As a Trust Beneficiary, Am I Required to Pay Taxes?

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As a Trust Beneficiary, Am I Required to Pay Taxes?
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Beneficiaries who receive distributions from a trust often have tax questions about whether they have to pay tax or not. Fundamentally, whether a beneficiary pays taxes on distributions or not depends on whether the money they receive is considered “income” or “principal”.

When an irrevocable trust makes a distribution, it deducts the income distributed on its own tax return and issues the beneficiary a tax form called a K-1. This form shows the amount of the beneficiary’s distribution that’s interest income, as opposed to principal. With that information, the beneficiary knows how much she’s required to claim as taxable income when filing taxes.

Investopedia’s recent article on this subject asks “Do Trust Beneficiaries Pay Taxes?” The article explains that when trust beneficiaries receive distributions from the trust’s principal balance, they don’t have to pay taxes on the distribution. The IRS assumes this money was already taxed before it was put into the trust.

After money is placed into the trust, the interest it accumulates is taxable as income—either to the beneficiary or the trust. The trust is required to pay taxes on any interest income it holds (in other words, the income it doesn’t distribute by the taxable year-end). If the trust distributes the interest income, though, it is considered taxable income to the beneficiary who gets it.

The money given to the beneficiary is considered to be from the current-year income first. That means that a distribution to the beneficiary will first be categorized as “income”, and the beneficiary will have to pay taxes on it. If a trustee gives a beneficiary a distribution that is more than the amount of the current-year income, then it is considered to be a distribution from the accumulated principal. This is usually the original contribution that was placed into the trust account, plus any subsequent deposits.

Capital gains may be taxable to either the trust or the beneficiary. All the amount distributed to and for the benefit of the beneficiary is taxable to her to the extent of the distribution deduction of the trust.

If the income or deduction is part of a change in the principal or part of the estate’s distributable income, then the income tax is paid by the trust and not passed on to the beneficiary. An irrevocable trust that has discretion in how much to distribute and how much to keep as retained earnings will pay trust tax based on the rate schedule for trusts and estates, but a beneficiary will pay income tax based on the rate schedule that applies to the beneficiary (single, married, head of household, etc.).

The two critical IRS forms for trusts are the 1041 and the K-1. IRS Form 1041 is like a Form 1040. This is used to show that the trust is deducting any interest it distributes to beneficiaries from its own taxable income.

The trust will also issue a K-1. This IRS form provides details about the distribution. Specifically, it will tell the beneficiary how much of the distributed money came from principal and how much is interest. The K-1 is the form that allows the beneficiary to see their specific tax liability from trust distributions.

The K-1 schedule for taxing distributed amounts is generated by the trust and given to the IRS. The IRS will deliver this schedule to the beneficiary so that they can pay the tax. The trust will fill out a Form 1041 to determine the income distribution deduction that’s conferred to the distributed amount. Your estate planning attorney will be able to help you work through this process.

Reference: Investopedia (July 15, 2019) “Do Trust Beneficiaries Pay Taxes?”

The Biggest Estate Planning Errors

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The Biggest Estate Planning Errors
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Nobody likes to plan for events like aging, incapacity, or death. However, failing to do so can cause families burdens and grief, thousands of dollars and hundreds of hours. Fox Business’ recent article, “Here are the top estate planning mistakes to avoid,” says that planning for life’s unexpected events is critical. However, it can often be a hard process to navigate. Let’s look at the top estate planning mistakes to avoid, according to industry experts:

1. Failing to have a will (or one that can be located). The biggest mistake is simply not having a will. Many people wait for “a more appropriate time” to put a will together. The truth is, we all need estate planning, no matter the amount of assets a person may have. In addition to having a will prepared and executed, it needs to be findable. The Wall Street Journal says that the biggest estate planning error is simply losing a will. Make sure your family has access to any estate planning documents you create.

2. Failing to name and update beneficiaries. An asset with a beneficiary designation supersedes any terms in a will. Review your 401(k), IRA, life insurance, and any other accounts with beneficiaries after any significant life event. If you don’t have the proper beneficiary designations, income tax on retirement accounts may have to be paid sooner and your heirs will have to pay a lump sum tax immediately. Without a life insurance policy, the proceeds will have to go through probate, which means they are subject to creditors’ claims.

Another mistake that impacts people with minor children is naming a guardian for minor children and then naming the guardian as the outright beneficiary of their life insurance. If money is left to the guardian, then the proceeds are now considered the assets of the guardian and do not transfer to the minors. The cash also now faces exposure to the creditors and spouse of the guardian named as a beneficiary Instead, parents should leave the money to a trust for the children and name the guardian, or another trusted and responsible person, as the trustee of the trust.

3. Failing to consider powers of attorney for adult children. When your children reach age 18, they’re adults in the eyes of the law. If something unfortunate happens to them, you may be left without any say in their treatment or even access to their medical records. In the event that an 18-year-old becomes ill or has an accident, a hospital won’t consult with their parents if a power of attorney for health care isn’t in place. Further, without a financial power of attorney, a parent may not be able to take care of bills, make investment decisions or pay taxes without the child’s signature. This could create an issue when your child is in college—especially if he or she is attending school abroad. It is very important that when your child turns 18 that you have powers of attorney put into place.

Reference: Fox Business (October 15, 2019) “Here are the top estate planning mistakes to avoid”

How Can Life Insurance Help Me with my Post-Divorce Estate Planning?

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How Can Life Insurance Help Me with my Post-Divorce Estate Planning?
Agent protects family figures. Life Insurance policy on a desk.

Divorce can be extremely stressful in and of itself as you work through you and your ex-spouse’s current financial landscape. To add insult to injury, divorce can bring some extra challenges to estate planning. The good news is that there are some easy solutions that can help. In many instances, a frequently overlooked strategy can provide real solutions for divorcees as they go through a divorce, as well as provide for future blended families. That’s life insurance. Using life insurance to address some of these issues, can help you create an estate plan that really fits your needs, goals and unique family circumstances.

Insurance News Net’s article “5 Ways Life Insurance Eases Post-Divorce Estate Planning” provides us with five ways life insurance can help you in the event of a divorce:

Have money for divorce-related expenses. If the divorce is contested or includes child custody issues, the proceedings be quite long, maybe months or years. As a result, your attorney’s fees could be hefty. Those with an established permanent life insurance policy can take withdrawals or loans from the policy’s cash value to help pay expenses. If the policy is designed effectively, you won’t have to liquidate other assets or take money from your estate that was designated for beneficiaries.

Protect your income post-divorce. Your income can change significantly after a divorce, especially if one spouse was a stay-at-home parent. They may get alimony payments to help make up the difference, but if the payor unexpectedly dies, the lost income can create a lot of stress and financial hardship for those left behind. Permanent life insurance on the paying spouse can help provide coverage and replace any income lost in the event they pass away suddenly.

Preserve your estate post-divorce. Life insurance can also provide funds to pay off existing debt held by the deceased ex-spouse, which may otherwise eat through the estate. This also can eliminate the need to liquidate other assets from the estate that would have gone to the surviving spouse or other heirs. Take withdrawals or loans from the policy–tax-free, if the policy is set up correctly–and you can effectively plan your legacy, even if your ex-spouse hasn’t been financially responsible.

Ensure that children get a fair inheritance. If you have children from a previous marriage, it may make sense to provide for them through life insurance, rather than passing their assets through a new spouse first. In the alternative, you can provide for your new spouse through life insurance and leave the estate to the children outright or in a trust. With either option, dividing how you leave assets to biological children and a new spouse in a blended family can eliminate stress and bad feelings, especially if the new spouse has children of their own.

Help fund college or other expenses for your children. There is a lot of value in getting life insurance on the lives of both parents, even if only one of them previously worked. Protecting the lives of both parents with permanent life insurance allows you to make certain that the expenses for the children are addressed. Therefore, if the former spouse is responsible for paying medical expenses, college expenses, or other costs for the children, life insurance can provide needed funds if that ex-spouse passes. Permanent life insurance with cash value can also provide funds during the insured spouse’s lifetime (if cash isn’t readily available) to pay college tuition or help adult children repay student loan debt.

You should also look at permanent instead of term insurance. Term insurance may be less expensive, but permanent insurance can accumulate cash value that can be drawn from the policy while the spouse is still alive, as well as providing a death benefit. You may want to also look into adding riders to customize your policy. With a permanent life insurance policy and a long-term care rider, you have the ability to accelerate the policy’s benefit while you’re alive to pay for long-term care costs. This can put to rest some of the concerns for divorcees about who will take care of them if they can’t take care of themselves.

A carefully planned permanent life insurance policy can help you protect yourself, your income, and your estate throughout your lifetime, even if you experience divorce.

Reference: Insurance News Net (November 5, 2019) “5 Ways Life Insurance Eases Post-Divorce Estate Planning”

Is a Retirement Community in Your Future?

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At some point in life, many people face the decision of moving into a retirement home or welcoming in-home care. Living in these communities has some advantages that are not present when you age in a place, and it actually gives you more independence. This is because you are not busy caring for a house or being confined to a solitary life in a private home. In fact, according to the article “The Many Faces of Aging” from Harrisburg Magazine, it can be a very flexible and dynamic option.

Deciding to buy or rent a home in an age-restricted community is a major step toward achieving a new lifestyle. If you think this is the right choice for you, you should keep a number of factors in mind as you look for the community best for you. Here are some questions and answers to consider.

What’s your budget? Make sure that you have the numbers right. Consider additional expenses, like yearly or monthly resident fees. Some luxury communities have equity memberships, which require extra financial investment. Don’t forget taxes.

What are the rules and covenants? Every community will have some kind of homeowner’s association that governs what residents can and cannot do. If you want to have grandchildren stay with you for an extended period of time, make sure that this is permitted in the communities you are considering. The homeowner’s association will implement and enforce restrictions, so know what they are beforehand.

What are the neighbors like? Your future social life is key to your enjoyment of the new community. If you are seeking like-minded people, be sure you’ll know what kind of people live there. Get a sense of the general vibe and personalities. Will you feel included and accepted?

What will a different climate feel like year-round? If you are thinking about moving far from your current home, be sure the new climate suits you. Rent before you buy, if at all possible. A southern home is great during the winter, but if you’re too uncomfortable with summer heat, or dislike living most of your summer in air-conditioned spaces, it may not be for you.

Are there activities you’d enjoy? Make sure the activities you like are offered. If you are a reader, you’ll prefer a community with an active lending library and book groups. A golfer will, of course, want a high-quality golf course (although there will likely be additional fees).

Is good medical care nearby? When it comes to convenient medical care, every community is different. In large communities, there may be on-site health care services. Some may rely on local ambulance companies and hospitals for all medical care. Medical services that are five minutes away may be a better choice than those that require a one-hour transport to a hospital.

As you look around, one of the biggest questions is: can you imagine yourself being happy in the community? If it represents a chance to thrive and grow safely as you age, then it just may be the right place for you.

Reference: Harrisburg Magazine (Nov. 8, 2019) “The Many Faces of Aging”

The Conversation with Your Doctor, Estate Planning Lawyer and Family Members

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Everyone needs to have an annual checkup, taking stock of their health with their primary doctor. The annual check is also a good time to make sure that everyone is on the same page when it comes to instructions for health care and an advanced healthcare directive, also known as a living will. When people sign their last will and testament, everyone breathes a big sigh, says The Huntsville Item’s article “Make sure you talk to your doctor and family.” But that’s not the end of estate planning.

Your primary care doctor needs to know what your wishes are, as well as your spouse and children. The best way to make sure they have this information, in addition to having a conversation, is to bring a copy of an advanced healthcare directive or living will with you to your next check up and talk with your doctor about it. Ask them to keep a copy on file.

It’s a good idea to give a copy of documents such as the Medical Power of Attorney and Medical Directive to Physicians and Family to each primary care doctor, and a copy to the healthcare agents you have selected.  Don’t forget to keep a copy or two in your records to take with you if you ever have to go to the hospital.

The signed original should be kept with all of your estate planning documents—in a safe place in your home, possibly in a fireproof safe. Make sure to tell a few family members where these original documents are, in case of an emergency.

The hardest part of estate planning is not usually picking the right fiduciaries or deciding how to distribute assets among loved ones. The hardest part is almost always having these conversations with family and loved ones.

It can be so daunting that families often don’t have these important discussions. Here’s the problem: avoiding the conversation doesn’t mean the issues go away. More family infighting takes place after a death than any other time. Emotions are running high, old wounds are opened, and unresolved issues, especially between siblings, come pouring out. If the parent who has died has always been the one who made peace between everyone, that buffer is now gone.

Having this discussion in a low-pressure, non-emergency time is something that every parent should do for their children. Consider a family gathering where the underlying agenda is to get everyone comfortable with the concept of talking about what the future holds. It doesn’t have to be a formal meeting; a casual family get-together is likely more comfortable for everyone.

If the conversations are taking place in a casual manner over an extended period of time, a lot of ground can be covered with less tension and stress. Once you get people used to the idea that you know that you are not going to live forever, it’s easier for everyone because you have now told them you want to be sure they are taken care of.

In some families, these conversations begin when all are invited to attend a family meeting with the estate planning attorney to discuss wills, financial powers of attorney, and medical powers of attorney. Sometimes having this conversation with an experienced professional can take some of the sting out of planning for the future.

Reference: The Huntsville Item (June 30, 2019) “Make sure you talk to your doctor and family”

Why Do I Need a Power of Attorney?

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People often wonder why they would need a Power of Attorney, also known as a POA.

Fed Week’s article, “Giving Someone the Power of Attorney,” uses the example that you might suffer a stroke with no prior warning signals and be unable to sign your name. This could mean serious financial consequences. However, executing a POA can protect you in that kind of situation.

It’s important for just about everyone to have a POA. You can name more than one attorney-in-fact, stipulating if they are permitted to act alone or if they must act in concert.

Of course, the individual you designate must be someone you trust. This is typically a close (albeit younger) member of the family or a close friend. You might nominate both of your children as attorneys-in-fact, requiring that they agree to act on your behalf under a power of attorney.

If desired, you can assign different responsibilities to different individuals. For instance, you can name your spouse to make your housing decisions and your son to manage all your financial affairs.

You may not want to give power over your assets to a family member, while you’re still in command of your faculties (or have capacity). To address this, many states recognize what are called springing powers of attorney. These powers do not become effective until specified events take place, like incompetency (certified by a doctor) or when you go into a nursing home.

If your state doesn’t recognize springing powers, you often can see the same result with a durable power of attorney that’s accompanied by a letter saying that the power will go into effect, if certain events occur. For example, in Florida, contingent or “springing” powers of attorney are not permitted after legislation was passed in 2011.

Talk to an experienced estate planning attorney in your state, who can help you understand the type of POA your state laws allow. He or she can also keep these signed documents until they’re needed. Your attorney will also know if the law also provides that powers of attorney properly executed under the laws of another state are recognized in your state of residence.

Reference: Fed Week (October 3, 2019) “Giving Someone the Power of Attorney”

The Shocking Cost of Caregiving Expenses – and What to Do About It

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If you provide caregiving services for an aging relative, you might not realize how much it costs you out of pocket to help your loved one. Expenses like taking food to your older parent, picking up prescriptions and supplies, buying clothing and providing transportation and other incidentals, can add up to $5,000 a year or more. Most Americans do not have an extra $5,000 lying around to spend – year after year – on these additional costs.

Covering these items will likely mean you have to work. Since you cannot be in two places at one time, you will miss work when you run your aging parent to the doctor and take care of other necessary errands. You might get to work late or have to leave early. Many caregivers lose their jobs based on work absences that result from taking care of an older parent. You need to know about the shocking cost of caregiving expenses – and what to do about it.

Find Sources of Funding or Services

Your state or county may have programs that can help with the financial burden of caring for someone. For instance, your loved one might qualify for additional benefits through Social Security. Medicaid (also known as Medi-Cal in California) can help with Medicare premiums, co-pays, deductibles and other out-of-pocket expenses. Supplemental Security Income (SSI) can provide additional funds to help pay for everyday items.

Your state might also offer programs that can provide food and transportation. Check with your local Council on Aging office for services in your area.

If either of your parents served in the military, the Veterans Administration (VA) might provide Aid and Assistance to pay for caregiving services if your parent does not have a lot of property or income. Veterans and their spouses can also receive other types of benefits, like medical care.

If your aging parent needs long-term care, think about having them sell their home. Doing so can reduce many of their monthly costs and provide a source of funds to pay for memory care, assisted living, or a nursing home. See if your parent has bank accounts or investments that could get liquidated to pay for their needs. They might be able to “spend down” to qualify for Medicaid coverage.

Try to Avoid Having History Repeat Itself

Many people end up paying for everyday items for their parents because their elderly parents cannot afford even the necessities of life. Pensions are almost unheard of now. When a person retires, they will have to live on their savings, investments, retirement income and Social Security.

For quite a few Americans, the Social Security check is barely enough to pay the utilities. People often do not understand that your Social Security check is impacted by the amount you contribute. As a result, they do not plan for how Social Security retirement income can get reduced because they were a stay-at-home parent or working part time for a period of their lives. Too often, they find out too late that they might only get a few hundred dollars a month during their golden years.

To make sure your children do not have to help you financially when you retire, use a free online tool to calculate how much Social Security and other income you can expect when you retire. If that number is too low, explore ways to increase your retirement income, like contributing more to your 401(K), investing in a standalone IRA, and working a few more years to retire after your full retirement age. Consider long-term care insurance, particularly if Alzheimer’s disease or other forms of dementia seem to run in your family.

Every state has different regulations and programs. You can talk with an elder law attorney in your area about how your state differs from the general law of this article.

References: HuffPost. “Caregiving Will Cost You $5000 A Year – And Maybe Your Job.” (accessed October 9, 2019) https://www.huffpost.com/entry/caregiving-will-cost-you-_b_12047182

Protecting Kids from Too Much, Too Fast, Too Soon

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When parents think about their kids inheriting a large sum, they often have some concerns. Protecting your kids from frittering away an inheritance is often done through a spendthrift trust but that trust can also be used to protect them from divorce and other problems that can come their way, according to Kiplinger in “How to Keep Your Heirs from Blowing Their Inheritance.”

We all want the best for our kids, and if we’ve been fortunate, we are happy to leave them with a nice inheritance that makes for a better life. However, regardless of how old they are, we know our children best and what they are capable of. Some children, even once they are adults, are simply not prepared to handle a significant inheritance. They may have never learned how to manage money or may be involved with a significant other who you fear may not have their best interests in mind. If there’s a problem with drug or alcohol use, or if they are not ready for the responsibility that comes with a big inheritance, there are steps you can take to help them.

Don’t feel bad if your kids aren’t ready for an inheritance. How many stories do we read about lottery winners who go through all their winnings and end up filing for bankruptcy? An inheritance of any size needs to be managed with care.

A spendthrift trust protects heirs by providing a trustee with the authority to control how the beneficiary can use the funds. A spendthrift trust works like a regular trust but includes special language indicating that the trust qualifies as a spendthrift trust and including limitations to the beneficiary’s control of the funds.

Even if you do not need to protect your child from themselves, a spendthrift trust also protects assets from others. For instance, it shields it from your child’s creditors because the assets are not considered legally your child’s. The trust owns the assets. This also protects the assets from divorces, lawsuits, and bankruptcies. It’s a good way to keep the money out of the hands of manipulative partners, family members, and friends.

Keep in mind, however, that once the money is paid from the trust, the protections are gone. However, while the money is in the trust, it enjoys protection.

The trustee in a spendthrift trust has a level of control that is granted by you, the grantor of the trust. You can stipulate that the trustee is to make a set payment to the beneficiary every month, or that the trustee decides how much money the beneficiary receives.

You can also direct that the trustee pay for things directly. For instance, if the money is to be used to pay college tuition, the trustee can write a check for tuition payments every semester, or they can put conditions on the heir’s academic performance and only pay the tuition if those conditions are met.

For a spendthrift trust, carefully consider who might be able to take on this task. Be realistic about family dynamics. A professional firm, bank, or investment company may be a better, less emotionally involved trustee than an aunt or uncle.

An estate planning attorney can advise you on creating an estate plan that fits your unique circumstances.

Reference: Kiplinger (June 5, 2019) “How to Keep Your Heirs from Blowing Their Inheritance.”