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Avoiding Probate – Or Not

By Bob Carlson on September 27, 2010

With the estate tax eliminated for 2010 and changes for 2011 and later years still on the back burner, this is a good time to take a look at another key element of estate planning. One of your key estate planning issues is to what extent, if any, your estate should avoid probate. This is very different from decisions about avoiding estate taxes.

Everyone has at least two estates. There is the taxable estate under federal estate tax law. No one who passes away in 2010, of course, will have a taxable estate because there is no estate tax (though Congress may try to reinstate it retroactively). But there will be an estate tax in 2011 and following years. The details are unknown right now, but we can be fairly sure there will be an estate tax. (If your state has an estate or inheritance tax, there might be a separately-computed estate for that. Some states piggyback on the federal estate tax; others have their own tax.)

The other estate is the probate estate. This is the part of your estate that must be processed through the state court system before assets can be distributed to creditors and heirs. 

The probate court reviews the estate executor’s work, certifying the assets and debts. The debts must be paid before assets can be distributed. After the court is satisfied that all valid debts were paid and the assets accounted for, the assets are distributed under the terms of the will.

Probate can have some advantages. Everything about the estate and how it is distributed is in public and reviewed by the court. There’s less of a chance for shenanigans. Anyone who disagrees with how things are being handled can file a complaint with the court. The probate process also certifies title to the assets, making it more difficult for someone to challenge the ownership.

Yet, probate is not without its disadvantages.

The most frequent complaints about probate are the time and cost involved. The process varies among the states, but in some states it can take a couple of years to process even a modest, simple estate. The cost, mostly in lawyer’s fees, can be high for the work involved. Lawyers might charge a percentage of the estate instead of an hourly rate.

Probate also puts everything on the public record. Your will is filed with the court and available for anyone to read. The listings of your assets and liabilities also are part of the public record. If you want some privacy for your financial affairs, you want to avoid probate.

You avoid probate by keeping assets out of your probate estate.

It’s important to keep in mind that the federal taxable estate and the probate estate are completely separate. The federal estate tax has a comprehensive definition. Assets that are excluded from the probate estate often are included in the federal taxable estate. Don’t think that avoiding probate means you avoided estate taxes. With that caveat, here are tools for avoiding probate.

The probate estate includes most assets held in your name, but it does not include assets that, upon your demise, are transferred to new owners by operation of law or by contract. It also does not include some assets you own or control indirectly or benefit from without owning.

Revocable living trusts. The prime and comprehensive way to avoid probate is to have your assets owned by a revocable living trust. You (or your lawyer) draft a trust agreement. When you sign the agreement the trust is created.

The typical revocable living trust names the creator (you) as also the initial trustee and beneficiary. If you’re married, your spouse also might join in each of these roles. You transfer ownership of assets to the trust and manage them through the trust. Since the trust is revocable, you can change the terms and even revoke the trust at any time.

The trust agreement also has many of the key features of a will. It states who will be trustee after you or how the successor trustee will be selected. The agreement also names the beneficiaries who will receive the assets after your demise. The beneficiaries could be individuals or other trusts for the benefit of your children or others. The trust also can convert into a different type of trust after your passing. Your will doesn’t have a direct effect on how the assets owned by the trust are disposed of, unless you put that in the trust agreement. Only the trust agreement controls who inherits those assets.

The living trust (actually the trustee acting for the benefit of others) owns the property. You as an individual don’t own the property outright, so it is not included in your probate estate. (Under the federal estate tax, however, you are considered the owner; all the trust property is included in your federal estate. Under the federal income tax, all trust income and gains are taxed to you.)

A “will contest” is easy in probate court and airs all a family’s dirty laundry. It is more difficult to sue under a living trust, and there are far fewer cases of a disgruntled heir successfully altering the terms of a living trust.

There are disadvantages to living trusts.

All the assets you want to avoid probate must be transferred to the trust. That means changing the deeds to real estate, titles to and registrations of automobiles, and names and tax identification numbers for financial accounts. Checks need to be printed with the trust’s name on them, not yours. Other assets without paper legal titles can be transferred to the trust by attaching a list of them to the trust agreement.

Many living trusts are dormant or “empty” because the creators never transferred title to their assets. They found the process too burdensome.

I’ve talked to people who became successor trustees after the passing of their spouses. Though the ownership transition using a living trust is supposed to be smooth, they didn’t find it that way. In particular, financial services companies make it easy to set up an account in the name of a trust but require rigorous proof that the person claiming to be the successor trustee really is entitled to that role. The proof required varies among the firms. The original trustee should ask financial services firms how they will confirm a successor trustee and do in advance what he or she can to ensure a smooth transition.

While privacy is an advantage of a living trust, it can be disadvantage. It could be possible for the successor trustee to hide or loot assets or not give a beneficiary all the trust creator intended. The trust agreement can provide that beneficiaries have the right to an accounting or audit. If those rights aren’t in the trust agreement, however, a beneficiary has to sue the trustee just to be allowed to look at the records.

Joint title. Another way to avoid probate is joint ownership with right of survivorship. The co-owner automatically takes full title after the other owner does. Joint title is most often used with real estate and financial accounts.

A problem with joint title is you can’t change your mind. It is harder to change a joint title with right of survivorship than to revise a will or living trust. When the federal estate tax is in effect there also can be tax disadvantages to joint title.

Insurance contracts. Life insurance and annuities pass to the beneficiary automatically and avoid probate. They generally are included in the federal taxable estate.

Retirement plans. Qualified retirement plan (including IRAs, 401(k)s, and defined benefit plans) generally are not affected by your will or included in the probate estate. The beneficiary designation form filed with the plan sponsor determines who inherits the account. If there is no beneficiary form, the estate likely is the beneficiary. Then, the will and probate court may come into play.

Some states streamlined their probate processes and reduced the cost, especially for small and medium-sized estates, by adopting a law called the Uniform Probate Code. Before deciding whether to avoid probate, learn about your state’s probate process. You want an estimate of how long the process will be, how much work is required of the executor, and how much it might cost. Then you can decide to what extent you want to avoid probate and which vehicles to use.

Even if you plan to maximize probate avoidance, you still need a will. All your assets won’t avoid probate. You also need to address issues such as paying debts and taxes, guardianship of minor children, and other matters.

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