Table of Contents
Proper estate planning can help to increase the size of your estate, whether large or small. Its basic purposes are to (1) choose how your property will be distributed after your death, (2) help assure that your property will be distributed in an orderly and efficient way and (3) minimize taxes.
This Financial Guide gives you a roadmap to the estate planning process. It will help you to get started: to provide for your heirs, to lessen the administrative burden on your survivors, and to understand what you'll have to do to minimize estate and income taxes. It will enable you to approach your attorney and other professional advisors with a clearer idea of what the process should entail.
What is your "estate?" Simply stated, it includes everything you own at your death minus your debts. However, some rather tricky rules apply, which may bring back into your estate assets you've given away, or thought you'd given away.
Most estates do not need to pay the federal estate tax, in many cases because you can leave an unlimited amount to a surviving spouse without having it being subjected to federal estate tax (i.e., the bequest provides a marital deduction). And in 2010, the estate tax was repealed--but just for that year. In 2015, there is an exemption of $5,430,000 (up from $5,340,000 in 2014) per individual before the federal estate tax kicks in. State inheritance taxes, which vary from state to state, must also be considered in addition to federal estate tax.
In addition to the two primary estate planning tools, wills, and trusts, there are other essential tools you should consider such as:
The 2001 Tax Relief Act repeals the federal estate tax in one of the most confusing tax measures ever enacted. The law reduced the overall estate tax burden over the years 2002-2009 until it was repealed in 2010, and then reinstated on January 1, 2011. This revival of the estate tax came about because of a sunset provision that voids all provisions of the 2001 Act, effective 1/1/11. The sunset provision was considered a practical necessity under the parliamentary moves-limited Senate debate and amendments-adopted to put the 2001 Act on a fast track to enactment. There have been other tax sunsets, with less sweeping consequences. As a result, the federal estate tax was repealed only for those dying during the calendar year 2010.
States had death taxes long before there was a federal estate tax, but today, many state death taxes are loosely based on the federal estate tax model. In some cases, the amount subject to the state death tax falls as the amount subject to federal estate tax falls (absent further state action. In other states, death taxes are of the federal tax and apply whether or not a federal tax applies. Maine and Connecticut, for example, all have exemptions of $2 million and Oregon, and the District of Columbia have exemptions of $1 million, whereas the basic exclusion amount for federal estate tax is $5,430,000 in 2015.
Gift tax. The lifetime gift tax exemption is $5.43 million ($10.86 million joint) in 2015.
Gifts (apart from the annual exclusion of $14,000 per donee in 2015 (same as 2014) are applied against the $5,430,000 exemption so that gift tax is due when their total exceeds $5,430,000. If estate tax is still in existence when the donor dies, the estate will include prior taxed gifts and prior untaxed gifts counted against the $5,430,000 exemption. If an estate tax results because the estate at death plus these prior gifts exceeds the estate tax exclusion amount applicable in the year of death, that tax is reduced by prior gift tax payments.
Some states impose gift taxes.
Gift tax is continued after estate tax repeal as a device to limit asset transfers designed to avoid income tax.
Income tax after estate tax repeal. Assets acquired upon another person's death usually take a tax basis to the heir equal to the asset's fair market value at date of death. Thus, for example, if a person bought 1,000 shares of stock at $10 a share and died when the shares were worth $50 a share (a $40,000 unrealized gain), his or her heir takes the shares at a total basis of $50,000. The heir can sell the shares for $50,000, free of income (capital gains) tax.
Fair market value basis at death is usually a step up in basis although the basis is stepped down at death where value has fallen below cost. Basis step up-by which most inherited assets escape most capital gains tax-has been justified as a kind of compensation for the possible exposure of the entire asset (not just the unrealized gain) to estate tax, whether or not estate tax was actually imposed. The theoretical reason for basis step up is reduced if there is no estate tax. Accordingly, in 2010 the basis step up was repealed, but with a major provision that allows a modified step up basis to continue for up to $4,300,000 of appreciation in a decedent's assets (surviving spouse).
Complex estate planning for making use of this surviving basis step up is possible, but your professional adviser's view of the prospects for estate tax repeal should govern whether such planning should be done now.
The will is the foundation of good estate planning and it's critical to obtain competent legal help when drafting a will. A will that is poorly drafted or does not dot every legal "i" and cross every legal "t" can be the cause of endless trouble for your survivors.
Many people believe they do not need a will, but there are many good reasons, other than saving estate taxes, for having a valid and updated will.
Why You Need a Will
There are five basic reasons to prepare a will:
1. To Choose Beneficiaries. The laws of the state in which you live determine how your property will be distributed if you die without a valid will. For example, in most states the property of a married person with children who dies intestate (i.e., without a will) generally will be distributed one-third to his or her spouse and two-thirds to the children, while the property of an unmarried, childless person who dies intestate generally will be distributed to his or her parents (or siblings if there are no parents). These distributions may be contrary to what you want. In effect, by not having a will, you are allowing the state to choose your beneficiaries. Further, a will allows you to specify not only who will receive the property, but how much each beneficiary will receive. You may also wish to leave property to a charity after your death, and a will may be needed to accomplish this goal.
2. To Minimize Taxes. Many people feel they do not need a will because they believe their taxable estate is below that taxable amount for federal estate tax purposes. However, your taxable estate may be larger than you think. For example, life insurance, qualified retirement plan benefits and IRAs typically pass outside of a will or of estate administration. But these assets are still part of your federal estate and can cause your estate to go over the threshold amount. Also, in some states an estate becomes subject to state death taxes at a point well below the federal threshold. A properly prepared will is necessary to implement estate tax reduction strategies.
3. To Appoint a Guardian. Your will should name a guardian for your minor children in the event of your death and/or the death of your spouse. While naming a guardian does not bind either the named guardian or the court, it does indicate your wishes, which courts generally try to accommodate.
4. To Name an Executor. Without a will, you cannot appoint someone you trust to carry out the administration of your estate. If you do not specifically name an executor in a will, a court will appoint someone to handle your estate, perhaps someone you would not have chosen. Obviously, there is an advantage, as well as peace of mind, in selecting an executor you trust.
5. To Establish Domicile. You may wish to firmly establish domicile (permanent legal residence) in a particular state, for tax or other reasons. If you move frequently or own homes in more than one state, each state in which you reside could try to impose death or inheritance taxes at the time of death, possibly subjecting your estate to multiple probate proceedings. To lessen the risk of this, you should execute a will that clearly indicates your intended state of domicile.
You should review your will every two or three years, or whenever your circumstances change. Changes that warrant revising your estate plan might include:
Today, trusts are not just used by the very wealthy, people with a wide variety of income levels use them as estate planning tools too, despite the fact that trusts are complex and costly to set up and run, and require a higher level of services from an attorney than wills do.
What is a Trust?
A trust owns its own property (holds the title). When it is set up, the trust appears on official papers and records as the legal owner of any property that is placed into it. The trust's principal is the property that the trust owns, as distinguished from the interest or dividends earned by that property. The terms of the trust dictate who will get the benefit of the income from the trust property, how long the trust will last, and so on.
The trustee is the person or entity whose job it is to administer and manage the trust: make investment decisions, pay taxes, make sure the terms of the trust are carried out, and take care of the trust's property. Generally speaking, the trust must pay income tax on any of its undistributed interest or other income.
There are basically two types of trusts:
Another way to categorize trusts is the living (or inter vivos) trust, which is set up by a living person, or a testamentary trust, which is created by a will.
What is a Trust Used For?
A trust can be used for many worthwhile purposes:
Giving property to children. People generally do not want to just give property to a minor child outright because of the financial risks involved (e.g., the child could squander it). Many people give property to a minor through a trust. The trust's terms can be written so that the child does not get outright ownership until he or she has achieved a certain age, so that the child receives only the income from the trust property until that time. Another way to give property to a minor is via the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act. These provisions, which apply in most states, provide for a custodianship over property given to a minor.
Reducing estate taxes. As noted earlier, if you leave everything to your spouse, it passes free of federal estate tax. However, when your surviving spouse dies, anything in his or her estate over the exclusion amount (also called "exemption amount") would be subject to estate tax. The exclusion amount for 2015 is $5,430,000. In 2014 it was $5,340,000, in 2013 it was $5,250,000, in 2012 it was $5,125,00 in 2011, and it was $5,000,000, and there was no limit in 2010. The credit shelter trust or bypass trust is used to shelter up to the exclusion amount from the estate tax. Here's a simplified example of how it might work:
Does anyone but you know where your tax records and consultinging tax documents are located? How about deeds, titles, wills, insurance papers? Does anyone know who your accountant is? Your lawyer? Your broker? If you pass away without leaving your heirs this information, it will cause a lot of headaches. Worse than that, part of your estate may have to be spent in needless taxes, claims, or expenses because the information is missing.
The post-mortem letter is an often overlooked estate planning tool. It tells your executors and survivors what they need to know to maximize your estate-the location of assets, records, and contacts. Without the post-mortem letter, you risk losing part of your estate's assets because necessary documentation cannot be located.
A living will, sometimes called a health care proxy, makes known your wishes as to what medical treatment or measures you want to have if you become incapacitated and unable to make the decision yourself. It tells family and physicians whether you want to be kept alive through mechanical means or whether you would prefer not to have such means used. If there is no living will, this decision is left up to the family, or the physicians, to decide. Stating your preference in a living will can take some of the burden off family members and decrease the stress in an emergency.
The main purpose of life insurance is to provide for the welfare of survivors. But life insurance can also serve as an estate planning tool. For example, it can be used to finance the payment of future estate taxes or to finance a buy-out of a deceased's interest in a business. It can also be used to pay funeral and final expenses and debts.
The disclaimer is a way for an heir to refuse all or part of property that would otherwise pass to him or her, via will, intestacy laws, or by operation of law. An effective disclaimer passes the property to the next beneficiary in line.
The annual gift tax exclusion provides a simple, effective way of cutting estate taxes and shifting income. You can make annual gifts in 2015 of up to $14,000 ($28,000 for a married couple) to as many donees as you desire. The $14,000 is excluded from the federal gift tax so that you will not incur gift tax liability. Further, each $14,000 you give away during your lifetime reduces your estate for federal estate tax purposes.
Share This Guide
Recordkeeping For Your Taxes: Frequently Asked Questions
Tax Benefits of Higher Education: Frequently Asked Questions