Establishing a trust or will is vital to a well-designed estate plan; you might even use both. However, even the best estate plans can’t anticipate changes in the future or head off new tax legislation. Fortunately, a power of appointment can help your beneficiary take control of your estate to minimize taxes and keep the property from falling into the wrong hands. Here’s how it works.
Consider working with a financial advisor if you need help setting up an estate plan or managing inherited money.
What Is a Power of Appointment?
A power of appointment is an ability a grantee or beneficiary receives from the grantor or creator of a trust. The power of appointment allows the beneficiary to change a trust in specific ways in specific contexts. For example, a grandparent might place his or her assets in a trust and give their grandchildren the power of appointment over the trust once the grandparent passes away.
In addition, a power of appointment affects irrevocable trusts – which, as the name implies, are not easy to change. Fortunately, a power of appointment means beneficiaries can modify a trust within the boundaries the trust’s creator sets.
Types of Powers of Appointment
There are two types of powers of appointment: general and limited. General power of appointment allows the appointed individual to change and direct the trust however he or she wishes. In essence, a general power of appointment gives over complete control of the trust, and the person who has that power can allocate the trust’s assets how that person sees fit.
On the other hand, a limited or special power of appointment has boundaries the holders must follow.
Powers of Appointment and Ownership
Depending on appointment type and state law, powers of appointment have varying effects on ownership. For example, your state’s laws may allow you to immediately own property within the trust as the holder of a general power of appointment. However, such ownership also exposes the property to your creditors.
Therefore, if you’re in debt or serious financial trouble, the ownership you receive through a power of appointment could mean losing the property altogether. That said, state law may prohibit creditors from seizing the property until the power holder dies. On the other hand, a limited power of appointment typically doesn’t grant property ownership.
Power of Appointment Tax Treatment
A power of appointment can affect your tax circumstances, even if you don’t exercise the power. Specifically, tax law declares that a general power of appointment designated after Oct. 21, 1942, will add the related trust’s value to the power holder’s estate upon that person’s death. As a result, a general power of appointment usually exposes a trust to federal estate taxes.
In contrast, a limited power of appointment doesn’t create tax implications. The exception to this rule is if the power holder creates another power of appointment granting themselves greater control of the trust.
In addition, a general power of appointment creates gift tax implications. Specifically, unless the transferred property from a trust is less than $5,000 or 5% (whichever is higher) of the trust’s total value, the government will apply the gift tax to said property.
Income taxes also come into play with a general power of appointment. If the trust becomes part of the power holder’s estate, the power holder’s death triggers a reassessment of the trust’s property. If the property appreciates, it steps up to the current market value. On the other hand, if it depreciates, it steps down to a lower value.
Lastly, if a power of appointment enables the beneficiary to take the property, they may receive income taxes according to its value.
Powers of Appointment Key Considerations
While there are a number of factors to evaluate as you make decisions about power of appointment, there are three that are particularly important.
Creating Boundaries in Volatile Situations
Let’s say John and Sue are married, and they have three children together. John dies and leaves his estate to Sue with a limited power of appointment. Sue will receive income from the trust while she is alive, and the trust will be split three ways to the children after she passes away.
Unfortunately, the youngest child has been hiding a gambling addiction that only comes to light after John passes away. So, Sue uses her limited power of appointment to amend the trust’s conditions. She changes the trust so it will pay for the youngest’s child’s basic needs and addiction recovery.
In addition, she creates a limited power of appointment for her oldest child to continue managing the trust after she is gone. This way, she preserves the trust’s stability and ensures the youngest child won’t squander the wealth.
Caring for Special Needs
With the same scenario in mind, let’s say the middle child has a child with special needs. The child (Sue’s grandchild) will need continuous support from paid caregivers. The trust can provide for some of the grandchild’s needs, but a transfer of wealth could disqualify him from governmental assistance.
As a result, Sue structures the trust so it pays solely for what government assistance doesn’t cover. Plus, she modifies the trust to continue paying for non-covered care, items, etc., after she passes away. Lastly, she specifies who will gain the power of appointment if more grandchildren are born later.
Allocating Wealth for Grandchildren
Continuing with the example, let’s say the oldest child is a high-net-worth individual who doesn’t need wealth from the trust. In fact, receiving money from the trust would only cause hefty tax rates because the oldest child is in the highest tax bracket.
Additionally, the oldest child has two children after the first grandchild arrives. Therefore, Sue modifies the trust to split the oldest child’s portion for the two grandchildren instead.
Tax Planning Considerations
Fortunately, a limited power of appointment can direct property worth just under the limit to follow tax exemption laws. In addition, it can prioritize transferring assets with the highest capital gains to transfer them while incurring no taxes. You may need to designate a trustee to carry out the calculations necessary to make these allocations possible.
The Bottom Line
A power of appointment can help preserve and distribute your family’s wealth in specific ways. However, a thorough plan and intentional verbiage are key to making one work correctly. In addition, it’s crucial that the power of appointment complies with state laws so it works as intended. Therefore, consulting an estate planning professional or tax attorney can help tremendously when setting up a power of appointment for your beneficiaries.
Estate Planning Tips
- A power of appointment is a complex financial tool that must follow state laws to be effective. A financial advisor can help you ensure the power of appointment will have the desired effect after you pass away. Luckily, finding the right financial advisor doesn’t have to be hard. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- A power of appointment impacts trusts and wills. But how do trusts and wills function in an estate plan? Here are the key differences to help you tell which one you need.
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