Estate planning offers many ways to leave your wealth to your children, but it’s just as important to know what not to do. The following ill-advised estate planning strategies can cause confusion, or even cost your children some – if not all – of their inheritance….
If you feel you have a good rapport with your family or don’t have many assets, you might be tempted simply to tell your children or loved ones how to handle your estate when you’re gone. However, even if your family members wanted to follow your directions, it won’t be up to them. Without a written document, any assets you own individually must go through probate, and “oral wills” carry absolutely no weight in court. It would be up to a judge and the intestate laws written by the legislature, not you or your desired heirs, to decide who gets what. This strategy should be avoided at all costs.
In lieu of setting up a trust, some people name their children as joint tenants on their properties. The appeal is that children should be able to assume full ownership when the parents pass on, while keeping the property out of probate. However, this does not mean that the property is protected; it doesn’t insulate the property from taxes or creditors, including your children’s creditors, if they run into financial difficulty. Their debt could even result in a forced sale of your property.
And there’s another big issue, too. Choosing this approach exposes your properties to otherwise avoidable capital gains taxes. Here’s why. When you sell certain assets, the government taxes you. But you can deduct your cost basis—a measure of how much you’ve invested—from the selling price. For example, if you and your spouse bought vacant land for $200,000 and later sell it for $500,000, your taxable gain would be $300,000 (the increase in value).
However, your heirs can get a break on these taxes. For instance, let’s say you die, and the fair market value of the land at that time was $500,000. If you use a trust rather than joint tenancy, your spouse’s cost basis is now $500,000 (the basis for the heirs gets “stepped-up” to its value at your death). So, if she then sells the property for $515,000, her taxable gain is only $15,000, rather than the $315,000 it would have been before your death! However, with joint tenancy, she does not receive the full step-up in basis, meaning she’ll pay more capital gains taxes.
Giving Away the Inheritance Early
Some parents choose to give children their inheritance early–either outright or incrementally over time. But this strategy also comes with several pitfalls. First, if you want to avoid hefty gift taxes, you are limited to giving each child $14,000 per year. You can give more, but you start to use up your gift tax exemption and must file a gift tax return as well. Second, a smaller yearly amount might be seen by your kids more like “free money” than the beginnings of your legacy, so they might squander it rather than invest. Third, if situations change that would have caused you to re-evaluate your allocations, it’s too late. You don’t want to be dependent on them giving the cash back if you ever need it for your own maintenance and support.
Shortcuts and ideas like these may look appealing on the surface, but they often do more harm than good. Consult with an estate planner to avoid these pitfalls and find the best strategies to prepare for your and your families’ future.
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