows someone else to act on your behalf. Legal terminology denotes the individual designating the power of attorney the “principal” and the designated person the “attorney-in-fact”. There can be multiple attorneys-in-fact, but of course they must make decisions in concert. The scope of the power can be limited or broad, but the purpose is for the attorney-in-fact to make decisions that are in the best interests of the principal. A broad power of attorney is an attempt by the principal to give their attorney-in-fact the same rights the principal would have if they were able to act on their own behalf.
What does “durable” mean? A power of attorney goes into effect upon signing and terminates if the principal becomes incapacitated. Adding the durable specification means that the power of attorney will stay in effect if the principal becomes incapacitated. There is also the option to add a “springing” specification, which means that the durable power of attorney does not go into effect upon signing, but springs into effect if the principal becomes incapacitated. This addresses the situation whereby the principal wants to remain in control until they are unable to do so, and only at that point does the attorney-in-fact take over. While this is efficient, a drawback of the springing specification is that there could be disputes over whether or not the incapacity has occurred.
In addition to the durable financial power of attorney discussed here (also called a durable power of attorney for finances), there is a durable medical power of attorney (also called a durable power of attorney for health care). With a durable financial power of attorney, the attorney-in-fact has the right to pay bills, deposit checks, file tax returns, buy and sell real estate, invest in securities, make gifts, and even sue, among other things. As one would expect, with the durable medical power of attorney, the attorney-in-fact has the right to make health care decisions for the principal in the event of incapacity. Due to their different concerns, and even if the attorney-in-fact is the same for both of them, these two documents should be drawn up separately for purposes of privacy and simplicity.
Families can benefit from having a durable financial power of attorney in place if there’s a significant chance that an older family member will become incapacitated due to disability, illness, or age. A durable financial power of attorney can prevent the family from having to go through the court system to appoint a guardian or conservator to manage the principal’s financial affairs. Additionally, a durable financial power of attorney can make it easier for a family member to take the helm and avoid conflict with other family members.
You don’t have to be older to benefit from having a durable financial power of attorney in place, because you never know if an accident might happen that could lead to your own incapacity and leave financial chaos behind. For example, it’s common for spouses to have durable financial powers of attorney for one another in case something happens to one of them. In community property states especially, many transactions require the signature of both spouses, and so it’s prudent for spouses to confer durable financial power of attorney upon one another. Some community property states such as California already provide that if one spouse becomes incapacitated, the other spouse automatically assumes the management of the community property. Which, to avoid conflict, makes it important that the other spouse and the attorney-in-fact are the same person.
In your suite of estate planning documents, a durable financial power of attorney could be an essential one.
For a standout option for college savings, look no further than 529 plans. 529 plans are investment accounts with tax-deferred earnings and tax-free withdrawals, as long as they are used for qualified education expenses. 529 plans, also known as “qualified tuition plans,” are sponsored by states, available directly from plans or through advisors, and take their name from Section 529 of the Internal Revenue Code.
There is a second, little-known category of 529 plans called “prepaid tuition plans,” somewhat antiquated plans where you can lock in a tuition rate through the purchase of credits. However, these plans have many limitations and states are beginning to drop them. The first category of 529 plans discussed here have far greater visibility and popularity.
Along with tuition, 529 plans can be used to pay for qualified education expenses including room and board, fees, books, computers and related equipment, and supplies. However, earnings on withdrawals used for non-qualified expenses are subject to federal and state income taxes and a 10% federal penalty tax. 529 plans offer flexibility with choice of schools and can be used at a variety of institutions, including colleges, universities, trade or technical schools, and some foreign schools.
In addition to the benefit of tax-deferred earnings and tax-free withdrawals, some states offer tax deductions or credits for 529 plan contributions. In many cases, if the maximum deduction is met in one year, the deduction can roll over into subsequent years. Almost all states mirror federal law and offer state tax exemptions on withdrawals.
You don’t have to save in your state’s plan. The key is to first look at your state for tax deductions or credits, and if there is one, it usually makes the most sense to claim it. But if you live in a state with no income tax or you don’t have any tax deductions or credits available, by all means shop around with other states’ plans and compare and contrast their performance.
529 plans are very accessible, with investment minimums as low as $10 and high contribution limits. Individuals can apply the $14,000 annual gift tax exclusion to their contribution for one year ($28,000 for couples), or make up to 5 years worth of contributions at once by contributing $70,000, without triggering the gift tax ($140,000 for couples). For high-net-worth folks, this gifting strategy can be used to reduce the size of their taxable estate. Lifetime maximum account values are between $300,000-$400,000 per beneficiary, depending on the state, and a beneficiary can have multiple accounts as long as the total money in all accounts does not exceed the state limit on contributions. Anyone can contribute to 529 plans – grandparents, parents, aunts, uncles, friends, and so on.
The 529 account owner retains full control of the assets throughout the lifetime of the account, including the right to take the money back (although this would be a non-qualified withdrawal and subject to federal and state income taxes and the 10% federal penalty tax). If the original beneficiary gets a full scholarship, ends up with an unused balance, or doesn’t go to college, the account owner can change beneficiaries or transfer assets to another family member, as many times as needed. The IRS’s definition of family member is generous, including step-siblings and first cousins, for example. Account owners can also use the plan for their own educational needs.
To minimize impact on financial aid, it’s generally best for 529 account owners to be the custodial parent(s). Assets in a 529 plan held by a custodial parent count against need-based aid up to a maximum of 5.6%, whereas withdrawals from a 529 plan held by grandparents or non-custodial parents are considered untaxed income to the beneficiary the following year, and could reduce need-based aid by as much as 50%.
529 plans exclusively use mutual funds and offer two investment options. The first is an age-based portfolio option, similar to a target date retirement fund, where the investments shift from aggressive (high percentage of stocks) to conservative (high percentage of bonds and cash) as the beneficiary gets close to college age. The idea is that the portfolio increases the chance of gain early on and reduces the risk of loss later on. The second option is a static portfolio, where the funds stay the same over time, and the account owner rebalances as they see fit, up to once a year. Within both of these options you can still choose your risk tolerance and have a diversified portfolio. 529 plans are undeniably worth it – as JP Morgan Asset Management tracks it, even in its worst 18-year period, a 50/50 mix of stocks and bonds outperformed tuition inflation.
Lastly, a quick note about direct-sold versus advisor-sold plans. Advisor-sold plans have on average a 4.75% commission attached to them, increasing plan cost and cutting into plan returns. According to Morningstar, most 529 plan assets are invested in age-based portfolios, which are automatically rebalanced over time, and account owners tend to stick with this allocation. It makes you wonder, what is the need for an advisor then? In fact, Morningstar’s 2016 ranking of the best 529 plans overwhelmingly puts direct-sold plans at the top of the list.
If you are a Gen Xer or older, most likely you remember the highly publicized case of Terry Schiavo, a Florida woman in a persistent vegetative state who tragically became the center of a legal battle between her parents, who wanted to keep her alive, and her husband, who wanted her feeding tube removed because he said that would have been her wish. Since Schiavo did not have a living will, her case worked its way up through state and federal courts, eventually landing on the desk of President George W. Bush, and in the end it took seven years for her feeding tube to be removed.
I can’t think of a better example that illustrates the need for everyone to have explicit end-of-life care instructions, just in case. After all, it is your constitutional right to choose or refuse medical care, so why not exercise it? In California, the Advance Health Care Directive does just this, simply and unambiguously. This Advance Health Care Directive combines a living will and a power of attorney for health care, and following are descriptions of both parts of the document. (To be expected, each state uses slightly different terminology for these documents.)
Living Will: This document describes your health care wishes. The Living Will bears no relation to the traditional will or living trust used to leave property to your beneficiaries at death. It’s a document that lets you state what type of medical treatment you do or do not wish to receive if you are too ill or injured to direct your own care. (Among other things, you can use it to be sure that doctors do – or do not – “pull the plug.”)
Power of Attorney for Health Care: This document names someone to make healthcare decisions for you. The Power of Attorney for Healthcare, also known as a medical power of attorney, allows you to name a trusted person to make medical decisions for you if you are unable to communicate on your own. The person you name to make these decisions is usually called your agent or attorney-in-fact. You can give your agent the authority to oversee the wishes you’ve set out in your health care declaration, as well as the power to make other necessary decisions about health care matters.
Procrastinators take note and go-getters take a breather – it is a misconception that this is a costly and cumbersome process. You do not need an attorney to draft the Advance Health Care Directive for you as you can easily do it yourself. Conveniently, the Advance Health Care Directive provided by the State of California Department of Justice Office of the Attorney General is available on this website: https://oag.ca.gov/consumers/general/care#advance. Click on the link to “California Probate Code Sample Form.pdf”, download the pdf, and print. All you need to do is fill out the form, have it signed by two witnesses, and then keep it in your files. Needless to say, for most people this can be a significant accomplishment in estate planning, an oft-neglected subject.