Estate Planning Essentials: The Living Trust

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.

Estate Planning Essentials: The Durable Financial Power of Attorney

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.

Just Say No to Variable Annuities

Variable annuities are private financial contracts that provide income for a specified period of time, such a number of years or for life, and are tied to the investment performance of the mutual funds held in the contract. While the promise of a fixed income stream is enticing, I’ll level with you about the many downsides. In short, variable annuities are expensive, restrictive, and unnecessarily complicated financial products that offset any financial benefits they claim to offer.

Caveat emptor (“Buyer beware”). The salesperson pushing a variable annuity is largely motivated by the high commissions they will receive from selling it. I belong in the camp where if you are a financial professional, your fiduciary duty is implicit and paramount, and the client’s best interests always come first. The financial professional should never be incentivized to undermine the client’s best interests for their own gain. However, in the case of variable annuities, there couldn’t be a more egregious conflict of interest.

Here is a plethora of reasons not to buy one:

Commissions. Annuities are primarily front-end loaded, commission-based products. When a salesperson tries to sell you an annuity, don’t be afraid to ask about the commission they collect by selling it to you. Annuity firms can pay out commissions of 5% or more. Reality check: for each $100,000 you plunk into the annuity, that’s $5,000 or more in commissions. Furthermore, the mutual funds held in the annuity charge commission-like fees in the form of front-end loads, back-end loads, and 12b-1 fees.

Surrender charges. Most annuity firms charge a hefty surrender fee, usually on a seven year scale. For example, a $100,000 investment could cost you $8,000, or 8%, in surrender charges if you take your money out in the first year. The surrender charges usually go down 1% per year until reaching 0% at the end of the surrender period.

Fees. Additionally, there is a raft of dubious fees that may be charged by the annuity firm. This can include, but is not limited to, any of the following: asset fees, management fees, annual fees, quarterly transaction fees, withdrawal fees, rider fees, administrative fees, mortality and expense fees. With fees in aggregate costing between 2-4% annually, it’s difficult for investors to make money. At best, stated interest rate contracts (often called “guaranteed” interest rate contracts) may end up only paying out the stated rate (like 2%) because the rest is negated by fees. At worst, the fees negate any profits whatsoever.

Risk. The value of a variable annuity goes up and down with the market, so growth is not assured. Consider what would happen if the annuitant were to die prematurely. If the annuity has not been annuitized, the beneficiaries receive the value of the account. Depending on investment performance, this could be significantly less than what was originally invested. Or, if the annuity has been annuitized, all payments cease, even if only one payment has been made.

Irreversible consequences. Once you annuitize, you give up the ability to recover your lump sum or pass it on to beneficiaries. For example, if you put $250,000 into an annuity at age 60 and agree to receive a monthly income for the rest of your life, it could take 25 years to break even. It’s worth belaboring my last point as well – all payments cease at the death of the annuitant.

Poor tax planning. Once you put after-tax dollars into an annuity contract, withdrawals are taxed as ordinary income rather than at more favorable long-term capital gains rates.

Inflation. Rates are currently at historic lows, and will increase in the future. Over time, the purchasing power of fixed annuity payments is greatly reduced by inflation.

No socially responsible choices. Most annuities do not have any environmental, social, or governance screens that measure sustainability and ethics in regard to investments. As such, your investments may be supporting companies not aligned with your values.

Intentional derangement. Annuity contracts seem to be complex on purpose and the salespeople who tout them seem to skimp on disclosure. If the annuitant doesn’t fully grasp the terms of the contract, this benefits the salesperson, who likely doesn’t fully understand it either. Numerous clients have come to me with annuity contracts from other financial professionals and they can’t make heads or tails of them, and they certainly aren’t aware of all the limitations. Older retirees in particular are vulnerable to this dishonorable practice.

These myriad pitfalls of variable annuities add up to a vehement Do Not Touch With A Ten-Foot Pole rating.