A Discussion about Trusts with Attorney Matt Schwartz
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|The Lange Money Hour: Where Smart Money Talks
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- Guest Introduction: Matt Schwartz, Esq.
- What is a Trust?
- Advantages and Disadvantages of Revocable Trusts
- Trusts and Beneficiary Designation for Minors
- What if the Kids Aren’t Minors Anymore?
- Trusts and Taxes
- Lange’s Cascading Beneficiary Plan
- Trusts as the Beneficiary of an IRA
- Trusts for Children (Adult or Minor) with Disabilities
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Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.
Jim Lange: Hi, this is Jim Lange at The Lange Money Hour, Where Smart Money Talks. We have something a little different for you tonight. We actually are doing a show on trusts, and we’re going to be talking about revocable trusts and tax-motivated trusts and creditor protection trusts and trusts for minors, and rather than Nicole asking me questions (which is a typical and actually planned for tonight), we’re actually going to have a discussion between me and Matt Schwartz. Matt is the attorney who works with me in my office, has been with me for seven years now, and just does a wonderful job at actually drafting these trusts. So, he’s not only going to be talking about some of the basic concepts that I’ll be talking about, but actually getting into a little bit of the nitty-gritty. We are live and we encourage your telephone calls with questions and issues. The telephone number to call and reach us is (412) 333-9385 to ask any questions about trusts that we are talking about tonight.
And the way I thought I would first start is actually talking about what a trust is, and Matt, maybe you can help our audience with just the idea of what a trust is, and then we’ll get into some of the details about the different types of trusts.
Matt Schwartz: Well, Jim, first, thanks for having me on the show this evening, and I think the easiest place to start is the term that people often hear, which is revocable trusts, or living trusts, and many people don’t understand what a trust is. It’s really a will substitute. So, rather than having a will that says where all your assets go, instead people might have a will that says that their assets are controlled by their trust, and then the trust has all of the provisions about where your assets would go when you pass away.
Jim Lange: All right. So, basically, what you’re saying then is normally, at least in the old days (and probably still today for most people), when they die and they want to direct the property that they own, they have a will and it says you might leave it to your wife or you might leave it to your kids or you might leave it to another trust, but that will typically be in a will. And what you’re saying is, a revocable trust (and we’re going to get to the issue of what revocable means) is rather than having your will control what happens to your assets at your death, that it would be this trust that would control it.
Matt Schwartz: That’s correct, and as you mentioned, people often get scared when someone mentions a trust to them, thinking that it’s going to be irrevocable or non-changeable, but the type of trust we’re talking about is revocable, which means that you can change it as many times as you want until you pass away, and people often think when you draft one of these trusts that you go down to the courthouse and you record it right after it’s drafted, but in actuality, because you can change it as many times as you want, you don’t have to record a revocable trust after someone dies like you would record a will. So, it’s something that you can change as many times as you need to during your life.
Jim Lange: Right, just like a will. In fact, actually, one of the advantages of a revocable trust is it is not a matter of public record and that it is more private. I have a little bit of a strong opinion about this that I’d like to talk about before we go on. There are law firms and even national firms that go around putting on seminars: Avoid probate! Avoid probate! Do revocable trusts! And the whole idea that they are espousing, and frankly, they’re not all wrong, is that there are additional costs of going through probate (in other words, using a traditional will), that there are delays, and some attorneys charge their fee based on a percentage of the probate estate. So, these groups of individuals and firms are saying, “Hey, avoid probate at all costs,” and they are, in effect, selling the preparation of revocable trusts. I don’t think that they’re all wrong. I think that there is some merit in avoiding probate. But what I would say is that it is much more important what the content of the will or the revocable trust is rather that the difference between a revocable trust and a will.
So, for example, if you have the wrong theory, which I consider the traditional, very popular estate plan right now, that features a trust within a trust called a “B” trust or a family trust, and that becomes the primary beneficiary, which I think is the incorrect, or the least optimal theory for most estate plans. Whether you’re avoiding probate with a revocable trust or you’re using a traditional will, to me, it doesn’t matter. You have the wrong theory, and to me, it’s almost more of a question of if you have the foundation right and you have the infrastructure right, in which case the difference between a revocable trust and a will isn’t nearly as important as, you know, for example, what color the paint is on the house, or something like that. So, I’ll just say that I don’t think it’s critical whether you have a will or a revocable trust. In fact, in our office, we do quite a bit of both. Matt, maybe you can tell me when you tend to prefer doing a revocable trust and when you prefer drafting a will for somebody, and what criteria do you use to decide what you recommend to somebody?
Matt Schwartz: That’s not a question that has one answer for everybody. It’s really a question you have to determine for each individual client. But with the situation, you tend to look at their assets, and if a lot of their assets pass outside of a will, if they’re already IRAs primarily, and there’s just a house here in Pennsylvania, they’re generally not the best candidate for an estate plan with a revocable trust because when someone passes away, you’re going to have to do a deed to transfer the house whether it passes under a will or passes under a revocable trust. So, I generally don’t see much cost savings from using a revocable trust in that type of context. I see it more in situations where people maybe have their assets primarily in one or two after-tax accounts, and they’re pretty large accounts, and you could have some pretty significant probate fees if these accounts pass under a will, and it may be a very easy process, and this is a point you were making before, Jim, about differences between wills and revocable trusts. Wills don’t get funded until somebody passes away, but a trust can be funded during somebody’s lifetime. So, if you set up a trust and you don’t fund it during your lifetime, then you’re not really getting any cost savings because all those assets are going to pass under a will, even if the will directs that all those assets are going to ultimately be directed to this trust for distribution.
Jim Lange: Yeah, and that’s an important comment, and I think, in my mind, a lot of it is about cost savings and aggravation. It typically costs a little bit more (certainly in our office) to prepare a trust, and it’s not so much the additional cost of preparing the trust document as opposed to the will document, which might take a little bit more time, but I know, Matt, you are really a stickler with details, and if you are preparing a revocable trust for somebody, you not only prepare the documents, but you also hold their hand through the process of transferring assets from an individual’s name to that trust, and that tends to be the real time glutton, if you will, and that will tend to increase the fee that we would charge. Now, the benefit of that is several fold: one, after the money or property…and by the way, sometimes, you almost always want to do a revocable trust, for example, if you have real estate in more than one state, because going through probate in multiple states is not pretty and not cost effective.
Matt Schwartz: And particularly in certain states. We’re fortunate here in Allegheny County that our probate process for the most part’s not very onerous, and it’s generally that way across Pennsylvania, but if you have property in Florida or in New York, those states have a much more detailed and onerous and expensive probate process.
Jim Lange: Yeah. The old line about Florida is, if you die with property in Florida, it’s cheaper to just forget about it than to go through probate in Florida. Now, that might be a little bit of an exaggeration, but I think you’re right that in some other states, that going through probate is a real pain in the butt. So, it is usually more prudent to do the transfers while you’re alive, avoid probate, but, as you said, in certain situations, particularly when most of the money is, for example, in an IRA or something controlled by a beneficiary, then perhaps the additional costs of setting the trust up isn’t justified, but in other situations, particularly when there’s real estate outside of Pennsylvania, if there are significant after-tax dollars, that is money that isn’t an IRA, if the idea is to keep things simple, either for the surviving spouse or for the children, then is it fair to say that it probably makes a little bit more sense to go through the additional time and aggravation of setting up a revocable trust rather than just using a will?
Matt Schwartz: I agree with you there. Though, I think one thing people want to be cautious of is if you get a big book, just because it has more pages doesn’t mean that it’s better. We’ve seen a lot of situations in our office where clients have walked in with hundreds and hundreds of pages, and you ask them, “Are there any assets in the trust?” And the answer often is no, even though they have these trusts that are hundreds and hundreds of pages long.
Jim Lange: Yeah, and I sometimes like to think of it as somebody who is a little bit more detail oriented, like a CPA, than a lot of attorneys. You, on the other hand, you’re probably one of the most detail oriented attorneys that I know, and I think that that’s a very good point is that you often find people with documents that there isn’t money that is controlled by those documents. So, for example, many times, I’ve seen long, maybe not hundreds of pages, but twenty-thirty page wills that have all types of provisions, and I say, “Well, this is very nice. Where’s all your money?” “Well, virtually all of it’s in an IRA or a retirement plan.” I say, “Oh, what’s the beneficiary of your IRA or your retirement plan?” “Oh, well, it’s my wife first and kids equally second, and it’s literally two lines.” So, I say, “Let me get this straight: you know, you have thirty-forty pages of text that control a relatively little amount of money, and then two lines that control a vast majority of your estate.” And they go, “Yeah, that’s right.” So, sometimes, it’s really important that you’re cognizant of which money is controlled by which documents, and I think you’re right. A lot of attorneys don’t really get that right, and I think that that’s really important to kind of match the assets compared to the IRA beneficiary designation or revocable trust or a will.
All right. I think we have to take a quick break here, but when we come back, we will talk about more aspects of trusts, and again, we are at (412) 333-9385 for anybody with questions.
Jim Lange: We are going to talk about some of the advantages of trusts for minors, but before we get off the main topic of revocable trusts, I thought I would just run through a couple advantages and benefits of revocable trusts and some of the disadvantages before we switch topics. Some of the advantages of a revocable trust, as opposed to using a will, for estate planning is with the revocable trust, you also have the ability to manage assets in the event that somebody is incapacitated. So, let’s say if somebody is hurt, or if somebody develops Alzheimer’s, then there is automatically a new trustee that is named, and that person can step right in the shoes of the person who was the original trustee. You do avoid probate, which saves time, money and aggravation, and it’s sometimes faster after a death if you have a revocable trust because you don’t have to go through probate, you don’t have to work with the court system, and it’s probably a very good thing for people who have out-of-state property.
A few of the myths about revocable trusts: people sometimes think that if they have a trust, it reduces taxes, and that’s not true. The difference between a revocable trust and a will is there’s a zero difference in taxes. So, we should probably eliminate that. What really saves taxes is the tax planning and the strategies behind either the revocable trust or the will. That’s much more important.
Here are some of the disadvantages of the trust: it’s a little more expensive to draft a trust, but perhaps the biggest disadvantage, and one of the reasons that we don’t do as many revocable trusts as we might otherwise, is that we need your help, that is, the client’s help, in actually transferring the assets. It’s not something that you can just sign in an attorney’s office and forget. You have to physically go to the bank or to where you hold your CDs or your money markets or whatever it is, and you actually have to make a transfer of some of those assets, and it is additional work. In addition, you might need a new deed. So, those were a couple of things that I just wanted to talk about that I think are important when we talk about revocable trusts and avoiding probate. But Matt, I know that you had an important point about trusts for minors and the difference between IRA beneficiary designations and trusts that you might find in a will.
Matt Schwartz: Yeah, Jim. I would say probably out of the wills we review that come into our office, whether it’s a will or a revocable trust, I would say probably four out of five of those wills normally have some type of provision in there for minor beneficiaries that money would be held in trust for their health, education, maintenance and support until they’re a certain age, twenty-five or thirty years old. Yet most of our clients have a lot of their wealth in the IRAs and/or life insurance, and often, those beneficiary designations on those accounts, which pass outside your will, if the child share is going to be outright and the goal is for the grandchild share to be in trust because they’re a minor, often, the beneficiary designation does not account for that.
Jim Lange: That’s a big problem because I don’t think anybody listening either wants their child (or for listeners who are a little bit older, their grandchildren) to go out and buy a Ferrari when they’re twenty-one years old and then be under a bridge when they’re sixty.
Matt Schwartz: And I have a ten-year old and an eight-year old and I think they’re pretty responsible, yet I wouldn’t want them to have outright access to their assets if something happened, God forbid, to my wife and I before they were twenty-five or thirty years old, at least.
Jim Lange: Well, I think that’s a good point. On the other hand, the other thing that you bring up with that is that let’s say that your kids are pretty responsible, and I think my daughter is tighter about spending that I am, but let’s assume that you have a situation where you have, let’s say, two siblings, and let’s even assume that they are older, maybe twenty-five or thirty, and one is very responsible. They’ve always been a saver. They’re very tight with their money. They watch their money. They invest their money, whatever money they have, wisely. They have already started their Roth IRAs, etc. And then one, he’s the kind of guy who can’t seem to hold onto a dollar, kind of moving in and out of jobs and maybe has a drug problem, maybe has an alcohol problem, or maybe he’s a perfectly nice person, but doesn’t handle money well. And let’s say, for discussion’s sake, that person is even older than the younger, more responsible one. What is your opinion about should all siblings be treated equally, or are there situations where you say, “Well, gee, this sibling is responsible enough. We don’t think that he or she needs a trust, but this other one, if we left them all the money, they would blow it. And even though we want to treat our kids equally and we’re going to leave them an equal amount of money, we just don’t feel comfortable leaving the less responsible one all the money outright.”
Matt Schwartz: Well, I can tell you that the parents all want to treat their kids equally to the extent possible. However, there are many situations where it’s appropriate to treat them differently, and I think the harder question often comes up, Jim (and I know you’ve experienced this too in your discussions with clients): who should be the trustee?
Jim Lange: Well, that’s the most miserable question for trusts of minors because presumably, you’re talking about a situation when both parents are gone, all right? So, neither parent can be the trustee. Now, who are the remaining choices? Well, it could potentially be an uncle, but let’s assume that the trust is long-term in nature. Maybe the child has a drug problem, an alcohol problem, or is basically a spendthrift and we don’t ever feel good about leaving them money outright.
Matt Schwartz: Or maybe they’re in a bad marriage and we’re concerned what would happen if they would inherit.
Jim Lange: Ah, yeah. We talk about protection from creditors, and sometimes the most luminous creditor is the spouse. So, let’s assume that we have a situation where we might think that it is appropriate to protect even the adult beneficiary with a trust. So, yeah, you could maybe name an uncle, maybe you can name a friend, but if the friend or the uncle or aunt, that is, the uncle or aunt being likely your brother or sister, if they are your generation, that that perhaps leaves a gap down the road. I don’t want to name any particular banks or trust companies, but that’s always one choice. Some people don’t necessarily like the fees, and frankly, a lot of those trust companies aren’t that interested unless there’s a fair amount of money in there.
Matt Schwartz: And I think often in that situation, it’s still good to have an individual co-trustee so you have someone who knows the beneficiary, who can at least advocate on their behalf.
Jim Lange: Yeah, but I’ll tell you what we don’t like, at least, what I don’t like, but we usually end up doing it anyway, is we name the responsible sibling. So, let’s say you have Johnny and Susie, and Susie’s the responsible one. She always pays her bills on time. She’s the one who already set up her Roth IRA. She has a college fund for her child. She’s responsibly employed, and she is the kind of kid who not only doesn’t need it…and by the way, I say, “kid”, but she might be twenty-five or thirty or thirty-five, etc. She might not be the type of individual that needs a trust if you leave money to her outright. But Johnny, on the other hand, either has the bad marriage or the drugs or the alcohol or is the spendthrift, and we want to protect Johnny from himself. So, the question is: who’s Johnny’s trustee? And sometimes, even though we don’t want to name Susie because that’s not a nice thing to do to Susie, that’s what we end up doing.
Matt Schwartz: And the parents always think it’s all going to work out okay. That’s what they want to do, but we do try to advocate for an alternative solution when we can.
Jim Lange: Well, actually, even though it’s not directly on point, why don’t we talk about one alternative solution that I just suggested, and have suggested a number of times? In fact, Jonathan Clemens and I did an article in the Wall Street Journal on this same issue, because sometimes the issue of who is the trustee for the adult child is so difficult, that we have, in some situations, said, “We have directed the executor to take either all, or, at least, a portion of the money that was otherwise going to, let’s call him, Irresponsible Johnny, and purchase an immediate annuity (not a commercial annuity, it’s a different beast), where basically you plunk down X amount of dollars and the insurance company pays Johnny a certain amount of money every month for the rest of his life.” And that way, there’s no trust, Susie’s not involved, Johnny can’t go complaining to the trustee that he doesn’t have enough money. On the other hand, if he’s getting a check every month for the rest of his life, presumably, he will never be under a bridge. He will never have an acute need just for the basic necessities.
Matt Schwartz: And generally, the number one objection to that is when you have the executor purchase an immediate annuity for the benefit of a beneficiary, if that beneficiary suddenly passes away, then the money you had set aside for the annuity is not available for the rest of the family to spend down.
Jim Lange: Well, that’s right. On the other hand, if that beneficiary lives a long time, then you win.
Matt Schwartz: And I think a lot of families look at it and say, “Look, this was going to be their share anyway, and if it’s saving the aggravation and the conflict that would otherwise occur between the siblings, it might be a worthwhile thing to do.”
Jim Lange: Yeah. I’m not sure how much fun a holiday dinner will be after Susie says, “No, Johnny. You can’t have a Mercedes paid for out of the trust. You know, there’s enough money here for an old Chevy for you.” And then, “Oh, by the way, what time is the holiday meal?” That might be a little bit awkward. So, I think that these immediate annuities have some merit. Have you ever drafted a will where you have given the executor the option of purchasing the immediate annuity, or keeping the money in trust?
Matt Schwartz: Well, there was actually a case that I was working through today where that was an option we were considering. So, it’s definitely a possibility. I think you always want to be cautious to give the executor a direction to purchase the annuity from a top right company. You don’t want them purchasing the annuity and having it go belly-up so there’s not money for the beneficiary.
Jim Lange: Yeah, and you also probably don’t want to do it when interest rates are at an all-time low. It might not be the perfect time. So anyway, I will tell you that that is a real issue with different types of trusts for even adult children, and I know in our office, we’ve drafted, what? About 1,500 wills and revocable trusts?
Matt Schwartz: At least.
Jim Lange: All right, even more. So, we run into a lot of different family situations, and the issue of protecting adult children, in effect, from themselves is sometimes pretty challenging. Now, one thing that some firms do, and I will tell you there is an alternative that we typically don’t do, but just in full disclosure, there are attorneys who routinely will leave money in trusts for adult children and even spouses. So, in other words, you know, we’ve had several estate planning attorneys on, and the default, if you will, for them leaving money to an adult child would be to leave money in a trust for that adult child. I think that that’s probably a little bit too controlling from the grave, and I don’t like to see extra layers of aggravation, extra layers of tax returns or extra layers of trustees unless we have a good reason for it. I don’t know what your take is on that.
Matt Schwartz: And the reason for it used to be, in many cases, was we had a much lower estate tax exemption, and by leaving money in trust for adult children, perhaps we could bypass a generation of estate tax. But now, with this exemption of five million a person, now we know it’s only good for two years. So, who knows what it’ll be at the end of two years. But the motivation for the generation skipping transfer tax drafting has gone down significantly.
Jim Lange: Okay. I didn’t want to spend a lot of time on this issue, and the issue is, by the way, using trusts to save taxes, because, frankly, we’ve had about four shows on that. We’ve had Natalie Choate chime in on that, we’ve had Martin Shenkman, we’ve had Deborah Jacobs, and we had one other estate attorney, and we’ve kind of beat this issue up a little bit, but why don’t we just talk about what I call ‘the cruelest trap of all?’ This is where a lot of people, and many people listening today, have trusts within their wills or within their revocable trusts. So, in the case of a revocable trust, a trust within the trust that says at death, rather than the money going to the spouse, it goes into this trust where the spouse only gets income, and the purpose of that trust typically was to save estate taxes. But with the new exemption amount (at least for the next two years) of five million dollars, or, if you are married, ten million dollars, the tax motivation of these trusts pretty much goes out the window, and Matt, what do you think somebody should do if they fear that they have that type of document? Because I find that most of my clients, I even had somebody today, they are shocked to find that if, in this case, the wife died and for probably less than perfect reasons, there was money in the wife’s name that the husband just assumed that well, he was going to get the money, and that’s not what it said. What was going to happen is, the money was going to go into a trust, and the husband would get the income from the trust, but that’s not what might be appropriate. It might be appropriate that the husband might want the principle. It might be appropriate that the husband would prefer spending after-tax dollars and preserving IRA dollars, or preserving Roth dollars. So, this inflexible traditional estate plan, I think, is a huge problem. Do you come up into that very often, and when you do, what’s usually the best solution?
Matt Schwartz: Well, you’re right. I mean, it’s an exception to the norm for people to review their estate plans more that every couple of years. It’s very common, we see people with wills from 1987, 1992, and often, these wills are, as you described, when the tax exemption was $600,000, it made sense to definitely use the bypass trust, and we’re dealing with an estate right now where all the money that was in the wife’s name and it was divided for estate planning purposes between husband and wife, it’s going into trust for the husband when there’s no estate planning reason for it. So, it definitely happens a lot, and people aren’t aware of the best solution, and generally, the best solution was something that you’ve been championing for many years, Jim. You call it the ‘Cascading Beneficiary Plan,’ and it’s really giving the primary beneficiary the option to disclaim, and we could talk a little bit about what a disclaimer is and how that works in the plan.
Jim Lange: Okay. Maybe without getting too technical, we can do a quick review of the Cascading Beneficiary Plan.
BREAK TWOJim Lange: One of the problems with estate planning, and it has been ever since I’ve been practicing, actually, long before, is uncertainty. There’s just so many things that we don’t know when we are planning our estates. So, for example, we don’t know who’s going to die first. And by the way, often, we get that one wrong. Everybody assumed it was going to be the husband that died first, and that didn’t necessarily happen. We don’t know how large the portfolio is going to be. We don’t know what the tax laws are going to be, either at the first or the second death. We don’t know the needs of the surviving spouse. We don’t know the needs of the kids. We don’t know the needs of the grandchildren. So, planning for all this…and then, no matter what we choose, almost inevitably, either one year or two years or three years later, things change and in today’s environment, you have enormous swings in estate taxes. So, for example, in 2008, we had an exemption of $3.5 million. In 2009, also the same thing. In 2010, unlimited exemption. In 2011, $5 million. In 2013, unless they make another change, a million. So, how can you really plan effectively when the portfolio is a moving target, the tax laws are a moving target. We don’t know what’s going to happen. What we prefer to do, if we have the luxury of having a husband and wife trust each other, and typically having the same children (I sometimes call that the ‘Leave it to Beaver’ marriage), is rather than having all these rigid trusts and have everything fixed in stone and having the necessity of reviewing it and coming in every year or two and making changes, we prefer a more flexible plan known as ‘Lange’s Cascading Beneficiary Plan,’ which, by the way, has been featured in Wall Street Journal and Kiplinger’s and Post-Gazette, and actually literally over a hundred places in Google that all point back to me, and was also described in detail in Retire Secure!, the best-selling book with testimonials from Jane Bryant Quinn and Charles Schwab, Larry King, Ed Slott, etc. So, Matt, maybe you could talk a little bit about the mechanics of how that is set up, and why you prefer drafting that than the more traditional plan?
Matt Schwartz: Sure. The primary beneficiary under this plan is always the surviving spouse. There’s occasionally cases where you have an elderly surviving spouse and maybe you want the money to be in trust for their benefit. So, a son or daughter could be a trustee with them and look after the money with them. But generally speaking, the spouse is the primary beneficiary, and then the spouse has an option, if it makes sense for tax purposes, not to accept all the assets she would otherwise, or he would otherwise, be receiving from the deceased spouse and pass it into a trust for his or her lifetime benefit, that’s often known as the bypass trust, the B trust, the credit shelter trust, where they could have access to income for life and access to principle for their health, maintenance and support, and there are often cases where the spouse doesn’t need even income from some of the money and wants to give some money to their children now so their children don’t have to wait until they’re seventy years old to get an inheritance from mom and dad.
Jim Lange: So, you’re saying that the first choice is typically the surviving spouse.
Matt Schwartz: Correct.
Jim Lange: The second choice might be this B trust or family trust or bypass trust. A third choice might be the adult children.
Matt Schwartz: Correct.
Jim Lange: Typically equally, but not always. And what is the fourth choice if we are going to continue this whole cascade?
Matt Schwartz: The fourth choice most commonly is a trust for the grandchildren. So, for the children of the adult children.
Jim Lange: All right. Now, in the traditional wills and estate plans, usually the B trust or this bypass trust that says income to spouse, right to invade principle for health, maintenance and support, and at the second death, it goes to the children. That’s typically the primary beneficiary. In our plan, it would not be the primary beneficiary, but it would only be activated as the second choice if the surviving spouse wanted that, and under our plan, when is the real decision of who gets what made?
Matt Schwartz: After the first spouse passes away.
Jim Lange: All right. Does everybody see the power behind the idea of not forcing things today, but if we have the luxury of having a spouse that we trust who has the same children as you, making the decision later is really just so much more powerful. Matt, you’ve been practicing law for how many years now?
Matt Schwartz: Fourteen years.
Jim Lange: All right, fourteen years, and I have for close to twenty-five years. What has been your experience when people actually die with these flexible estate planning documents? Have you found that it helps and enhances the family? Do you think it has been an unnecessary burden of a choice, and have you seen people make wildly inappropriate choices?
Matt Schwartz: The vast majority of the time, the surviving spouse realizes that they indeed have enough money to last for the remainder of their lives in many of the cases we work on, and it’s a great opportunity to pass some money to the children that’s well beyond the $13,000 the surviving spouse could otherwise give them a year, and it gives them a sense of enjoyment to see their children have money now so they’re not struggling as much just meeting the day-to-day expenses of raising their children.
Jim Lange: And what I’ll add to that is that if people want this type of flexible estate plan, we typically draft this not only in wills and revocable trusts, but also beneficiaries of IRAs and Roth IRAs and life insurance. So, what that means is not only can the spouse decide whether they’re going to keep assets or whether they’re going to (the legal word is) disclaim or not accept assets, but they can pick and choose. So, it might be very appropriate, for example, for a child or even a grandchild to be the beneficiary of an IRA or even a Roth IRA, and maybe have other funds such as after-tax dollars go to a surviving spouse, and that additional flexibility allows us by, in effect, cutting the pie differently to make a bigger pie for the whole family.
Matt Schwartz: Yeah, and I do agree with that strategy. One downside that some traditional estate planners would point out is…although, in practice, I often don’t see spouses acting this way, is a power of appointment, which we can explain, would give a surviving spouse the chance to distribute unequally to the children if they’re the children from the first marriage. But so often, I see, and I think you do too, is the spouses generally want to treat the children equally, and if they don’t, they generally allocate for that in advance based on need.
Jim Lange: Yeah, I think I would agree with that. I would say, as we have seen some not so wonderful planning for wills and trusts, but what I find the biggest problem in, let’s say, new clients or new prospects, is the beneficiary of the IRA, and I think that a lot of people don’t get that with an IRA, and by the way, when I say IRA, I’m also including 401(k), 403(b), SEP, KIO, etc., any type of retirement plan where you have not yet paid income taxes on that money, there are options. When you die and you leave that, let’s say, to your spouse, your spouse can roll that money into their own IRA, have that money treated fairly similarly to when you were alive, but when that money goes to a non-spouse, whether it be a child or a grandchild or a niece or a nephew or a friend or a partner, etc., that asset that you pass on is a unique asset, and it’s not an IRA, and the beneficiary is not allowed to roll that into their own IRA, but the beneficiary, assuming everything is done right (and this is the huge assumption), doesn’t have to pay income tax on the whole thing, but, in fact, can continue to defer, or put off, a lot of the income, and there is a required minimum distribution of the inherited IRA. So, we could sometimes take ever-growing, but at least at the beginning, relatively small distributions, continue to have that money grow tax-deferred, or, in the event of a Roth IRA, income tax-free. We could also achieve the same result in a trust, and sometimes you want to do that because either the child is young or the child is a spendthrift or the child is married to a spouse that we fear is going to get divorced and fight about money, or perhaps there is a drug problem, perhaps there is a spendthrift problem.One of the things that we didn’t talk about today (and we’re probably not going to have time) is trusts for either children or adults with disabilities. You do a particularly good job of combining that and the rules I’m about to talk about, but could you talk about some of the rules that if you’re going to have a trust be the beneficiary of an IRA, what rules must be followed and what are the consequences of not following those rules?
Matt Schwartz: Well, the most general rules are that the trust has to be valid under state law, you have to be able to identify the beneficiaries (and we’ll explain a little bit more about that in a minute), the trust has to be irrevocable, and if it’s a trust set up at death, by definition, it will be irrevocable at that point. You have to eventually provide a copy of the trust to the IRA custodian or the plan administrator, and all your beneficiaries must be individuals. What’s often missed is for that trust to qualify as a designated beneficiary, so you can use the individual’s, who is the beneficiary, life expectancy, it’s often advisable to direct that the required minimum distribution (the amount that has to come out of the IRA) be distributed to the beneficiary on at least an annual basis, and that’s often not in many trusts that we see.
Jim Lange: All right. Let’s say that somebody drafts a trust that doesn’t have all these provisions, and it might be a perfectly capable attorney who maybe practices in other fields, you know, maybe they do divorces and real estate and some other things, and they just don’t have the time to really delve into this, and maybe they draft a trust that doesn’t meet all these conditions. What would then happen to the beneficiary, and let’s just say, for discussion’s sake, there’s a million dollars in an IRA that is the underlying asset, and it’s controlled by the beneficiary designation that has a trust. What happens to that inherited IRA if the language isn’t tight and they don’t get it right?
Matt Schwartz: Well, let’s suppose that we have an eighty-year old owner of an IRA that names a disqualifying trust as the IRA beneficiary. Well, what happens is, rather than getting to use the trust beneficiary’s life expectancy and get that great income tax deferral with a traditional IRA, or that tax-free growth with the Roth IRA, you end up being stuck with that individual’s remaining life expectancy. So, maybe instead of getting the forty-year stretch with a child beneficiary, or a seventy or eighty-year stretch with a grandchild beneficiary, that money may have to come out in a five or ten-year period, depending on how old your beneficiary is.
Jim Lange: Yeah. I actually ran some numbers on that, and we determined that if you made a million dollar IRA beneficiary and it was botched, that over time, the additional cost to the child would literally be a million dollars. That is the acceleration of income taxes as a result of inappropriate drafting. And not only do you have to draft the thing properly before death, you must have appropriate estate administration after death. And let me tell you a true story: an advisor called me from California. He was the advisor for both father and son, and father had roughly a million dollars in an IRA, and he wanted his son to have it at his death, and he named his son as the beneficiary, and since the advisor was doing the work for both, he went and he transferred the money to the son’s name. By the way, nobody can see the grimace on Matt’s face right now because Matt knows that rather than transferring it to the son’s name, it should have been under a special account called ‘inherited IRA,’ or something like ‘inherited IRA of Joe Schmoe for the benefit of Joe Schmoe, Jr. under the will dated…’ and then whatever date the will was dated, or other language, and Matt, I think that you can finish this up and say what do you think happened when the inappropriate titling took place?
Matt Schwartz: Well, if I recall the end of the story correctly, I think he spoke with the advisor about this matter, and I think his heart went into his throat when you were talking to him about it.
Jim Lange: Yeah, because basically, the son was going to have to pay income taxes on the entire amount. The other thing about titling it correctly is you get a little bit of cheap immortality, because let’s say you die, you leave even $100,000 in an IRA to a grandchild, let’s say you die when the grandchild is ten or twenty years old. When that grandchild is eighty years old and is taking money out of that account, it will still have your name on it. So, the grandchild will be reminded on a monthly basis when they get their statements. Of course, by then, it’ll probably be all electronic, but they will still see your name, and they’ll go, “Oh boy. You know, grandpa left me some money and I’m still getting it sixty years after his death.” So, I think the right way to do it requires that not only that the appropriate documents are set up before death, and Matt and I, in most cases with traditional families, are advocates of a more traditional plan, but you must have appropriate estate administration and estate strategies after the first death.
Matt Schwartz: And sometimes, at the first death, people think there’s nothing to do. So, they don’t come see the attorney and then they miss out on a lot of great opportunities that they would have otherwise had if they would’ve consulted with the attorney.
Jim Lange: All right, and I think we have to take one more break before we finish the show.BREAK THREE
Jim Lange: Matt, one thing that I mentioned briefly that I think really could use a little bit of a fuller explanation is trusts for children or even adult children with disabilities, and let’s assume that one of our listeners has a child who has some type of disability, and that they either are now, or it is relatively easy to predict in the future, will be getting some kind of government aide, either from the state or the federal government, and let’s even assume that the disabled child is a responsible one. Is it okay to just leave the money to somebody who is receiving a government benefit, or are there some advantages of drafting a trust for that child, or even adult child?
Matt Schwartz: Well, I would say in most cases, it’s not going to be okay to leave it outright to them because you may likely disqualify them from their public assistance, and with an appropriately drafted trust, money could be left to supplement public assistance but not supplant public assistance, and I often treat assets differently. If it’s a traditional IRA, it may be better to actually leave that money to children who are not disabled so they could really get the benefit of the stretch IRA, and leave other assets to the disabled beneficiary, where a Roth IRA (because it’s tax-free) is sometimes a good asset to put in a trust for a disabled beneficiary.
Jim Lange: Yeah, that’s a good example, by the way, of when you cut the pie differently, you literally created a bigger pie. That is, there’s going to be more purchasing power. So, basically, what you’re trying to do is you’re trying to save that child from losing his money, or losing his government benefit, and preserving that money for the benefit so he can have some of the extras or cover some of the things that the government might not cover.
Matt Schwartz: Absolutely, because everyone’s concerned with the government in its current state that public benefits could run out, and they want to make sure that they protect their disabled child the best they can.
Jim Lange: Well, I think that that makes a lot of sense, and I know one of the things that you do extremely well is that you combine several requirements into one document. So, for example, we talked a little bit before about the five or six conditions that the trust must meet in order to achieve the designated beneficiary, or the ability to stretch the IRA over the life of the beneficiary. Then you also have very specific rules on what works for a disability trust, and then I know that one of your areas of strength is to actually combine both of those rules into one document so that somebody with a disabled child can have the benefit of both the stretch IRA or the stretch Roth IRA, and then also protection from the government.
I am afraid we are out of time. Matt, thank you so much for coming in. You came in literally at the last minute when Nicole couldn’t make it, so we very much appreciate you having come on the show, and this is Jim Lange with The Lange Money Hour, Where Smart Money Talks.
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James Lange, CPA
Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania. He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again. He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans. His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans. Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger's Retirement Reports and The Tax Adviser (AICPA). Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.
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