Probate: Property Outside Probate

A. Overview.

Many arrangements exist for the transfer of money or property outside of the probate system. (Such property is said to be “non-probate” property, and is not part of the “probate estate.”) These arrangements should be made for convenience and to avoid probate court – not for state or federal death tax savings, because there will be no such benefit. The definition of “estate” for federal tax purposes is much different from that in probate court.

Insurance

BEWARE! A Will has no control at all over any disposition of property outside probate. Overlooking this fact is a common and potentially huge estate planning blunder.

Think of it this way: Your Will disposes of all property that is NOT disposed of by some other way. Some of these “other ways” are mentioned below. All are familiar and in common use. What these legal arrangements have in common is that each – independently – provides for the disposition of property at or before the death of the owner. In other words, the terms of these arrangements themselves dictate who gets the property at the estate owner’s death – not the owner’s Will.

Unfortunately, people just forget that if an asset falls into one of the below-listed categories, the Will cannot dispose of it. A Will disposes of only the probate estate. If that consists of little or nothing, so be it. You had better be happy with the “out of probate” dispositions you have put in place. People also forget that some very common non-probate property arrangements – like life insurance and retirement plan beneficiary designations – do not necessarily become invalid upon divorce, as does a bequest to an ex-spouse in one’s Will.

B. Joint Tenancies With Right of Survivorship (JROS).

Each of the two or more “tenants” (owners) has an equal, undivided interest in the whole account or asset. Most couples own their house and checking accounts in this way. By what is called simply, “operation of law,” a decedent’s share automatically shifts to the surviving joint tenant(s) at the very moment of death. The transfer of ownership is complete at that point. Nothing the Will says makes any difference whatsoever, as to this property. Of course, there is paperwork to be completed before the account will be switched to the survivor’s name alone.

In almost all situations, no federal tax is saved by using joint accounts. For estate tax purposes, 50% of property held jointly with a spouse is included in the decedent’s estate. If the surviving joint owner(s) is not the spouse, 100% of the jointly held property is included in the decedent’s taxable estate, unless the surviving joint tenant can prove his/her actual contribution to the account or property.

So, opening a joint account with an adult child might be a convenient way to handle business, but it does not save death taxes. True, upon the parent’s death, the account balance immediately belongs to the child. But the full amount must still be included in the deceased parent’s taxable estate.

One alternative to JROS ownership is “tenancy in common.” This is not what most married couples in common law states have or want, with respect to their marital property. In this arrangement, each tenant takes a 50% interest and can sell or bequeath it independently of the other owner. Community property also can be bequeathed independently. Tenancy in common is a frequently seen and appropriate form of ownership in many situations, as when siblings inherit a piece of real estate from their parents. Recognize, however, that discord between the tenants in common could lead to a sale of one of their shares to an outsider.

F.Y.I. If a Will says simply, “I leave the following property to my son and daughter, Jack and Jill,” the property generally passes to them as tenants in common. The property would not pass to them JROS, unless specified. (This is fine, as long as that is what you want.)

C. Qualified Retirement Plan Benefits and Individual Retirement Accounts.

This money goes directly to the beneficiary as you specify when enrolling in the plan or opening the account, bypassing probate court. At one time, these funds enjoyed special treatment, but are now generally includable in the decedent’s estate for tax purposes.

D. Life insurance Proceeds.

The policy payoff is part of your private contract with the insurance company, and it should promptly go to whomever you direct, with no court involvement. Proceeds from a policy owned by the decedent to a named person as beneficiary are excluded from federal income tax, as well as state income or death taxes in most states.

BEWARE! BUT if the decedent owns the policy, proceeds are includable in his federal taxable estate, even though paid to somebody else. The proceeds are likewise includable if the policy owner names his “estate” as beneficiary. The latter beneficiary designation is also a bad idea because it exposes the policy proceeds to creditors of the estate, which would not otherwise happen.

E. Gifts.

One way to avoid probate of an asset is to transfer it before you die. If the gift is to young children, you should be aware of the Uniform Transfers to Minors Act (UTMA), which is used in most states.

Under this provision, a gift of money or other property is made by the donor placing the asset in the name of a person called the “custodian.” It is simply a matter of titling the asset or account initially, to show the world that it is held pursuant to the UTMA. There are no tax returns to be filed. Legal title is held by the minor, but the custodian manages the asset until the minor is 21 years old (18 in a few states), at which time the property is turned over to the minor.

Until then, the custodian is required to pay to, or for the benefit of the minor as much of the property as the custodian deems advisable for his/her support, benefit, maintenance and education.

BEWARE! If these funds are used to pay for basic parental obligations, this may be considered taxable income to the parents. The theory is that a taxable benefit accrues to the parents to the extent they are relieved of their legal duty of support.

F. Payable On Death (POD) bank accounts.

The account owner names a beneficiary (payee) who automatically receives the account balance on the death of the owner. Until then, the beneficiary has no rights in the account, since the beneficiary can be changed or the account closed. Many states (with more surely to come) have also adopted a Transfer on Death (TOD) law pertaining to shares of stock and bonds that works the same as the POD arrangement does for bank accounts. Note that these designations might offer time-savings and convenience, but neither of them saves any tax.