There are three purposes to estate planning:
- Determine where your kids and stuff go when you die
- Avoid/minimize the expensive, time-consuming, and public probate process
- Avoid/minimize the payment of estate, inheritance, and income taxes
The first is done primarily with a will, which is cheap and easy to do. You can hire an estate planning attorney in your state, use an online legal service, or in 27 states, write a simple holographic will (i.e. one you write yourself on a napkin).
The third is minimally significant for most readers of my blog. Thanks to a federal estate tax exemption of $11.4 Million ($22.8 Million married) indexed to inflation, most of us will never be rich enough to pay federal estate taxes. Only fifteen states and D.C. have an estate tax and only six states have an inheritance tax (4 have both), leaving 33 states with neither. It just isn't much of an issue for most of you.
What is an issue for all of you, however, is reason #2—avoiding probate.
What Is Probate?
Probate is a process of “adjudicating” a will. It involves lawyers and judges and courts determining what the will really means and carrying out its instructions. It can be expensive. While the cost varies, a typical cost might be 4% of the first $100K, 3% of the next $100K, and 2% after that. So a $5 Million estate could cost $103,000! In some states, like Utah, the attorney is not allowed to charge a percentage of the estate, but even at hourly rates of $150-300, that cost can add up quickly. It is also a public process, so everybody gets to see what you owned. It can be time-consuming; your heirs might not receive their inheritances for over a year! Clearly, avoiding probate is a worthwhile goal, if for no other reason than to maximize what you leave behind.
Most estates are partially subject to probate and that's not always a bad thing. The probate process is less painful in some states than others and it does have the benefit of certifying title to assets so there won't be any squabbling about them later. It also reduces the likelihood of shenanigans by the executor.
The 11 Methods of Keeping Assets Out of Probate
So today, I'm going to discuss 11 ways to keep your assets from going through probate. Many of these methods have pluses and minuses, so it is important to personalize your plan to you. The assistance of a good estate planning attorney in your state can be invaluable. We'll start at easy and cheap and move toward the complex and expensive ways to avoid probate.
# 1 Give Your Stuff Away Before You Die
This one seems really simple, but it is incredibly effective and often very cheap for everyone involved. If it isn't yours when you die, it doesn't go through probate. Duh. Now you need to keep gift tax rules in mind (once you get beyond $15K/year per recipient, the gifts start counting toward your estate tax exemption) but since most of us won't be anywhere near the exemption limit anyway, that's not a big deal.
What is a big deal is the capital gains tax rules. When you give something away, the recipient acquires your basis in that item. This is a big deal if you're giving away real estate or investments with low basis, but not if you're giving away cash or consumption items. Real estate and investments with low basis are best inherited, where the recipient gets a step-up in basis to the value on the date of your death.
# 2 Not Being Wealthy
This one works really well too in most states. If your estate is tiny enough, it doesn't have to go through probate. In Utah, that limit is $100K not including vehicles registered in the state. This probably won't work for most of my readers, but it works for a surprisingly large number of Americans.
# 3 Joint Ownership
This is really just another method of giving your stuff away, it just happens at death instead of before. There are a number of methods of joint ownership:
Geographically speaking, this is mostly a Southwest thing. In Louisiana, Arizona, California, Texas, Washington, Idaho, Nevada, New Mexico, and Wisconsin, anything acquired during the marriage is considered to be owned equally by both spouses (50/50) and both spouses may pass on their share of the property to their chosen heirs similar to tenancy in common. Alaska, Tennessee, and Puerto Rico are optional community property states.
Community Property with Rights of Survivorship
Some of the nine community property states allow property to be titled this way, which like joint tenancy ensures the deceased's portion passes to the spouse. This is very similar to Joint Tenancy but avoids capital gains taxes on any of the sale of property after the death of one spouse.
Joint Tenancy with Rights of Survivorship
Sometimes called just joint tenancy, both owners own the entire property and can use it as they see fit. When one dies, however, the other acquires the property without it passing through probate no matter what the will says. As note above, part of the sale of property after the death of one spouse is subject to capital gains taxes.
Tenancy in Common
In this set-up, owners only own part of the property, for example splitting it 75/25. Their portion of the property goes to their heirs rather than their co-tenant.
Tenancy by the Entirety
You've most likely heard about Tenancy by the Entirety from an asset protection standpoint. It's available only to married couples in Alaska, Arkansas, Delaware, D.C., Florida, Hawaii, Illinois, Indiana, Kentucky, Maryland, Massachusetts, Michigan, Mississippi, Missouri, New Jersey, New York, North Carolina, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont, Virginia, and Wyoming for real estate. This titling is available for other assets (investments, bank accounts, etc.) in all of those states except Alaska, Illinois, Indiana, Kentucky, Michigan, New York, North Carolina, and Oregon.
Basically, in this set-up, both spouses own the entire property so a creditor of just one spouse cannot take the property. As far as estate planning goes, however, this one is exactly like Joint Tenancy—when you die, your spouse gets the whole property.
# 4 Leave It to Your Spouse
If you're married, estate planning isn't as big of a deal if your plan is to leave everything to your spouse. It will be a much bigger deal when the second one leaves! There are lots of advantages to leaving stuff to your spouse. Your HSA becomes their HSA rather than taxable income (as it becomes to any other heir). Your IRA can become their IRA instead of an inherited IRA (especially given Congress limiting the Stretch IRA). There is no limit to how much you can leave a spouse without the payment of estate taxes. And most of your stuff is probably jointly owned anyway as discussed under # 3. They don't get a step-up in basis on joint assets at your death, but that seems a fair trade-off for all the other benefits.
# 5 Designate Beneficiaries
This is one of the easiest, cheapest ways to keep assets out of probate. You simply designate primary and secondary beneficiaries for your retirement accounts, life insurance, and annuities. All of that passes outside of probate and is a great way to ensure your heir has access to quick cash even if some of your estate has to go through probate. You already have a beneficiary for a 529 account, but you can designate a successor owner of your 529. You can even designate a successor for your DAF (although they have to be an adult). This is a simple, easy, effective method that will likely take care of a large percentage of your assets and estate planning. Just remember to review your beneficiaries after major life events like death, divorce, or estrangement.
# 6 Payable on Death Accounts
This is similar to designating a beneficiary but for a bank or credit union account. It is sometimes referred to as a Totten Trust, a tentative trust, an informal trust, a revocable bank account trust, or an ITF (in trust for) Account. For some reason, you cannot have a secondary beneficiary, so be sure to keep this one updated carefully and don't go heli-skiing with the beneficiary! One extra bonus here is that these accounts are eligible for a completely separate $250K FDIC insurance limit than your account without a pay on death designation.
# 7 Transfer on Death
# 8 Revocable Trust
This is the classic method of avoiding probate. While a revocable (or living) trust is almost useless as an asset protection technique, it can be very useful for avoiding probate. While it costs a lot more than simply naming beneficiaries or designating assets as payable on death or transfer on death it provides an additional benefit—you can control the assets after you're gone, or at least your trustee can do their best to follow your instructions. If you have assets that are not going to avoid probate in some other way, it is a good idea to have them in a revocable trust.
# 9 Irrevocable Trust
An irrevocable trust is great for asset protection because you no longer own the assets as far as your creditors are concerned, at least after a 1-2 year period where it can be deemed a fraudulent transfer. It isn't so useful for assets you actually want to use during your lifetime though unless you are in one of the states (Alaska, Delaware, Hawaii, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia, or Wyoming) that offers one of the new-fangled asset protection trusts where you are both the owner and beneficiary of an irrevocable trust. As far as avoiding probate, it works just as well as a revocable trust or giving the assets away prior to death. In a legal sense, the assets in the trust are no longer yours.
# 10 Family Limited Partnerships
Now we're really getting into the big-ticket, complex methods of avoiding probate. A Family Limited Partnership (FLP) is simply a limited partnership where all the partners are members of a single family. Usually, the general partners (the ones with all the control, at least until their death) are the older generation and the limited partners (the ones that get all the benefits) are the younger generation. Like any partnership, there has to be a legitimate business going on here somewhere. So this tends to be a good way to pass on a closely held family business, a farm, or rental properties.
A FLP is particularly useful for avoiding estate taxes. The older generation gifts shares of the partnership to the younger generation. Because the younger generation doesn't have full control over the partnership, those assets are discounted significantly, so less of the estate tax exemption is used up than they really received in assets. Each year, a number of shares equal to the estate tax exemption can be transferred, and then going forward, the returns/distributions on those shares are not subject to gift/estate tax laws. So this is mostly for those with an estate tax problem (although there are asset protection benefits), but upon the death of the general partners, the partnership agreement dictates what happens rather than probate.
# 11 Family Limited Liability Companies
A Family Limited Liability Company (FLLC) works very similarly to an FLP. An FLLC is simply an LLC where the operating agreement specifies that only family members can be owners. An FLP can be simpler to form and maintain, but an LLC can include members who are not family members and can be taxed as a corporation (or even converted to a corporation) if needed. You can also dissolve an LLC with a majority vote rather than unanimous agreement. Either way, assets pass outside of probate.
Given these 11 methods to avoid probate, it seems a shame to have any significant portion of your estate go through this expensive, public, time-consuming process. While a revocable trust does cost more than a will, it costs a lot less than probate.
What do you think? What have you done to ensure your assets don't go through probate upon your death? What do you plan to set up in the future to avoid probate? Comment below!