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5 estate planning terms you need to know

June 09, 2009

Everyone knows it's important to have a solid financial plan to manage your assets. But it's equally important to have a good estate plan so that your heirs are taken care of when you're no longer around.

"Most individuals consider estate planning to be about who gets the money, but it really encompasses much more," says Liza Kester, a senior advisor with Vanguard® Financial Planning Services.

Estate planning is a way to manage and safeguard your assets while you are alive and to conserve and control their distribution after your death, says Ms. Kester. It also allows you to determine how much medical intervention you want while alive and who should make health care decisions for you when you're not able to.

The task of setting up an estate plan can be daunting, but understanding just a few terms can get you started on ensuring a secure future for you and your loved ones:

1. Will

A will is the legal document that directs the distribution of your probate assets after you die. If you have children, a will is a must to ensure that your wishes regarding their care and inheritance are followed. In the absence of a will, state law will govern the distribution of your probate assets for you.

Common misconception: A will is the only document you need.

A will is very important, but it does not cover all assets—some assets pass by contract or by operation of law. For example, beneficiaries named on life insurance contracts or retirement accounts such as IRAs overrule the directions in your will. Assets that are owned by more than one person, such as joint mutual fund accounts or a home, also overrule what's in your will and by law transfer to the surviving joint owner(s). To make sure all your assets are distributed as you wish, make sure these beneficiary designations and the titling of your property work together with your will.

2. Living will

A living will is a written expression of your wishes concerning life-support procedures. Stephani Smith, a Vanguard principal, recommends having your family on board with your medical plans. Also consider getting a durable power of attorney and health care proxy, which, respectively, allow you to delegate decisions regarding property and health care to someone who will work on your behalf if you become incapacitated. Be sure to discuss your intentions so he or she follows your instructions—even if those instructions differ from what your representative might choose for you.

Common misconception: A living will is ironclad.

Although a living will is a binding agreement, it is not always the final word. "People need to realize that living wills don't always work as anticipated. The hospital might not enforce your wishes if there is any doubt about the authenticity of the document," says Ms. Smith. Also, your living will might not cover the particular medical situation you experience.

3. Beneficiaries

Beneficiaries are those individuals whom you have designated to receive certain assets such as IRAs, 401(k) plans, insurance policies, and annuities. Your primary beneficiaries receive your assets first; secondary beneficiaries usually receive them only if there are no remaining primaries.

Common misconception: You can name a beneficiary to inherit real estate.

Beneficiary designations may overrule instructions left in wills, but they don't trump names written on a deed. That's because real estate generally transfers by law according to how property is titled on a deed; in most states, you cannot name a beneficiary in a deed to receive real estate, says Ms. Kester. "If you write in your will that you want your sister to have your house, her rights will be enforced through the probate process," she says. To avoid confusion, court dates, and costs, one potential alternative is to set up a trust and title the real estate in the name of the trust; the property will then be distributed according to the trust’s terms.

4. Living trust

A living trust is established while you are alive. At your death, any assets in the living trust do not have to go through probate, but pass as you've stated in your trust document.

Common misconception: A trust's primary purpose is to reduce taxes.

"People mistakenly think this, but the trust's most important role is to control your assets," says Ms. Smith.

5. Probate

Probate is the process by which a court determines the validity of a will, if any, and authorizes the executor named in the will (or if no will, appoints one or more personal representatives) of an estate. In current usage, the term has been expanded to include the entire probate process such as collecting a decedent's assets, paying necessary taxes and other expenses, and ensuring the transfer of assets to the legally entitled beneficiaries.

Common misconception: You'll avoid probate even if you forgot to name beneficiaries.

According to Ms. Smith, most people don't know when probate applies and when it doesn't. "For example, trust assets and assets that have a beneficiary designation [such as an IRA or a 401(k) plan] don't go through probate. But if you forget to put a beneficiary designation on your IRA or if you indicate that your 'estate' is your beneficiary, then the asset will most likely go through probate."

In conclusion

Regardless of the size of your estate, you need to know what your assets are and what you want to do with them. Make sure you title your assets properly and understand the hierarchy of your beneficiary designations. Your will should state what you want to do with assets that don't pass by operation of law or to designated beneficiaries. Most important, consult an estate-planning attorney and read our helpful guide on estate planning.

Notes:

  • All investments are subject to risk.
  • Vanguard Financial Planning Services are provided by Vanguard Advisers, Inc., a registered investment advisor.
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