You may have heard that it’s important to have an “estate plan.” But what exactly is an estate plan?
In short, an estate plan is a means by which a person makes clear their wishes for how they want their assets to be managed and distributed at death or if they become incapacitated during life. A basic estate plan typically includes the following types of documents:
- A will
- A revocable trust
- A financial power of attorney
- A health care power of attorney (known as a “health care proxy” in some states; it also may be part of an “advance directive”)
Let’s take a closer look at each of these to see what role they play and how they may help you and your family manage your legacy when the time comes.
What is a will?
A will (often called a Last Will and Testament) is a document executed by a person (the “testator”) during life that directs how, and to whom, their assets are to be distributed at death. The probate court of the state in which the person dies will “prove ” the will to ensure it is validly executed in accordance with that state’s laws. The court will also supervise the transfer of the testator’s probate assets. This means that a will is part of the public record; any nosy neighbor can go to the courthouse and see a copy of the will after the person dies.
Notably, a will only governs probate assets, or assets that were titled in the person’s name alone during life. A person’s will cannot direct distributions of assets that are held in trust, held jointly with right of survivorship with another person, or for which there is a valid, executed transfer on death or beneficiary designation (for example, life insurance or a retirement account). A will also typically nominates a personal representative (sometimes known as an executor) to administer the testator’s probate estate. A person’s will may also nominate guardians for any minor or otherwise incapacitated children.
(Learn more: What does it mean to be an executor?)
A person who dies with a will is said to have died “testate.” Conversely, a person who dies without a will is said to have died “intestate.” Each state has default rules that apply in cases of intestacy—effectively, the state has determined what most people would typically do with their property and assumes that the intestate person would have acted similarly.
These default rules do not always align with what a testator may have actually wanted to happen at death. For example, there may be a child that the testator wanted to disinherit, or a sibling who the testator felt needed more financial assistance. For this reason, it is important for a person to have a valid, executed will that distributes property in accordance with their wishes.
It may also be worth considering drafting a “letter of intent,” a non-legally binding document that is often used to provide additional context for the instructions in a will.
(Learn more: The role of a letter of intent in estate planning.)
What is a trust?
A trust is a fiduciary arrangement whereby a “grantor” or “settlor” gives assets to a “trustee” (which may be the grantor, another person, or an institution, depending on the type of trust and circumstances involved) to hold for the benefit of the grantor and/or others (“beneficiaries”). The trustee is required to manage and distribute the assets of the trust in accordance with the terms enumerated in the trust document.
A trust can be advantageous for many reasons. The top reasons to utilize a trust are privacy and probate avoidance, creditor protection for the grantor’s beneficiaries, to assist beneficiaries with management of trust property after the grantor’s death, and to protect assets from estate taxes. Unlike assets governed by a will, assets that are held by a trust during the grantor’s life avoid probate and allow the person’s assets, and how the assets are being distributed, to remain private. Only certain people (usually “qualified beneficiaries”) are entitled to see a copy of the trust document. Certain trusts can be used to minimize, or eliminate, a person’s estate tax at death and for other tax planning strategies.
(Learn more: What is the estate tax exemption?)
There are many different types of trusts that can be utilized to accomplish a person’s particular estate planning goals. Some trusts are revocable, allowing the grantor to modify or even terminate the trust. Other trusts are irrevocable, so the grantor generally cannot modify the trust terms after the trust has been executed. Some trusts are used to minimize or eliminate a person’s federal (and/or state) estate tax on death, such as marital trusts, bypass (or “credit shelter”) trusts, spousal lifetime access trusts (SLATs), qualified personal residence trusts (QPRTs), and irrevocable life insurance trusts (ILITs). Other trusts are used to provide a person with an income tax deduction and benefit both the grantor (or others) and charity, such as charitable lead trusts and charitable remainder trusts.
(Learn more: How trusts may fit into your estate plan.)
What is a power of attorney?
A financial power of attorney is a legal document that allows a person (the “principal”) to delegate to another person (the “agent”) the authority to manage and to make decisions with respect to the principal’s property and finances.
The agent can sign checks and tax returns, enter contracts, buy or sell property, deposit or withdraw funds to/from a principal’s account, manage the principal’s business, and more. The agent can do just about anything the principal could have done (provided it is authorized in the power of attorney document or by state law). This tends to be advantageous when a person becomes incapacitated or even just when a person travels or lives in multiple places.
A durable power of attorney can be either effective when executed or "springing." A springing power of attorney is effective only after the principal is determined to be incapacitated or on the happening of some other event as defined in the power of attorney. Whether effective when executed or "springing," a durable power of attorney is effective until it is revoked by the principal or until the principal passes away, and it allows an agent to act while the principal is incapacitated.
A practical note, however, would be to ensure in advance that a financial institution will accept the power. Many financial institutions have their own rules for durable powers of attorney, requiring special "medallion" signatures and/or their own forms, among other requirements or hurdles designed to prevent fraud. Understanding this in advance can prevent undue frustration in the event the power needs to be used.
What is a health care proxy?
A health care proxy, sometimes referred to as a durable power of attorney for health care, is a legal document that allows a person (the “principal”) to delegate to another person (the “agent”) the authority to make health care decisions on behalf of the principal if the principal is unable to make or communicate the health care decisions themselves. Depending on the state, a health care proxy may be part of or in addition to an advance directive such as a living will. If applicable, an advance directive would relay the principal’s wishes around certain aspects of health care. Depending on the state, an advance directive may or may not be binding.
While it’s important to have powers of attorney and health care proxies for yourself and your partner, you may also want to encourage any unmarried, adult children to have these documents prepared. Without these documents, if an adult child becomes incapacitated, a conservator and guardian will need to be appointed for them through the court system—an expensive, time-consuming, and avoidable process. In particular, in the absence of a health care proxy or guardianship for an incapacitated adult child, time-sensitive determinations about the child’s care and treatment may be left up to the medical institution in which they are hospitalized.
(Learn more: Health care proxies for adult children.)
Every estate plan is different
There is no one-size-fits-all estate plan, and plans are likely to change over time as family members die, are born, or reach the age of majority, as assets are acquired or sold, and as other situations change. An estate plan is customized to take into account, among other things, family dynamics, the value of the individual’s (and their spouse’s) assets, how the individual wants assets managed during life and at death, whether the individual wants to avoid probate at death, and income, estate, and gift tax planning. Consequently, it is critical that individuals are advised to seek professional legal, financial, and tax guidance when crafting an estate plan.