There are six types of assets that are considered “non-probate assets.” These can bypass the cumbersome probate process, saving both time and money. They are:
- Brokerage or bank accounts held in joint tenancy, or with a transfer-on-death (TOD) or payable-on-death (POD) beneficiary
- Retirement accounts (e.g. 401k, IRA)
- Life insurance policies with a 3rd party beneficiary
- Real or personal property held in a trust
- Real property held in joint tenancy or as tenants by the entirety
When someone passes away, any bank or brokerage accounts held with a joint owner with rights of survivorship or as tenants by the entirety can pass to the joint owner without going through probate. Most financial institutions only require attaching a death certificate to a form to initiate the process, which is significantly easier than transferring ownership through probate. However, while joint accounts can avoid probate, they can give rise to other complications that are worth considering.
This is arguably the greatest risk with a joint account, and much of the time the mistake is made involuntarily. If an aging parent adds an adult child to their account as a joint owner but does not add other heirs to the joint account, then only the joint owner can take over the account at the time of death. Even if the decedent leaves instructions to disperse the account amongst the heirs, non-probate assets supersede the will and would not be subject to the will’s directives. To make matters more difficult, if the joint owner agreed to liquidate the account and disperse the funds between the heirs indicated in the will, then the joint owner may be subject to gift tax limitations, and would only be able to transfer $14,000 per person in a single year.
The best way to prevent this from happening is to list all the heirs on the account as either transfer-on-death (TOD) or payable-on-death (POD) beneficiaries. Most financial institutions also allow you to list contingent beneficiaries, in case the primary beneficiaries die before the account owner.
Income Tax Consequences
Most people understand that taking full ownership of a joint account entails taking on the income tax burden for the account. From the day the account is transferred, the joint owner is responsible for paying taxes on any income generated by the account.
What many fail to realize is the responsibility for income taxes during the year the deceased (known as the decedent) passed away. This isn’t an issue for a surviving spouse who files income taxes jointly, but for spouses who file income taxes separately, or for adult children or other family members who take over the account, taxes are still due for the decedent for a portion of their final tax year. For example, if an individual passes away on July 1 and a joint brokerage account transfers into the joint owner’s name, the income generated by the account for the first half of the year will need to be included in the decedent’s final tax return. Income generated by the account after July 1 will be reported on the joint owner’s income tax return for the same year.
The decedent’s income tax obligations should be itemized during the probate process. Before liquidating any assets from the joint account, it would be wise to consult with a tax professional to evaluate any potential income tax burdens. The decedent can also prepare for this in advance by indicating in the will which funds/assets should be used to cover their final income tax return.
Estate Tax Consequences
If the surviving joint owner is not a spouse, then the fair market value of the entire account will be included in the decedent’s estate. If the surviving joint owner is the surviving spouse, then only 50% of the fair market value is included in the value of the decedent’s estate.
The decedent’s will should determine how any applicable estate taxes are paid for, and whether proceeds from the joint account are required to pay for a portion of the estate tax. It’s common practice to use a life insurance death benefit to cover liabilities such as an applicable estate tax, funeral costs, etc., so that the joint account owner does not need to use funds from the joint account to cover those costs. If the decedent did not leave a will, then the state will determine if funds from the joint account are required to pay an estate tax obligation.
Spouses are free to transfer and share funds between themselves, but if an account owner adds another joint owner such as a child or other relative, and the new owner doesn’t contribute money to the account, the IRS may consider that a gift. If the value of the account exceeds the annual gift tax exclusion of $14,000, then you are required to file a gift tax return with the IRS.
Utilizing transfer-on-death or payable-on-death beneficiaries can circumvent this issue. While funds transferred to the beneficiaries will still be included in the decedent’s estate for inheritance tax calculations, the funds will bypass probate and would not require filing a gift tax return.
In the event the joint owner is a minor and the account is intended to be used for the minor’s benefit, you’ll need to establish a court-supervised guardianship or conservatorship. To circumvent that, many people set up a revocable living trust. If the account is titled in the trust’s name, it can be used for the benefit of the minor without the hassle of guardianship or conservatorship.
If the decedent is subject to a lawsuit and the court imposes a judgement lien, the funds in the joint account may be liable, either in portion or in entirety. The only way to shield assets from liability would be to purchase liability insurance or place the exposed assets into a revocable trust before the decedent passes away.
Inheriting The Decedent’s Debt
It’s a common misconception that the joint owner automatically inherits the decedent’s debt when taking over the account. If you are a surviving spouse, or if you cosigned for the debt, then you are responsible for the debt; otherwise, no debt obligations are transferred with the account. Instead, creditors will make claims against the decedent’s estate through the probate process.