General Practice, Solo & Small Firm DivisionMagazine

American Bar Association
General Practice, Solo, and Small Firm Division
The Compleat Lawyer
Spring 1998
© American Bar Association. All rights reserved.

Financial and Estate Planning for Elder Clients


L. Rush Hunt is a lawyer in Madisonville, Kentucky, where he devotes much of his time to areas of estate and trust law. He is the author of Financial Planning for You and Your Clients: What Every Lawyer Should Know About Insurance, Investments, Estate Planning & Taxes (ABA General Practice, Solo and Small Firm  Section, 1997).

Risks and rewards, trusts and gifts. Elderly clients have a lot of questions about financial and estate planning. Lawyers can offer clients general investment information, and can advise on the use of trusts to lessen federal estate taxes for married clients, the use of trusts for single and married clients for non-tax reasons, and gift giving to grandchildren.

Clients approaching retirement years are often bombarded with investment advice from various salespeople. While most lawyers cannot (or do not want to) become financial planning experts, they can certainly provide meaningful advice. For example, it is shocking to see the number of elderly clients who are convinced to cash in certificates of deposit or high-grade bonds to buy annuities.

Investment Advice

A good sales technique focusing on the desire for high investment returns (older clients still remember the double digit rates of CDs in the late 1970s) and promises of income tax deferral cause many clients to purchase annuities.

An annuity may be an appropriate investment, but most are pushed on elder clients by the salesperson's desire to make a 5 percent sales commission, rather than because it is a good investment. The same is true for many other investments.

The last 15 years have been such a generous time in the stock market that many salespeople have been spared defending their advice—most equity investments have grown in value, even though few kept pace with the S&P 500 index. One did not have to be a very good investment advisor to make money for a client during the last 15 years. That trend may continue, but markets do not always go up. Stocks historically make a modest 10 percent annual return, so guarded optimism should be the approach.

The most important consideration in advising on investments is to consider the client's risk tolerance. It is essential that the client consider the nature of the investment risks he faces with a particular type of investment. No two clients will assess investment risks the same, but they must honestly assess their own risk tolerance. No investment is a good one if the client can't sleep after making it.

There is no clear way to discover a client's risk tolerance. Simply explain to the client that she must face that question before selecting the right investment. Then, explain that investments can be viewed like a pyramid. The low risk investments at the bottom of the pyramid consist of savings accounts, certificates of deposit, U.S. treasury bills, and long-term government bonds. Moving up toward the middle of the pyramid are municipal and corporate bonds, and mutual funds that invest in corporate bonds. The third level of the pyramid includes mutual funds that invest in stocks, individual issues of common stocks, and real estate. The very top of the pyramid consists of such risky investments as precious metals, options, and commodities. The greatest rewards are given to those who climb the highest up the pyramid, but they take the greatest risks. With that said, the older your client, the less risk she should take.

One of the better ways to put investments in perspective is to remind your client that on average, during the last 70 years the compound rate of return on U.S. treasury bills has been slightly under 4 percent, long-term U.S. government bonds about 5 percent, long-term corporate bonds nearly 6 percent, common stocks 10 percent, and small company stock 12 percent. At the same time, inflation has averaged 3 percent. These statistics should put in perspective the overly optimistic returns promised by overeager salespeople.

Next, the client must understand the volatility of stock and bond investments. A husband and wife who are both 55 years old may choose to be somewhat aggressive with stock investments, since they have a joint investment horizon of more than 20 years. But how many 65- or 70-year-old clients are willing to experience a 4 percent loss in the hope of a 30 percent gain in the next five years? Can they afford such a loss? One can assume that risk at 35 or 45, but few can at 65 or 75.

Lawyers cannot become investment advisors overnight, but they can take the stars out of clients' eyes and place them with competent investment advisors. For more information on investments, see two of the recent publications by the ABA General Practice, Solo and Small Firm Division: Financial Planning for You and Your Clients and Fundamentals of Personal Investing.

Estate Taxes for Married Couples

The A-B trust (or as it is often termed, the marital-credit shelter trust) is a basic approach used in estate planning by married couples that is designed to lessen the federal estate taxes owed on their estate. Generally, for decedents dying in 1998, a federal estate tax is not owed on an estate of $625,000 or less due to the unified credit, but an estate tax is owed on estates above that amount.

Thanks to the Taxpayer Relief Act of 1997, the amount excluded from the federal estate tax increases during the next eight years as follows: 1999, $650,000; 2000 and 2001, $675,000; 2002 and 2003, $700,000; 2004, $850,000; 2005, $950,000; and thereafter, $1,000,000.

The federal estate tax on estates that are double the size of the above exclusions can be entirely eliminated with this A-B trust approach. The size of the estate and the amount of estate tax that can be eliminated with this technique for the years between 1998 and 2006 are illustrated in table 1 and table 2 (which for simplicity do not consider the state death tax credit). Table 1 illustrates the estate tax savings depending on the year each spouse dies when using the A-B trust approach coupled with the increasing unified credit. Table 2 illustrates the estate tax savings using the A-B trust approach for estates for various sizes assuming there is no increase in estate size following the first spouse's death.

To illustrate the savings, assume an estate in 1998 of $1,250,000 is owned entirely by one spouse and all assets pass by will outright at death to the surviving spouse. Due to the marital deduction, no federal estate tax is owed when the estate passes from one spouse to the other, but a $246,250 estate tax is owed if the survivor also dies in 1998. This entire $246,250 can be saved. In larger estates, the savings will be somewhat higher because of the progressive rate structure of the federal estate tax, although some estate tax is unavoidable in those larger estates. Now for the mechanics.

In the A-B trust approach, the $1,250,000 estate in the above example is placed in trust at the decedent's death and divided into two separate trusts termed the A trust and the B trust, or if you prefer more sophisticated terminology the marital trust and the credit shelter trust. The A trust must qualify for the marital deduction, whereas the B trust is designed intentionally not to qualify.

If the client prefers, the A trust can be given outright to the surviving spouse. In either event, the B trust is drafted to equal the first $625,000 of the estate (or whatever the exclusion amount is in the year of death) with the balance of the estate passing into the A trust, or outright to the surviving spouse. The federal estate tax otherwise owed on the B trust ($202,050 if the spouse dies in 1998) is offset by the unified credit, resulting in no federal estate tax on the B trust. Because the A trust, or share passing outright to the surviving spouse, qualifies for the marital deduction, no estate tax is owed on that share either.

The surviving spouse can receive the entire income from both trusts if desired, but he must receive the income at least annually from the A trust. The principal from both trusts can be spent for the surviving spouse if necessary for the survivor's health care, maintenance, and support. Traditionally, the surviving spouse is granted a general power of appointment over the A trust, but this is no longer required if a Q-TIP election is made and those rules are met (the Q-TIP trust is discussed below). Upon the surviving spouse's death, the A trust and the surviving spouse's own property are subject to the federal estate tax. The B trust assets pass to the ultimate beneficiaries (typically the children) of that trust without any estate tax. Therein lies the estate tax savings. This savings is permissible even though the surviving spouse has the benefit of income and principal from the B trust.

Oftentimes, a spouse does not want the A trust subject to a general power of appointment. This is commonly the situation when there is a second marriage and each spouse has children from a prior marriage. A general power of appointment flirts with disaster, since the survivor can exercise the power and redirect the trust assets to the survivor's own children, or to a new spouse if the survivor remarries. Until 1982, there was no alternative. Beginning in 1982, an amendment to the marital deduction requirements of the federal estate tax permits a qualified terminable interest property (Q-TIP) trust to qualify for the marital deduction.

A Q-TIP trust must pay income at least annually only to the surviving spouse just like an A trust, but principal distributions can be restricted to a limited standard such as health care, maintenance, and support; or no principal distributions can be allowed at all. Further, the surviving spouse need not be given any power of appointment exercisable during lifetime or at death over the trust property. Thus, the Q-TIP trust property passes at the surviving spouse's death to whomever the grantor-spouse designates, such as to the children of the grantor-spouse's first marriage.

Trusts for Non-Tax Reasons

A revocable living trust is often used by older clients. The traditional benefits of a living trust include privacy, a reduction in estate settlement costs, and convenience. Assets transferred to a client's trust prior to her death are not disclosed to the probate court following death and thus are not listed on estate inventories that become public documents. If privacy is important to the client, the living trust is the solution.

Many clients believe a living trust will lessen estate settlement costs. That is true if those costs (executor and lawyer fees) are set as a percentage of the probate estate. Many executors and lawyers charge percentage fees, but if they base the percentage on the gross or taxable estate rather than the probate estate, the expected savings become illusory. The lawyer must be familiar with state law in her jurisdiction to determine if the mere use of a living trust will result in a true savings.

Even when executor and legal fees are not set as percentages of the probate estate, there still are some possible estate settlement savings. Assets held in trusts can be transferred by the trustee immediately after death, whereas many assets titled in the decedent's own name require a multiplicity of documents to transfer or sell the estate assets—a time-consuming task. Thus, for clients with numerous mutual funds, stocks, and bonds, the titling of assets in a living trust during lifetime (thus the name living trust) simplifies the estate settlement. Since time is saved, executor and legal fees should be lower.

Simplifying estate settlement is important to many clients who do not want the surviving spouse to be involved in a lengthy estate settlement process. Since the living trust simplifies asset transfer, leaving many estate settlements to be a matter of merely filing tax returns, many older clients opt for a living trust for this convenience alone. Also, the trust is a convenient management vehicle, which is particularly important if the elderly client becomes disabled or experiences poor health. At disability, the successor trustee (very often a child) can immediately assume management of the trust assets. Finally, clients owning real estate outside their home state will find that titling real estate in a trust avoids the inconvenience and expense of ancillary estate administrations.

To establish a living trust for non-tax reasons, the client transfers property to the trust and acts as his own trustee, naming the other spouse, a family member, or a financial institution as a successor trustee. The trustee pays all trust income to the client and client's spouse and pays principal as requested by the spouses or based on a standard set in the trust document, such as health care, maintenance, and support. Upon the client's death, the trust continues during the surviving spouse's lifetime and terminates at some later date, such as upon the death of survivor.

Gift Giving to Grandchildren

Grandparents often consider making lifetime or testamentary gifts to their grandchildren. Testamentary gifts to older grandchildren is a simple matter of making a bequest in a will with proper consideration to allocation of the death taxes. Typically, testamentary gift giving to younger grandchildren involves the traditional drafting of a testamentary trust as part of the client's will. The lawyer simply writes the trust, considering such factors as the frequency and circumstances under which income and principal are paid, the duration of the trust, alternate distribution of the trust should the grandchild pre-decease the grandparent, and naming the trustee and a successor trustee.

In addition to the federal estate tax, the client must be made aware of the generation skipping transfer tax and the $1,000,000 exemption from that tax. A testamentary gift to a grandchild is a direct skip and subject to this tax. The election to use the exemption must be made on the client's federal estate tax return.

To qualify lifetime gifts for the annual gift tax exclusion of $10,000 per year per donee, the client must make a present interest gift. Present interest gifts are those in which the donee has current use of the property, as contrasted with a future interest gift, such as a gift to a trust. Again, gifts to older grandchildren can be outright, thus qualifying for the annual gift tax exclusion. For younger grandchildren, the options are somewhat more complicated.

If the client is making small or infrequent gifts, the Uniform Transfer to Minors Act provides a simple statutory substitute for a trust. The gift is transferred to a custodian (typically a parent) and still qualifies for the $10,000 annual gift tax exclusion. The custodian then manages the gift property for the grandchild's benefit, transferring the property to the grandchild at the statutorily mandated age, which depending on state law is either 18 or 21.

For clients who are making regular gifts, or who do not want the gifts available for outright distribution to the grandchild as early as ages

18 or 21, a trust authorized under I.R.C. §2503(c) is an alternative. The I.R.C. permits the $10,000 annual gift tax exclusion even though a gift to a trust is a future interest.

For this type of trust:

  1. The trustee has the discretion to distribute income and principal to the donee before age 21, irrespective of whether any income or principal is in fact distributed.
  2. The trustee must distribute the entire trust principal and any accumulated income to the donee when the donee reaches age 21, although the trust can continue beyond age 21, if the donee is granted the right to withdraw the entire trust at age 21 but elects not to do so.
  3. The trustee must distribute the trust to the donee's estate should the donee die before reaching age 21, or pursuant to the terms of a general power of appointment granted to the donee in the trust.

A trust drafted to meet these statutory requirements gives the trustee (usually a parent) greater control over the gift than does the UTMA, and allows the trust to terminate (if the child agrees) at a later age, such as age 35.

A third alternative is an irrevocable trust that meets the so-called Crummey trust rules. These rules permit the $10,000 annual gift tax exclusion for gifts to a trust when the trust gives the beneficiaries a right to withdraw the gift from the trust. Beneficiaries must be given notice of any gift to the trust and have a right to immediately withdraw the gift, but typically for only 30 or 60 days.

This kind of trust is somewhat more complicated administratively than the 2503(c) trust, due to the notice requirements, but both types of trusts qualify for the $10,000 annual gift tax exclusion and delay termination of the trust until the grandchild is older. Also, the Crummey trust has none of the just discussed restrictions of a 2503(c) trust; and the $10,000 annual gifts to the trust can continue after the beneficiary reaches 21, unlike a 2503(c) trust.

IRAs provide a unique asset for gift giving. This planning option is best illustrated by an example. Assume a husband owns an IRA and upon his death passes it to his wife as the primary beneficiary. The wife rolls the IRA into her own IRA. The wife then names the sole grandchild as the beneficiary. IRA benefits can remain invested until the wife reaches 701/2, allowing continued tax-deferred growth.

The IRA is then distributed over the joint life expectancy of the wife and grandchild, subject to a special ten-year restriction. If the wife is age 70, this restriction will result in distribution based on 26.2 years. Assume the wife dies ten years later at age 80. Then the life expectancy calculation for payments to the grandchild returns to the actual joint life expectancy less the 11 years of payments. The exact payout is determined from IRS life expectancy tables, but will typically result in IRA benefits paid to the grandchild for a term of 50 or more years.

Because the amount paid each year to the grandchild for many of these years will be less than the investment return, the IRA will grow significantly in value during most of the grandchild's life. Then, as the grandchild reaches her own retirement, the payout becomes greater as the life expectancy grows shorter. This can result in a significant gift to the grandchild. As with all gifts to grandchildren, the generation skipping tax and the $1,000,000 exemption must be considered.

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