Estate of Confusion: Why You Shouldn’t Fear Estate Planning
By A. Andrew Raub
For most people, the driving forces in estate planning are federal estate taxes and fear. They hear rumors and whisperings about how someone’s entire estate was decimated by these taxes, and they don’t want the government to do that to them! However, because of increased exemptions, you really have less to fear in the estate tax than you might think. By understanding this tax and then carefully planning out your estate, you and your heirs can avoid the headaches and heartaches commonly associated with this infamous tax.
This month I will answer a few common questions regarding the estate tax and estate planning. Then, I’ll share my own thoughts on what I think estate planning should be.
Q: How does the estate tax work?
The estate tax is essentially a federal tax levied on the transfer of property at death. For federal estate tax purposes, this includes your home, cars, retirement accounts, taxable investment accounts, collectibles, and so on. It also includes any death benefits from life insurance policies you own.
Here’s a quick breakdown of the estate tax laws as we know them today:
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Under current legislation, the estate tax will completely phase out by 2010, only to be reinstated in 2011 with a tax rate of 55 percent on estates larger than $1 million.
Q: What is Congress doing about the estate tax exemption?
The 2010 repeal and 2011 reappearance make estate tax planning a shot in the dark. The House of Representatives recently passed a proposal that would permanently increase the exemption to $5 million per person and decrease the tax rate to 15 percent for estates up to $25 million. But the Senate rejected it. This is beginning to look like the mother of all political footballs.
Q: Does the estate tax apply between spouses?
Normally no estate tax is levied when the first of a married couple passes away. All the shared assets pass directly to the surviving spouse. This is technically called an “unlimited marital deduction” which means that an individual can give an unlimited amount to a spouse either during life or death.
However, without proper planning, the death of the first spouse may result in losing the value of their estate tax exemption. Remember that the exemption is for each person, but if everything goes to the surviving spouse, the ability to capture and retain the first exemption goes away, and the family is left with only the exemption of the surviving spouse. A simple way to capture both exemptions is to write a “bypass trust” into both spouses’ wills.
Q: Is probating a will really as bad as people say?
Not really. Probate is the process of legally establishing the validity of a will, which can be a time consuming and expensive process in many states. However, Texas, as a community property state, is one of the easiest states in which to probate a will. I have noticed that much of the fear of probate generates from those who want to sell living trusts as a way to avoid probate. In my opinion, living trusts are typically unnecessary for three reasons.
First, living trusts can be quite a bit more expensive than a well-written will because of the way they are sometimes sold. So be careful at those “free” estate-planning dinners. Secondly, living trusts do not save you any more taxes than a good will that includes a bypass trust. Thirdly, a living trust is useless unless your property is re-titled to be owned by your trust. The trust essentially provides a beneficiary designation to your property, much like your life insurance or IRA.
However, a living trust can be invaluable when dealing with property in other states. If you own land in Florida, a house in Colorado, or oil royalties in Oklahoma, putting these assets in a living trust would avoid probate in these states and can be a useful planning tool.
Q: How should I title my investment accounts?
If your estate plan calls for everything to pass through probate, then your accounts should be titled accordingly—“Joint” or “Community Property.” Be careful with the designation “Joint Tenants with Right of Survivorship” (JTWROS). This designation has the effect of adding a beneficiary and could render your will and trust arrangements useless.
Q: Can I include my IRA or retirement account in my will or trust?
Actually, you cannot include qualified retirement accounts in a will because they transfer through beneficiary designation. This means they pass directly from one person to another and therefore bypass the probate process.
Q: Will my children have to pay estate taxes on my IRA or retirement accounts if they are named as beneficiaries?
Your children may not have to pay estate taxes on the accounts, but they will have to pay income tax on them, providing they are non-Roth IRA accounts. If your total estate is more than the federal exemption, your children will need to cough up enough to pay the applicable estate and income taxes. If your estate is less than the federal exemption in the year of your death, they will only pay income taxes on the accounts. However, there are some ways your children can stretch this tax out over time if needed.
The Game Plan
Simply put, estate planning is preparing to transfer everything you own to someone else. It is not just about reducing estate taxes. Did you catch that? Estate planning is not just about reducing estate taxes. It is about doing some other things for the right reasons, though.
Estate planning for the Peace of Mind Investor should not be driven by fear of taxes but by the desire to arrange your legacy around three essential questions:
- Where—will it go to the people and organizations I want?
- When—will it go when I want?
- How—will it go in the manner I want?
By approaching estate planning through these three simple questions, you will minimize any estate taxes and provide careful and thoughtful planning for your family. If you handle estate planning this way, you will ensure that your property is strategically allocated for multiple generations...and you won’t be driven by fear.
Estate planning is too important to leave to chance (or to the government). Make sure you have a plan for transferring your property at death so you and your loved ones don’t have to worry about it.