CFP® Questions & Misconceptions: Estate Planning

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The BIF Bites podcast covers topics that are important to those seeking CFP® certification and really anyone that wants to better understand the financial services industry in general.

Adam Scherer, CFP®, MS is the Co-Director of Curriculum at the Boston Institute of Finance (BIF) and has over decade's worth of experience in the financial services industry.

Transcript

00:00:08  

Hey BIF Bites listeners, this is Adam Scherer from the BIF group bringing you another special installment of our new miniseries called CFP Questions and misconceptions. In today's episode, I am going to be bringing you some lessons learned from the CFP education classroom in estate planning. 

00:00:29  

Now, estate planning, even though it only comprises 10% of the CFP exam at a point, tends to strike some fear into the hearts of key candidates because it's one of those topics that is just generally less familiar.  

00:00:44  

Now in certain cases, that is due to a firm having a particular stance on the scope of the work that they do, but also it comes down to one of our CFP code and standards duties owed to clients, that being the duty of competence, right. So we need to be competent in a given area in order to be serving the cleint to the best of our abilities and with their best interest in mind.  

00:01:06  

Estate planning just happens to be one of those pretty clear line-in-the-sand topics where there aren't many practitioners on the financial planning side, save those JD's that are out there that can actually do some deep meaningful estate planning work.  

00:01:33  

So, often what I hear from firms that do estate planning is that they're looking at more foundational pieces, right? Do we have those core estate planning documents in place? But as far as fancy trust strategies - that's often left to some of the specialty firms that are going to be dealing specifically with those matters.  

00:01:50  

So, the point being here is that this is less common territory, and as a result, it generates a lot of questions. There's a lot of question volume that comes through my inbox during CFP education and the Bryant/BIF CFP program, but also when students get to the BIF Review  - quite a bit of questions. Again, even though this is only 10%, it's just one of those areas that takes people out of their wheelhouse quite a bit. 

00:02:18  

And I don't want to say it's universal, but the majority of people in the program definitely have opportunities to build out their base and knowledge and prepare them properly for the CFP exam. So today we'll be looking at 3 common questions/misconceptions as well - in estate planning and where I want to begin my discussion today is on just the meaning of the estate. OK, So, what the estate is, it is property that is owned by the decedent.  

00:02:55  

The decedent is the person that has passed away, that own property in some capacity and the estate in general will pull in everything that is owned by the decedent. It all also pulls in the debts, too.  

Everything's owed by the decedent as well, but there are two major categories that we need to define and understand that often cause a lot of questions and that simple breakdown between what we call the gross estate versus the probate estate.  

00:03:28  

Alright, so I'm going to speak very simply about these because we could actually dedicate a few episodes to really parsing all of this out, but know that for you to be prepared on your CFP Exam, you're going to have to know clearly what is included in a gross estate versus what is included in the probate estate. And here's the thing, that's a little tricky sometimes. 

00:03:50  

Sometimes things are included in both. Other times things are included in one of the two, so let's set out and define that.  

So, gross estate is everything owed and owned by the decedent. They could have a variety of different property interests, so there could be things that they own by themselves—self owned, individually owned property assets. There could be things that they own in a fractional interest under other forms of property interest, let's say tenancy, in common. 

00:04:20  

Or spousal or not, spousal joint tenants with right to survivorship property or community property, if you're talking about spouses in community property states. So, you have all of these different ways in which a person could have full ownership or a portion of ownership over property or asset interest. If you have some sort of interest for that individual that is going to get pulled into their gross estate, right? And that's just kind of like the baseline understanding with gross. 

00:04:50  

Now the probate estate is a subset of that, and with the probate estate, what you're going to see go through. There are pieces of property. 

00:05:01  

And property interests and assets that are individually owned that are going to be transferred via the will. And they're going to go through the probate process in their state of domicile. So, that's basically where they reside.  

This [is] the state probate system, which varies from state to state. You're not going to need to know that for your CFP Exam. But for those of you in practice, it is very important that you're locked into how probate works in your state. Here in Connecticut, it's going to work vastly different than someone in Oregon, [or] someone in Texas.  

So, take a look and see how your clients' states handle the probate process because there are ways to avoid going into probate. 

00:05:43  

So, within the will, the probate process is going to serve to get things organized to pay creditors of the estate, and also, it's going to document everything. Now, the downside is pretty well known and to keep in mind for your exam and for your work with clients is that - yeah, the probate thing is not the worst place to be because it does impose that layer of organization. It's over. There's a court oversight on the process, but the downsides can be kind of big.  

00:06:17  

There can be time delays on transfers because the estate has to get sorted out through the probate process, [which] could be very costly, very time intensive and the worst, I think of all, is that it's public facing. 

So, you know, being that finances are one of those topics that few people in general, are [not] really comfortable talking about with others. I just don't feel that for the majority of people there having a public facing probate process is really something that people are going to want to look at. 

00:06:46  

So that's the probate estate stuff goes through there. Now there's a separate path that can lead into probate and that is if property is in a state, not a physical state, but it is in a state of intestacy, intestacy means that you have no one appointed to that, there's no beneficiary. 

 It's not included in the will and what the probate process serves in that case is that it gets to take that property, and it has a predetermined way of accounting for the property and then distributing it to the various again varies greatly from state to state.   Again, it varies greatly depending on the decedent situation. 

00:07:27  

Was this someone that was married at the time of their death? Was this someone that was single? [Or a] business person that has relatives that are nearby and live in state? Do they have children?  

And the distribution of the estate— if you are going through the probate estate and your property is in a place where it is in a state of intestacy. Basically, the states are going to determine how your estate is divvied up amongst your various—so gross estate versus probate estate. The first area where there's a ton of questions. Spend some time so you understand conceptually what these look like. OK, which brings us to the second piece related to the gross estate. 

00:08:08  

We're going to look a little deeper in one form of property titling, that being joint tenants with rights of survivorship. Now, a little birdie told me there are a couple of programs out there that teach that there's only one type of joint tenants with rights of survivorship. It's only for spouses, [but that is] not true. There is a spousal form of joint tenants with right to survivorship titling. There's also a non-spousal version and they vastly differ.  

00:08:36 

OK, so with the spousal piece it doesn't matter how much you've initially put into the property by way of purchase. Each spouse is considered a 50% owner of that property. So if my wife and I buy a $100,000 car and we title it joint tenants with rights of survivorship. If I put in $0.50 and she puts in the remaining $999,999.50, sorry couldn't do the quick math there. Whoo. We're still treated as 50% owners. That's the way it works with spouses. Now with non spouses. It actually does depend on how much one initially puts in, so if it's me and my nephew are going in and we're buying a plot of land, we're buying a boat, we're buying whatever, right. Our initial contribution percentage determines how much is going to get pulled into our estate. Alright.  

00:09:34  

One of the common lines of questions on this front is what is the step up in basis to the survivor or survivors? Because actually with joint tenants with rights of survivorship, you can have several owners. It doesn't have just have to be two, all right, but what is that step up? Because basically the way that it works, if something is included in the estate, it's going to be valued either as of the date of death of the decedent or something separate which is called the AVD alternate valuation date, definitely a topic you want to look into.  

00:10:07  

Alright and the estate captures all of the property. It is taxed now are actual tax dollars paid always no because we have this magical thing called the lifetime gift tax and estate tax exemption amount and its relative the applicable credit amount that is going to offset taxes due up to a certain threshold, right? So they're are not actual tax dollars paid in certain situation. However, when that property transfers out back to the joint owner, the joint tenant or tenants, it is going to be stepped up and there's a step up to the survivor. 

00:10:47  

Because that amount has been taxed through the decedents estate. OK, so understand the differences between the two. Read carefully on your exam and know that this is a way to get around the probate estate. OK, so that's going to pass by operation of law on to the surviving spouse, the surviving tenants. OK.  

00:11:09  

Third and final piece, I want to bring up just in this quick episode on questions and misconceptions is a little topic that causes a great amount of confusion. It's called the three-year rule. Now this has changed over time.  

The way that the three-year rule used to work was that if property was transferred out of the estate within three years of the decedents death, that was all pulled back into the estate and considered as they worked through the estate tax calculation. There was a law change, and the law change added an extra check in the box that actually makes quite a difference when we're trying to understand this concept.  

00:11:54  

So there are two checks in the boxes now in order for the three-year rule to apply. The first one is “Was this property transferred out of the estate within three years of death?” If we check the box there, there then needs to be a separate check for one of four circumstances.  

00:12:11  

The IRC code numbers and section numbers in case you're interested IRS or if you’re an IRS nerd like me they are IRC 2036. Hmm. IRC section 2038, IRC Section 2037 and IRC Section 2042. So these are a set of four circumstances, one of which must apply in order for the three-year rule to be actually be triggered at this point.  

00:12:35  

The first one, section 2036, is any transfer that has a retained life estate. So if you have a life estate, you have just beneficial enjoyment, you have possession of that property. You have certain voting rights on that property. All right. But during your lifetime you were able to use that property as part of a life estate. So if three years and part of a life estate that could be considered something that's pulled back into the into the estate for estate tax calculation. 

00:13:08  

The second one is when you have a reversionary interest and what does that mean? It means that the property transferred out could return to the decedent or to their estate and could be subject to different powers that they have or control. And I think what you're going to see with all of these, these more nuanced exceptions, is that really what it comes around is just control. Was there any retained control? Because one of the basic IRS tax tenants is that the tax follows the person that is ownership and control. OK, so that's number two that's in section 2037.  

00:13:45  

2038 we're talking about revocable transfers. And these are situations where you can have a revocable trust that becomes irrevocable at death, that could get pulled into the gross. Estate. Now a lot of people use revocable trusts to go around the probate estate, and that is a great reason. Revocable trusts offer a whole lot, but when you transfer that property out and it transfers into the trust at death, revocable becoming irrevocable. It's going to cue that three-year rule. 

00:14:21  

Now, the last one we're talking about proceeds of life insurance. So if the death benefit of the life insurance, first of all, I mean, if it's going to be received by the estate, it's going to get included by the estate. OK. But here the real cruxes has the ownership of that policy transferred within three years? If we put a check there and the decedent had incidents of ownership incidence of ownership, this is a long list of different things that they could do; but a couple of examples are they can change the beneficiaries, they can change the setup of the life insurance, they have access to the cash value of the policy. Those are incidents of ownership. And if we have check for three years, check for incidents of ownership, we're in a place where that could potentially be pulled in under the three-year. 

00:15:12  

So learn this stuff well OK? This is one of those topics you do want to step into the deeper weeds a little bit to get that complete understanding. And that's all I got for today. Now I can continue to go on and on and on and be sure to reach out to our team if you're finding value in in this mini series. 

00:15:31  

Because there's plenty to talk about here, plenty of things that cause confusion, especially in estate planning. So I'm happy to throw up a Part 2 of this if there's interest from the audience, be sure to get in touch.  

00:15:43  

We're on the cusp of another great BIF review. If you're looking for an exam prep provider, be sure to reach out to our team, we'd love to have you on board. We have a passion for teaching this stuff and bringing you to the finish line with your CFP exam and looking forward to catching up with you next time. We have some great episodes that are lined up that we're all really excited about. The New Year may bring some new surprises on the podcast front. You never know, but really fun spending this short episode with you and I look forward to doing another one really soon. Take good care and be well.