Estate Planning: How To Get Started

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.

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 without having it be subject to federal estate tax (i.e., the bequest provides a marital deduction). And in 2010, there is no exemption level for others survivors either ($3,500,000 in 2009). In 2011, the exemption level will revert back to $1,000,000 without paying federal estate tax. See Estate Tax Repeal section below. 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"

The 2001 Tax Relief Act repeals the federal estate tax in one of the most confusing tax measures ever enacted. The law reduces the overall estate tax burden over the years 2002-2009, until it is repealed in 2010-subject to revival, as if these changes had never happened, on January 1, 2011. This revival arises under a sunset provision which voids all provisions of the 2001 Act, effective 1/1/11. Sunset 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.

Under the current statutory scheme, absent further change, the federal estate tax is repealed only for those dying during the calendar year 2010. While the 2011 sunset would affect other provisions of the 2001 Act (such as tax rates), its biggest impact is in those situations for which taxpayers and tax professionals do long-term planning: especially estate planning.

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 repeal will have become effective in the year the individual happens to die. Second, the uncertainty about the law, that any repeal will stick-because of changes in economic forecasts and national priorities since repeal was voted.

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. A number of states will revise their own death tax policies depending on what Congress decides to do to resolve the scheduled repeal and year-later reinstatement of the pre-2002 estate tax system.

Gift tax. The lifetime gift tax exemption is $1,000,000. Gift tax rates fall at the same rates as estate tax rates but continue (at 35% or the top income tax rate) after estate tax repeal.

Gifts (apart from the annual exclusion of $13,000 per donee in 2009 ($12,000 exclusion in 2008) are applied against the $1,000,000 exemption so that gift tax is due when their total exceeds $1,000,000. 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 $1,000,000 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.

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'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, though 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, basis step up is repealed effective 2010, but with a major provision that allows step up to continue for up to $4,300,000 of appreciation in a decedent's assets.

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.

Wills

The will is the foundation of good estate planning. It's critical to obtain competent legal help in 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.

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.

Why You Need A Will

There are five 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.

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. 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. Trusts are complex and costly to set up and run, requiring a higher level of services from an attorney than wills. 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.
• 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:

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.

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 2009 is $3,500,000. No limit in 2010 and reverts back to $1,000,000 in 2011. 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 and Sylvia have an estate worth $4 million. Simon's will puts $2,000,000 worth of assets in a bypass trust. The ultimate beneficiary of this trust is Simon and Sylvia's daughter. (The beneficiary can be anyone other than Sylvia.) Sylvia is to receive the income from that trust for her life, 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 in his will.

Assuming Simon dies in 2009, the $2,000,000 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 $2,000,000 put into the bypass trust, which will be exempt from tax because of the $2,000,000 estate tax exemption.

Thus, the federal estate tax on Sylvia will apply only to her assets in excess of $3,500,000. Result: The family has sheltered assets worth $4 million from estate tax in the Simon/Sylvia generation. Without the bypass trust, the estate tax would have applied to an additional $2,000,000 of the estate.

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.

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.

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

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. 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.

Life Insurance

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.

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

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 2010 of up to $13,000 ($26,000 for a married couple) to as many donees as you desire. The $13,000 is excluded from the federal gift tax, so that you will not incur gift tax liability. Further, each $13,000 you give away during your lifetime reduces your estate for federal estate tax purposes.

Government and Non-Profit Agencies

• An organization that provides information on officers' benefits and estate planning:

  Army and Air Force Mutual Aid Association

  800-336-4538

• This veterans' benefit organization for Navy, Marine Corps, Coast Guard, Public Health, and NOAA personnel provides information:

  Navy Mutual Aid Association

  800-628-6011

• These publications contain estate planning tips for military personnel:
  • National Guard Almanac
  • Reserve Forces Almanac
  • Retired Military Almanac
  • Uniformed Services Almanac (Active Duty)