WEALTH: Financial & Lifestyle Perspective from Northern Trust - Fall 2007

Whether you've chosen not to marry for personal reasons or because you're in a relationship the law doesn't acknowledge, carefully crafting your estate plan is critical. Without the protection offered by law to married couples, you need a plan to ensure that your assets are transferred without being subject to undue taxes.

Estate planning can be complex enough in a traditional family situation, requiring thought and input from skilled professionals to ensure the plan accomplishes your goals. But if you share your life with a partner to whom you are not married, your need to engage in careful estate planning is even greater. Without it, you may leave your family facing strife and unanticipated pitfalls.

Few Legal Protections
Approximately 60% of Americans die without a will, according to the American Bar Association. While married couples are afforded some protection under the law, unmarried couples generally have no more connection than strangers under federal and state legislation.

Although some states are enacting
legislation that recognizes the rights of cohabitants and same-sex partnerships, the existing laws generally continue to favor married couples. While marriage allows couples to transfer property and gifts to each other tax-free, and defer estate taxes on any property passed between them until the death of the second spouse, unmarried couples don’t have those protections. As a result, if you and your partner are not married, you could face substantial tax bills for the same transfers.

In addition, if you die without a will, state law will typically transfer your assets to a member of your immediate family. As a result, your partner could be left with nothing.

Nevertheless, remaining unmarried — for whatever reason — does not mean you and your partner cannot protect yourselves financially. Through careful planning and use of the gift and estate tax exemptions, you can make sure your assets are distributed according to your wishes, without being subject to unnecessary taxes.

Get Informed, Stay Organized
Many unmarried couples don’t realize the disparity between the rules for married and unmarried couples until it’s too late. This is a growing problem, as there are more unmarried couples in the United States today than ever before — roughly 5.5 million, according to the U.S. Census Bureau.

“I’m sure most unmarried couples are confused and misinformed. But the good thing is there are many ways they can protect their assets and each other,” says Stephan Leimberg, chief executive officer of the estate and financial planning software company Leimberg & LeClair. “They just have to work a little harder to do it.”

While everyone should have a will, it’s crucial for unmarried couples. You need to be very specific about how you want your assets distributed to avoid family conflict.

Leimberg, who wrote The Tools & Techniques of Estate Planning, says unmarried couples should start by making a list of what they own. The lists often are longer and more complicated than people anticipate, he says.

Next, you need to consider carefully how these items should be divided — particularly items that may have sentimental value. This can become complex if either of you have children from previous relationships. When you’ve decided how you would like your assets to be distributed after your death, work with a skilled estate planning attorney to integrate your wishes into your estate planning documents. This also can help minimize conflict in the case of a death.

Ownership Complexities
Because your house is a substantial asset, you want to consider how to best ensure your partner retains sole ownership after your death. You can employ several strategies to accomplish this, each with its own gift and estate tax consequences.

Joint ownership with rights of survivorship is one of the most popular choices used by unmarried couples. Under this arrangement, ownership of the entire property automatically transfers to the surviving partner.

Michelle McClaine and her partner Fred Pearson chose this option when they recently bought a home together in New York. “We just bought an apartment, and that put a lot of things into perspective for us,” says McClaine, a restructuring lawyer. “We had to ensure that we both took title to the property so that if something happens to me, Fred would get total ownership of the property.”

If only one partner contributes toward the purchase of the home, or contributes more than the other partner, a joint ownership arrangement may be subject to gift taxes. Lucy Tearman discovered this when she and her partner bought their first home together. “Because my income is substantially higher, we decided I would purchase the house,” explained Tearman of the $1.3 million home she purchased last year.

“We thought we had been very careful in our planning — we have the title in both our names as joint tenants, with right of survivorship,” says Tearman. “We were very surprised when our accountant told us I made a $650,000 gift to [my partner] with the purchase.”

Also, joint ownership does not address the estate tax issues the surviving partner will face. Without the unlimited spousal transfers allowed for married couples, the value of the property transferred (half of the home’s value) will be subject to estate taxes. As a result, your partner could face a substantial estate tax bill.

An alternative approach is tenancy-in-common in conjunction with a living trust. The advantages of this approach are twofold: your share of the property will pass to your partner (if specified in your trust), and you can own unequal interests in the property. For example, you can own just 30% of the property but become the sole owner when your partner dies.

Give and Receive
Developing a strategy for giving to your partner will allow you to take advantage of tax benefits now and in the future.

For 2007, the first $12,000 of gifts to any person — other than gifts of future interests in property — are not included in the total amount of taxable gifts made during that year, and the recipient will not owe income tax on the gift amount.

Current rules grant you a lifetime gift tax exemption of $1 million, and you don’t use up any of this total until gifts to one person in a single year exceed the annual exclusion amount. Only the amount that exceeds the $12,000 limit will count toward your lifetime limit.

The law currently allows individuals to exclude the first $2 million of an estate from the estate tax return. That exclusion total will rise to $3.5 million in 2009. However, it’s important to note that amounts you use from your lifetime gift tax exclusion count against the total you can exclude from estate taxes. For 2007, assets within your estate will be taxed at a 45% rate. It’s important to consider gift and estate taxes on an annual basis, while keeping the long-term picture in mind as well.

Be Aware of Gift Tax Rules
Although you may see your assets as belonging equally to you and your partner, the tax law sees the situation differently. As a result, gifts to your partner — including payments for household expenses — are limited to $12,000 per year. You must file a federal gift tax return for anything above that amount, which reduces your $1 million lifetime gift tax exemption.

To avoid inadvertently making gifts to your partner, it is important for each of you to keep records of your contributions to the household and any joint accounts you may have. If you have a significantly higher income than your partner, you may want to take advantage of certain unlimited exclusions, such as those for direct payments of medical care or tuition.

You also can use the gift tax rules to your advantage, particularly if you have significantly more wealth than your partner. In this situation, making annual gifts and taking advantage of your lifetime exemption may be the best financial option for your relationship, says Loretta Nolan, an estate planner with Loretta Nolan, LLC in Old Greenwich, Conn. Transferring assets while you are both living often makes sense because it reduces the portion of your estate that will later be subject to estate taxes, Nolan says.

New IRA Rollover Rules
If either of you has a substantial amount invested in a qualified retirement plan, you will want to take advantage of an exciting new planning option available starting this year for “nonspousal beneficiaries.” Thanks to new IRA rollover rules, a nonspousal beneficiary can set up an IRA to receive a tax-free rollover from an inherited qualified retirement plan. This will allow the surviving partner to take withdrawals (and pay the associated income taxes) over his or her life expectancy (as determined by IRS rules), rather than receive the money in a lump sum.

Keep Your Plan in Focus
Once all of the planning is complete, get ready to do it again a year or two later. Michael Musgrave of Chicago updates his will and other estate planning documents annually to address new assets and any other changes in order to protect his partner.

Recently retired from his family’s manufacturing business, Musgrave, 42, began planning his estate in his late 20s after witnessing bitter squabbles over his father’s estate.

“It’s a difficult issue dealing with mortality but I have to say that when I first sat down and did it, I felt such relief,” Musgrave says. “It’s amazing how little people know about what will happen to their estate unless they make their wishes known. If you want to protect a loved one, it’s a task you must undertake.”

Vital Power of Attorney
One tool unmarried couples often overlook is the power of attorney. You should create a power of attorney for both financial decisions and medical decisions, says Wendy Goffe, an estate planner with Graham & Dunn, a Seattle-based law firm, and co-author of Estate and Charitable Gift Planning for Unmarried Couples. Powers of attorney become important if one partner becomes incapacitated by illness or otherwise unfit to make his or her own decisions. Because you are afforded no more rights than strangers under law, without a power of attorney you will have no say in your partner’s care.

“It’s important to have the legal documents that ensure your wishes are followed in the event you are no longer able to make your own decisions,” says Goffe, noting that she has seen cases in which an individual’s parent tries to take over the process and starts making decisions that go against that person’s wishes. “Things can get ugly fast,” Goffe says.