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Estate planning, the process of planning how to preserve your assets for your heirs, is not just for the very wealthy. Everyone should engage in some form of estate planning. After working hard for many years, building up a business, and accumulating assets, you should make sure that those assets will not be unnecessarily used up but are preserved for your survivors. Here's a basic guide to wills, trusts, and other estate planning tools.

Table of Contents

Estate Planning


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.

The Overall Picture

Just what is your "estate?" Simply stated, it includes everything you own at your death minus your debts. 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 pass free of federal estate tax. You can leave an unlimited amount to a surviving spouse, who is a US citizen, without having it be subject to federal estate tax (i.e., the bequest provides a marital deduction). And you can currently leave your other survivors up to $5,340,000 in 2014 (this amount was unlimited in 2010, 5M in 2011, 5.12M in 2012 and 5.25M in 2013) without paying federal estate tax. In addition to federal estate tax, state inheritance taxes, which vary from state to state, must also be considered.

In addition to the two primary estate planning tools wills and trusts, there are other essential tools you should consider:

  • The post-mortem letter to your spouse and survivors,
  • Living wills,
  • Life insurance,
  • Disclaimers,
  • Lifetime gifts, and
  • Powers of attorney.

Estate Tax "Repeal"

In a nutshell, it didn't happen.  The 2001 Tax Relief Act repealed the federal estate tax only for individuals dying in 2010.  On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 was enacted.  This set the estate, gift and generation skipping transfer tax exemptions at $5,000,000 per person.  The Act also makes the unused portion of the exemption of the first spouse to die "portable" between spouses.  

Tax professionals consider that this situation presents at least two major reasons for planning as if your estate (if large enough) will be subject to estate tax: First, the uncertainty as to the time of death-that the law in the year the individual dies will be uncertain. Second, the uncertainty about the law-that any changes in the law after a person dies will create missed opportunities.

States had death taxes long before there was a federal estate tax. Today, many state death taxes are modeled in some way on the federal estate tax; some have other taxes taking effect at death. In some cases, the amount subject to state death tax falls as the amount subject to federal estate tax falls (absent further state action) and the tax will be repealed automatically (again absent further state action) upon the repeal of its federal counterpart. In other states, death taxes are independent of the federal tax and apply whether or not a federal tax applies. 

Gift tax. The lifetime gift tax exemption is $5,340,000 in 2014.

Gifts (apart from the annual exclusion of $14,000 per donee in 2014 are applied against the $5,340,000 exemption so that gift tax is due when their total exceeds $5,340,000. 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 $5,340,000 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.

Caution: Under the estate/gift tax scheme now applicable, gift tax can result in situations where there would be no estate tax if assets of the same value had been held at death. So gifts that bring the gift total above the lifetime exemption should be made only on the specific advice of a tax professional.

Wills

The will is one of the foundations of good estate plan.  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.

Tip: Do not keep will originals in a safe deposit box. Instead, keep them in a fireproof safe at home. Give copies to your attorney and your executor.

Many people believe they do not need a will. There are many reasons, other than saving estate taxes, for having a valid and updated will.

There are four basic reasons to prepare a will:

To Choose Beneficiaries. The intestate succession 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.

To Minimize Taxes. Many people feel they do not need a will because their taxable estate does not exceed the amount allowed to pass free of federal estate tax. 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.

Tip: Review of your estate plan is advisable to take into account the changes in estate and gift tax rules and in rules on items that affect the size of the your estate, such as retirement and education funding plans. Amounts subject to estate tax, and estate and gift tax rates, are scheduled to change periodically in future years. Your plan should take these planned future changes into account, but further review may be necessary.

To Appoint a Guardian. If you have minor children, you should prepare a will to name a guardian for 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.

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, and peace of mind, in selecting an executor you trust.

You should review your will every two or three years, or whenever your circumstances change. A change that might necessitate a change to your estate plan might include:

  • Divorce,
  • Having a child,
  • Having children move out of the house,
  • Acquiring a large asset,
  • Selling a large asset, or
  • A change in the tax laws.

Trusts

Today, trusts are not used only by the very wealthy.  People of a wide variety of income levels use them as estate planning tools.  They are useful in accomplishing various estate planning and financial planning goals.

What They Are

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 trust:

  • An irrevocable trust is a separate entity, for both legal and tax purposes, and pays its own taxes. The irrevocable trust cannot be revoked or changed without costly court intervention.
  • A revocable trust is not considered a separate entity for tax purposes, although it may be considered a separate legal entity. The revocable trust can be changed or revoked-taken back-by the creator of the trust.

Another way to categorize trusts: A living (or inter vivos) trust is set up by a living person while a testamentary trust is created by a will.

What They Can Accomplish

Trusts can be used for many worthwhile purposes, some of which are:

  1. Give property to children.
  2. Reduce estate taxes.
  3. Leave assets to a spouse.
  4. Provide for life insurance used to pay estate tax.
  5. Probate avoidance

Giving property to children. People generally do not want to just give property to a 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.

Reducing estate taxes. [The following discussion would seem to be rendered meaningless by the $5,340,000 exemption and the portability of the exemption between spouses.  However it is still meaningful as we do not know what Congress has in store for us.]  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 is currently $5,340,000.  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:

Example: Simon has an estate worth $7.34 million. Simon's will or trust puts $5,340,000 worth of assets in a bypass trust. The ultimate beneficiary of this trust is Simon and Sylvia's daughter.  (The ultimate beneficiary can be anyone other than Sylvia.)  Sylvia is to receive the income from that trust for her life and limited amounts of principal, but her rights in the trust are limited, so that she is not considered the owner. The rest of Simon's estate ($2,000,000) is left to Sylvia outright.

Assuming Simon dies in 2014, the $5,340,000 in the bypass trust is sheltered by his estate tax exemption. The $2,000,000 that goes to Sylvia is deducted from the estate because of the marital deduction. Thus, on Simon's death, the federal estate tax due is zero. When Sylvia dies, her estate will include only the $2,000,000 (if she still has it), plus any other assets she has accumulated. It will not include the $5,340,000 put into the bypass trust, which will be exempt from tax because of the $5,340,000 estate tax exemption.

Thus, the federal estate tax on Sylvia will apply only to her assets in excess of 5,340,000. Result: The family has sheltered assets worth $7.34 million from estate tax in the Simon/Sylvia generation.  

If you will recall, Congress created "Portability." Simply put, Portability allows the survivor to use the "unused"exclusion amount of the decease spouse.  In the prior example if Simon had left everything to Sylvia, his estate would escape tax via the marital deduction.  When Sylvia passed away, her estate could have used the "unused" 5.34M exclusion that Simon's estate did not use plus Sylvia's exclusion.   So it would seem we are at the same place without the "fuss" of the bypass trust.  Why use it?  First, Portability has many rules, which, if not followed, do not allow the survivor to use the "unused" exclusion.  Second, many states (1) have a lower estate tax amount, and (2) do not recognize Portability.

Caution: Wills may be drafted to leave a bypass trust an amount equal to the exclusion amount in the year of death, rather than a specific dollar amount. However, because amounts change, review of the estate plan may be needed to keep the desired balance between what the spouse is to get and what trust beneficiaries are to get.

Leaving an asset to a spouse. The marital deduction trust allows the first spouse to die to place estate assets in a trust for the surviving spouse, instead of leaving them to him or her outright. If the legal requirements are met, the estate gets the marital deduction, but can still preserve assets for heirs other than the surviving spouse. Typically, the income of such trusts will go to the surviving spouse for life and the principal will go to children. All of the income must go to the surviving spouse for the trust to qualify for the marital deduction. It must be paid out at least once a year. The spouse may have some access to the principal. When the second spouse dies, the property is included in his or her estate for estate tax purposes.

Life insurance to Pay estate tax. Complex and expensive arrangements, life insurance trusts are usually used to finance future estate taxes on an estate that contains a business interest or real estate.

Probate Avoidance. This is the primary difference between wills and revocable trusts.  All of the aforementioned purposes can be accomplished with a will, however the assets passing through the will do so by going through probate.  A revocable trust will accomplish all of your goals but removes the probate aspect and its ensuing cost.

Post-Mortem Letters

Does anyone but you know where your tax records and supporting 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 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.

Related Guide: Please see the Financial Guide: POST-MORTEM LETTER: How To Prepare It And What To Include.

Livings Wills (aka Medical Directives or Health Care Proxies)

A living will 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.   Stating your preference in a living will can take some of the burden off family members and decrease the stress in an emergency.

Power of Attorney

A Power of Attorney allows someone else to act in your place for financial and/or for medical reasons.  The most common types of Power of Attorneys are Durable, General, Specific and Springing.

  • A durable Power of Attorney may be used at any time once signed and is still effective if you are disabled.
  • A General Power of Attorney will allow your agent unlimited powers on your behalf.
  • A Specific Power of Attorney is generally used for a specific function (i.e. real estate transactions, Social Security).
  • A Springing Power of Attorney does not allow your agent to act until such time as you become disabled.

 Life Insurance

The main purpose of life insurance is to provide for the welfare of survivors.  However, 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.

Tip: If the decedent owns the policy, the proceeds will be included in the estate, and subject to estate tax. However, if the decedent gives away all incidents of ownership in the policy, and names a beneficiary other than the estate, the proceeds will not be included in the estate.

Related Guide: Please see the Financial Guide: LIFE INSURANCE: How Much And What Kind To Buy

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Disclaimers

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.

Tip: With a properly drawn disclaimer, the property is treated as if it had passed directly from the decedent to the next-in-line beneficiary. This may save thousands of dollars in estate taxes. The provision for a disclaimer in a will and the wise use of a disclaimer allows intra-family income shifting for maximum use of the estate tax marital deduction, the unified credit, and the lower income tax brackets.

Tip: Disclaimers can also be used to provide for financial contingencies. For example, a beneficiary can disclaim an interest if someone else is in need of funds.

Lifetime Gifts

The annual gift tax exclusion provides a simple, effective way of cutting estate taxes and shifting income. You can make annual gifts in 2014 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.

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