The estate-planning process should be an integral part of everyone's financial plan. The benefits are obvious, including tax savings, efficient disposition of assets, end-of-life decisions, financial security for heirs and general peace of mind.
For married couples, the planning rules are fairly straightforward. For unmarried couples, however, whether same-sex or opposite-sex, the issues concerning financial and estate planning are often quite complex, and the rules cumbersome. This article will highlight some key planning strategies that unmarried couples should consider in order to protect both partners. (To keep reading on this subject, see Marriage, Divorce And The Dotted Line, The Tax Benefits Of Having A Spouse and Relationship Money Matters.)
Background Statistics On Unmarried Couples
According to the 2000 U.S. Census Bureau, it is estimated that there are more than 5.5 million unmarried couples living together in the U.S., up from 3.2 million in 1990. Of the 5.5 million, it is estimated that 600,000 are same-sex couples, who for the most part can't get hitched even if they wanted to.
For the increasing number of couples unable to or unwilling to get married, financial planning is crucial to avoid unpleasant surprises. After all, when it comes to taxes and other financial benefits, we live in a society that provides benefits to those who wed and punishes those who don't. Until the system changes, here are a few tips you can use to protect not only yourself but your loved one as well in these four areas of your personal finance:
1. Account And Property Titling
The legal ownership of property or accounts can affect how they are distributed in the event of the owner's death. Each type has its own benefits and drawbacks.
- Tenants in Common
Tenants in common allows ownership of property by multiple parties with varying percentages of ownership. Upon the sale of the property or asset each party receives their specific share of the proceeds. Similarly, when a tenants-in-common owner dies, their percentage of ownership becomes part of their estate. If there is a will in place the property will pass to the heirs listed in the will. In the event that there is no will, the property, asset or account will be distributed in accordance with the rules in the deceased's state of residence.
Unless your intent is to leave the asset to someone other than your partner, this is not a good option for unmarried couples. If however, your intent is to distribute the bulk of your assets to someone other than your partner, then this may be a good choice.
- Joint Tenants With Right of Survivorship (JTWROS)
JTWROS is one of the best forms of ownership for unmarried couples. The main difference from owning assets as tenants in common is that with JTWROS the property or asset must be split 50/50 between the owners. When one of the owners dies, the property automatically transfers to the surviving owner.
It is important to caution readers that assets must read "with rights of survivorship"; in the absence of this wording the ownership of the asset or property will be deemed to be owned as tenants-in-common. The other important consideration when titling assets as JTWROS is that the order in which the asset, property or account is titled is important. Income, gains and losses will be reported under the Social Security number (SSN) of the first owner. This can prove advantageous when it comes to tax planning if one of the owners is in a significantly lower tax bracket. On the other hand, the owner with the higher tax bracket could use the deductions when filing their taxes.
It is important to note that while it is pretty straightforward to own property titled JTWROS, the Internal Revenue Service will take the entire value of the asset and include it in the gross value of the estate of the first person to die, unless the surviving partner can prove that he/she made contributions to the asset. Therefore, accurate record keeping and paper trails are critical. This is not always easy to do, and it may also create a potential for major federal - and estate-tax liability for the surviving partner if the estate exceeds the federal respective exclusion amount per individual. (For more information on JTWROS, read The Benefits And Pitfalls Of Joint Tenancy.)
A trust is another option for owning property. Each individual can create a trust and place his/her individual assets inside that trust. The trust will spell out the legalities of what would happen if the trustee (the owner of the trust) dies, becomes disabled or becomes unable to transact on his/her own behalf. The owner of the trust can designate his/her partner as the successor trustee allowing the partner to manage the couple's affairs. (To learn about the basic types and components of trusts, read Pick The Perfect Trust.)
While setting up a trust can be costly, it may make sense if you have significant assets and would like to protect not only your partner but other family members. For example, you may wish to take care of your partner when you die, but after your partner dies you would like other family members to receive the remainder of your assets. It is important to note that assets and accounts must have the trust named as the beneficiary or be titled in the name of the trust.
A trust is sometimes the best vehicle for non-married couples to use since a trust generally can withstand the challenges brought on by family members better than probate. (For tips on navigating the probate process, read Skipping Out On Probate Costs.)
2. Retirement Plans
Unmarried couples have to take special care to ensure that the right person receives retirement benefits and that they are not subject to avoidable taxes.
- Beneficiary Designations
To ensure that your partner receives the assets from your retirement accounts (IRA, 401(k), 403(b), pension plan, etc.) you must fill out a formal beneficiary designation form with the administrator of the retirement plan. Just as important as having a beneficiary designation is keeping your beneficiary designation up to date. More times than not, people forget to update their beneficiary designation and the wrong person receives the money - and, in such a case, there is nothing your partner can do about it.
A beneficiary designation takes precedence over any will. The same holds true for life insurance policies, so make sure you update the beneficiary of those policies as well. (For more on the importance of choosing a beneficiary, read Don't Forget The Beneficiary Form.)
- Rollover/Distribution Options
As a non-spouse beneficiary of a retirement plan you have few options when it comes to distributing the assets from a retirement plan. Don't assume that in the event of your death your company will allow your partner to roll over the assets into an IRA. In many cases companies discriminate against unmarried couples by forcing the non-spouse beneficiary to take a taxable lump-sum distribution of the entire amount. This, as you can imagine, will eat away a lot of the balance, and you will not have the ability to stretch out the account. Surviving spouses can rollover the entire balance into an IRA that doesn't have to be tapped until age 70.5.
This is one of the reasons why you should consider rolling over the balance of the retirement account into an IRA when you leave an employer. If you do this, you can name your partner as beneficiary of the account without worrying that your partner will be forced to distribute the balance of the account as a taxable lump-sum distribution.
- Legislative Impact of the Pension Protection Act
The Pension Protection Act of 2006, commonly known as the PPA, amended many rules relating to IRAs and pension plans, including the rule that allows retirement plans to roll over corporate retirement-plan funds directly into a Roth IRA. One of the most significant changes the PPA made is that non-spouse participants now have the ability to roll over the inherited retirement-plan assets into an inherited Roth IRA, something that they were not able to do before. This is significant because beneficiaries cannot convert inherited Traditional-IRA funds into a Roth, but they can now convert inherited retirement-plan assets into an inherited Roth.
In order for the non-spouse beneficiary to take advantage of the Roth IRA, a direct transfer is necessary. If the beneficiary receives the distribution (a 60-day rollover), then they will not be able to rollover those assets to any inherited IRA, whether Traditional or Roth. Not only that, but the beneficiary will owe taxes on the distribution and will miss out on the ability to stretch out the account. Again, this is why it so critical for the plan participant or beneficiary to request a direct rollover or trustee-to-trustee transfer.
But before you attempt to rollover the funds into a Roth IRA, you should make sure that the employer plan allows non-spouse beneficiary rollovers into an inherited IRA - a lot of plans do not. If they do, some restrictions still apply. Here are two of the major ones:
- The beneficiary is subject to the same adjusted gross income (AGI) and marital restrictions as any other owner converting IRA funds into a Roth, but only for 2008-2009.
- If the beneficiary does the conversion from the employer plan, they will have to pay the taxes upfront and will not have the ability to defer distributions and taxes over his/her lifetime. This really limits the tax-free compounding benefit of this type of account.
3. Life Insurance
Insurance is especially important for unmarried couples because they are not afforded the same legal protection as their married counterparts. They are not entitled to receive Social Security survivor's benefits or corporate pensions. Life insurance is a great way to protect your partner by providing them with income substitution when you die, and also with assets to cover any potential inheritance tax they may have to pay as a result of receiving your assets.
It is important to shop around with different companies since some insurance carriers make it difficult for unmarried partners to designate each other as beneficiaries of life insurance. They will question whether a nonfamily member has an economic or "insurable interest" in the life of the insured. If the couple owns a home together and carries joint debt (ex. a mortgage), then this issue can usually be overcome. (To learn more about insurable interest and other insurance concepts, read Understand Your Insurance Contract.)
Irrevocable Life Insurance Trust
An irrevocable life insurance trust (ILIT) is an irrevocable trust created for the purpose of owning a life insurance policy. Just like with any other trust, the insurance trust is a contract between a grantor and a trustee to administer certain property, in this case an insurance contract, for the benefit of the beneficiaries. The caveat with this type of trust is that once the grantor contributes property to the trust, they cannot later reclaim ownership of the property or change the terms of the trust.
Estate-tax considerations are the biggest reasons for creating this type of trust. If an ILIT is properly structured, the death benefits paid to the trust will be free from inclusion in the gross estate of the insured. In order for this planning to be valid, the grantor must live three years from the time of the policy transfer, otherwise the policy proceeds will not be excluded from the grantor's estate. (For more on how life insurance can help you save on taxes, read Cut Your Tax Bill With Permanent Life Insurance.)
4. Wills, Healthcare and Power of Attorney
The following are also important documents unmarried couples should have to protect each other in the event of health, disability and death:
A will helps unmarried partners provide for a partner or other loved ones. A will details how you wish your assets to be distributed after you die. This does not include pension accounts, IRAs or life insurance. Remember that these are distributed according to what the beneficiary-designation form says. It is important to note that a will can be contested in court by family members which could end up leaving your surviving partner without property.
- Healthcare Directives
A durable power of attorney for healthcare (or a healthcare proxy) is one of the most important documents you can have. This document will specify the individual or individuals who can make healthcare decisions for you if you can't make them for yourself. If something happens to you and you do not have this document, your partner will be left out when making decisions about your healthcare at a hospital. Unmarried partners may even be denied visitations since they are technically not family.
- Living Will
Along with a healthcare directive, you should also have a living will documenting the circumstances under which you do or do not want your life prolonged. You should discuss this sensitive issue with your partner in advance and have the document drafted so it outlines the details of your wishes.
- Financial Power of Attorney
A financial power of attorney is important so your partner or another person can make financial decisions on your behalf. This document will dictate how the person is to make decisions when managing your financial affairs.
When it comes to powers of attorney, just because you have one does not mean that it covers both healthcare and financial decisions, unless it specifically says so. This is not a concern for married couples since they automatically have the right to make decisions for each other based in the legal system. (For more on the importance of these documents, read Six Estate Planning Must-Haves and Three Documents You Shouldn't Do Without.)
As the number of couples deciding not to tie the knot (and same-sex couples who cannot) increases, it is important that these couples understand how important it is to plan for unexpected events. The laws and tax system do not offer the same types of protections and benefits afforded to those who marry; therefore, if they are in a long-term committed relationship they need to take action to avoid expensive and unpleasant surprises. Because some laws vary from state to state and the issues are often very complex, especially when it comes to estate planning, couples should invest the time and money to visit a financial planner or estate planning attorney that specializes in unmarried couples to help them achieve their goals.