When we think of estate planning, we often think about preparing our clients’ accounts and property to go to their loved ones in a tax-efficient way, protected from probate, disgruntled heirs, beneficiaries’ creditors, divorcing spouses, bankruptcy, and the poor spending habits of beneficiaries. We rarely consider helping our clients prepare for receiving an inheritance.
Believe it or not, there are several essential things a client must consider if they anticipate receiving an inheritance. Helping them understand these issues brings value to your professional relationship, ensuring that they return for your advice and counsel for years to come.
Understanding the Nature of the Property to Be Inherited
The first way to help a client properly prepare to receive an inheritance is to discover what exactly they will be inheriting. Is it real estate, a 401(k), or an individual retirement account (IRA)? Perhaps it is publicly traded stock, an interest in a family business, or simply cash from a savings account or life insurance policy.
Whatever type of account or property it is, there are steps you can take to help the client plan to receive and manage it properly going forward. For example, if the client will receive a large IRA account from a parent, does the client understand the new rules associated with inherited IRAs implemented by the SECURE Act passed in late 2019? If not, you can provide crucial guidance on how to maximize the tax benefits available under the law regarding required distributions. If the client fails to understand these sometimes complicated rules, they could make an irreversible mistake and withdraw all of the IRA funds at one time, thereby substantially increasing their tax liability in the year of withdrawal.
Furthermore, by helping them plan to receive that inheritance, you may discover opportunities to help your clients properly invest and manage that inheritance under your own professional management. Doing so will allow you to continue to bring your expertise to the table for years to come for the benefit of your clients.
Powers of Appointment
If someone has established an irrevocable trust for your client, such trusts may include important features such as powers of appointment. A power of appointment in a trust is a right, often given to the beneficiary of the trust, to gift trust property to someone else or, in some cases, to themselves. These powers are often limited to making gifts to only certain classes of people (such as the descendants of the trustmakers) or they may be limited to making gifts only at death (a testamentary power of appointment) or during life (a lifetime power of appointment). Some trusts include both types of powers. These can be powerful planning tools given to your clients by their parents or other family members. Failure to recognize the existence of these powers can lead to unintended consequences, or at the very least, crucial missed asset protection and tax-planning opportunities.
If your clients know that they have been granted a power of appointment, encourage them to obtain a copy of the relevant trust documents to carefully review and determine the nature of these powers. With this information, you can properly advise them on the planning opportunities and tax consequences of their powers of appointment.
Keeping Inheritance Separate from Marital Property
A common mistake made by married heirs or beneficiaries of an inheritance is to commingle that inheritance with the property of both spouses. How can this be a mistake? An example may best illustrate the point:
Imagine Robin receives a cash inheritance from her deceased father of $300,000 and she and her spouse Morgan decide to use the inheritance to buy a vacation cabin in the mountains. When purchasing the property, the title company assumes that because they are a married couple, they want to take title to the property as joint tenants with rights of survivorship and the deed gets prepared and recorded accordingly. Further imagine that over the years, they furnish the property together, maintain it, and enjoy many family vacations there. One night, however, Morgan has a little too much to drink at a bar, gets behind the wheel, and causes a deadly accident that results not just in a DUI, but also in a wrongful death lawsuit. Because Morgan’s name is on the title to the property as a joint owner, Robin and Morgan discover that the family cabin is an asset that can be used to satisfy the lawsuit judgement against Morgan. As a result, they are forced to sell the cabin and use half of the proceeds to satisfy the judgement.
This unfortunate circumstance can be the result of Robin’s failure to keep her inheritance as separate property. By commingling her property with Morgan, she made it much easier for the judgment creditor in the lawsuit to reach what otherwise would have been considered Robin’s separate inheritance property.
Commingling inherited property can also lead to a similar result if Robin and Morgan ultimately divorce and the family court judge has to determine how to divide the marital property. Failing to keep the inherited property separate during marriage can often lead to that property being divided between spouses at divorce.
A fourth way to help your clients prepare to inherit property is by using an inheritor’s trust. This is a special type of trust that can be established with the help of your client and the individual who will be leaving an inheritance to your client. The inheritor’s trust is designed to receive the inheritance that your client would otherwise receive directly. It must be carefully designed and implemented to work properly, and an experienced estate planning attorney should most certainly be used in the effort. A properly drafted inheritor’s trust includes the following key elements:
It is created and signed by the individual who will be leaving the client an inheritance, not by the client
The trust creator names the trust instead of the client as the beneficiary of their will or revocable living trust
It typically has a spendthrift clause or is otherwise designed to protect the inherited property from creditors, divorcing spouses, lawsuits, bankruptcies, etc.
The client is the beneficiary of the inheritor’s trust
The client may also be named as the trustee or co-trustee of the inheritor’s trust, depending upon how protective the trust needs to be of the trust property
An inheritor’s trust includes the following benefits:
The inheritance can be excluded from the client’s taxable estate, potentially saving their family estate taxes
The trust can be a more cost-effective way to protect the assets instead of the client’s loved one revising their existing plans
Upon the client’s death, the inheritance will be distributed outside of their probate estate, which can help ensure privacy and lower attorneys fees and administration costs
The inheritance will be protected from creditors, lawsuits, and divorcing spouses
In some circumstances, the inheritance can even be controlled and managed by the client as a trustee
The client can decide how remaining trust assets will be distributed after they pass away if the trust gives them that power (through powers of appointment)
An inheritor’s trust can be a powerful tool to use for a client who anticipates receiving a large inheritance and would like to make sure that the inheritance is protected from certain tax consequences or threats from creditors.
Being prepared to discuss these important concepts with your clients is an important way to stay top of mind and bring value to your relationship. If you would like to learn more about any of these concepts, give us a call. We would love to discuss these ideas in greater depth with you so we can help you help your clients build and protect their wealth more effectively.