Estate Planning is a hugely important process that is often put off or ignored. Unfortunately, even for the well-meaning pre-planners out there, there are many pitfalls for the unwary. Below are the three major pitfalls you should avoid.
I. Failing to Do the Necessary Tax Planning
Currently, the gift and estate tax won’t affect most individuals, considering the threshold is $11.18 million for a single individual and double that for a couple. However, there are many other tax factors to consider when entering into retirement and creating your estate plan.
A. Social Security
Depending on your income level, you may be taxed on up to 80% of your Social Security (SS) income. The key to determining whether or not you will owe tax on your SS income, is to look at how much other income you receive in addition to your SS income. That number is known as your combined income. If your combined income is over the limit, you may be liable for tax on a certain percentage of your Social Security.
The limit for a single filer, head of household, or qualifying widow/widower with a dependent child is $25,000. The limit for joint filers is $32,000. If your combined income (or you and your spouses’ if married filing jointly) exceeds the limit, you must pay tax on some of your SS income, but never more than 85%.
If you are concerned about owing tax at the end of the year, you can adjust your withholding to ensure you do not underpay your tax bill. You can use Voluntary Withholding Request Form W-4V. You will have the option to withhold either 7%, 10%, 12%, or 20%. Over-withholding is a good planning option to guarantee you are not surprised by a hefty tax obligation come April 15th.
B. Tax on IRAs
i. How it works
IRAs are effective vehicles for saving for retirement; however, they do not allow for flexibility and can present issues down the road.
Traditional IRAs are tax deferred accounts. This means that you put pre-taxed funds into the account and you do not pay the tax on those funds until the money is pulled out in the future. The benefit of this type of account is that it allows you to put more money in the account, which increases your compounding interest. But, the Tax Man giveth and he taketh away.
Case in point, is the minimum distribution requirements (RMDs). The government will allow you to sit on pre-tax money and let it build, but only until you reach a certain age (70 ½ years). Thereafter, you will be required to start taking money out of the account—and, thus, pay taxes on it. The amount you must take out on a monthly basis as a RMD is calculated by dividing the balance of the IRA by your life expectancy. Thus, the more you have saved, and the older you are, the more money you will be required to take out.
This can present significant issues if not planned for. For example, your RMD counts toward your combined income in calculating whether you will be required to pay tax on your Social Security. It can also be an issue if you are trying to qualify for long-term care benefits, such as Medicaid or Veteran’s Pension Benefits.
ii. IRAs and Long-term Care
When planning for long term care, you will need to ensure you meet the requirements for income or asset levels. An IRA can count against you for both. There are options for spending that money down; however, a traditional IRA presents issues. To spend the money down, you will need to pull the money out of the IRA. This can result in a significant tax bill. Depending on your need for care, you may be able to spread the tax hit out over a number of years. However, not everyone has the luxury of time.
Depending on your situation, a traditional IRA may not be right for you. That does not mean you should avoid using a traditional IRA. You can utilize the benefits of a traditional IRA without incurring the full brunt of the downside by diversifying your retirement funds in more than one retirement vehicle. Furthermore, even though a traditional IRA may not be the best option, it could be your only viable option e.g. Roth IRA’s have an income and contribution limit.
Just because you no longer work, it does not mean you are out of the reach of the IRS. In fact, you may face more tax related considerations than ever. Planning for the future and retirement should include a comprehensive tax plan.
II. Not Considering Long-term Care Needs
Seventy percent of individuals over the age of 65 will need some type of long-term care in the future. With those type of odds, it is best to plan for the future as if the need for long-term care is a certainty rather than a possibility. The odds will only increase as medical technology improves and life expectancies rise. Ignoring the inevitability of the need for long-term care will surely result in disaster down the road.
- So, what are the options?
A great planning option for long-term care is long-term care insurance (LTCI). LTCI is similar to any other insurance policy where you pay a monthly premium and you receive a payout upon the happening of some event—in this case, the need for long-term care. Every policy is different based on the individual. The monthly premium, the term of coverage, and the amount of coverage depends on the individual. Additionally, there are options for hybrid plans e.g. a life insurance plan with a long-term care ride.
- What if you don’t qualify for LTCI or you cannot afford the monthly premiums?
If you do not have the safety net of LTCI, then you may want to structure your plan to allow you to qualify for means tested government benefits (i.e. Medicaid & Veteran’s Aid and Attendance) in the future.
- How do you set yourself up to qualify for benefits?
The key here is having flexible assets. Medicaid and VA both have a rather low asset threshold for qualification. However, there are many ways to preserve these assets. To ensure that your assets can be preserved to the largest extent possible, your assets should not be locked up in a manner that makes it difficult to roll them into an exempt status. For example, the use of a traditional IRA, as mentioned above, essentially locks the funds in the account. They cannot be preserved without taking a significant tax hit. Another example is real property (excluding the home). While deed work can be done to preserve most, if not all, of your real property while allowing you to qualify, it is much easier to preserve liquid funds or funds that can be easily liquidated. Furthermore, depending on the type of long-term Medicaid you need, deed work may not be the solution.
Your estate plan should not neglect the inevitability of the need for long-term care. Ignoring this possibility can result in catastrophic financial and emotional turmoil. The best way to preserve your assets for future generations, is to contemplate the need for long-term care in the future.
III. Choosing the Wrong Estate Plan
There is a huge amount of misconceptions regarding estate planning. Estate planning is similar to taxes in that everyone deals with it, but no one quite understands it (except hopefully your lawyer). So, what should you think about to avoid choosing the wrong estate plan?
- Your plan must be personalized:
No matter how tempting it may be to print out a fillable form from the web and get the process over with in an evening, your estate plan requires much more attention to detail. Prefabricated documents can lead to a variety of problems. There are many specific requirements associated with legal documents that have developed over years of legislation and case law. These requirements are technical and can vary on a case by case basis. In short, it takes an individual who has had these legal concepts hammered into their head for three years of law school to adequately ensure that the documents are correctly drafted.
Besides the obvious issue with prefabricated documents, another problem is they are not tailored to your needs and goals. Every individual has separate concerns about the future. Some of these concerns are not always explicit or obvious. It takes individual evaluation by an expert to determine what safeguards should be in place for each individual. For example, you may have a special needs individual in your family who will inherit your property. How do you ensure their inheritance is protected? Maybe, you have young children and want to appoint a guardian if something were to happen to you. How do you ensure your wishes are followed? The answer? Meet with a professional.
- Your plan must be practical:
In additional to contemplating your goals, your estate plan should be practical. It should address your needs in a straightforward manner without undue complication. To illustrate, you may want a trust, but do you need one? There are many benefits of forming a trust. One of those benefits is probate avoidance. But if, for example, you have modest assets and income, you may be able to achieve the same goal without needing to create a trust.
Practicality means also means that the plan adequately contemplates the future or is flexible enough to adapt to future events. Let’s say you have a will drafted with your young children as heirs. You put a provision in the will that puts their inheritance in trust if you pass away before they reach the age of 21. You pass away while your oldest is 17, the money is put in trust, and it is responsibly managed by a trustee, rather than outright given to a minor. This is the sort of flexibility your estate plan should have—because, after all, the future is a mystery.
Creating an estate plan can be a very involved process, both mentally and emotionally. But, just like everything else in life, putting the time and work in will make the plan more practical, more personalized, and ultimately more effective. The best gift we can give our loved ones is our time. Some of that time should be used planning for a future without you in it.
Do not fall for the common estate planning pitfalls. Start the process, stay informed, and speak to an attorney about what is right for you.
Brenton S. Begley
Elder Law Attorney
McIntyre Elder Law
“We help seniors maintain their lifestyle and preserve their legacies.”
PO Box 165
Shelby, NC 28151-0165