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Keep future options open with powers of appointment

One of the biggest challenges in estate planning is uncertainty over what the future will bring. It’s difficult to predict how changes in your family’s personal circumstances and financial needs will affect your estate plan. Fortunately, there are several tools that give your plan flexibility to react to changing situations. One of those tools is the power of appointment.

What's a power of appointment?

A power of appointment gives the “holder” of the power – often a beneficiary – the ability to decide how, when and to whom specified assets in a trust or estate will be distributed. Depending on its language, a power of appointment may allow the holder of the power to transfer assets during his or her lifetime (an inter vivos power of appointment) or at death through a will or trust (a testamentary power of appointment).

Powers of appointment may be general or limited, a critical distinction that carries significant tax implications. A general power of appointment gives the holder the right to transfer the assets in any way he or she sees fit. Thus, the holder can decide to keep the assets for him – or herself if so desired.

For this reason, assets subject to a general power of appointment are included in the holder’s taxable estate, regardless of whether the holder exercises the power. Consequently, such assets also would normally be subject to the claims of the holder’s creditors.

A limited power of appointment doesn’t allow the holder to transfer the assets to him- or herself. Typically, a limited power allows the holder to direct the assets to specific people or classes of people (the holder's children, for example). In some cases, the holder of a limited power may use it to benefit him – or herself, provided distributions are strictly limited based on “ascertainable standards” related to the holder’s health, education, maintenance or support.

For estate tax purposes, the holder of the limited power of appointment isn’t treated as the owner of the underlying assets. Thus, the assets aren't included in the holder's estate and aren’t subject to claims of the holder’s creditors.

What are the benefits?

The limited power of appointment is a versatile tool that can be used to accomplish a variety of estate planning goals. Let’s look at one scenario. Tom and Mary have two young children. Tom’s estate plan calls for his assets to be held in trust for Mary, with the trust income and, as necessary, principal going to Mary for life and the remaining assets divided equally between the children on Mary’s death. Tom’s plan also gives Mary a limited, testamentary power of appointment.

The power of appointment provides her with some flexibility to alter the distribution of the trust assets on her death depending on the children’s circumstances. For example:

These are just some of the many ways powers of appointment can be used to make an estate plan more flexible.

• If one of the children is financially independent, she might provide a larger percentage of the assets to the other child,

• If one child lacks the ability to effectively manage his or her finances, she could direct that child’s share into a trust that restricts his or her access to the funds, or

• If one child develops serious health problems, she could direct that a portion of the trust assets be placed in a special needs trust, which can be used to enhance the child’s quality of life without jeopardizing his or her eligibility for government benefits, such as Medicaid or Supplemental Security Income (SSI).

Be creative

With a little creativity, you can design powers of appointment to address a variety of estate planning issues. The powers can allow your family to make critical adjustments to your plan to reflect changing circumstances and needs.
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