When should I start thinking about estate planning?
Many people assume that estate planning is for high-net-worth individuals who want to plan around tax issues and other complex needs.
But when you start accumulating assets or having children, you should start thinking about a plan to control what happens to your assets. And if something happens to you when you have minor children, you will want to ensure who would be caring for them.
If you don't set up an estate plan, the assets will be distributed upon your death according to the rules of intestacy, which are the rules governed by the state in which you live.
Another consequence is that your heirs can end up going through probate, a court-administered process that is best avoided if possible.
What is probate?
Probate is the legal process for heirs to obtain authority to handle a deceased person’s assets. A judge helps to determine timing of distributions, when payments to any creditors need to be made, etc. This administrative court process would cost your estate money and time with possible delays.
What’s the difference between a will-based estate plan versus a trust-based estate plan?
Setting up an estate plan – the right type of estate plan – can help avoid probate. A trust-based plan helps avoid probate and maintains privacy, which is why it's a popular estate-planning strategy. Whereas with a will-based plan, your estate will go through probate, although you still control who will receive your assets.
The other key difference is that the trust-based plan tends to be for more complex estate plans. For example, if you want to build continuing trusts for your children, you get different layers within a trust-based plan.
Whichever plan you choose, it should be customized to your circumstances -- where you are in your life, what beneficiaries you have, if you have children, your net worth, etc. A professional estate planner will work with you to base the plan on your goals and wishes.
How often should you review your estate plan?
Think about it as a five-year plan. What do you want to happen to your assets if something happens to you five years from now? It's easier to envision a plan for the next five years rather than for 20 years.
Once you've set up your plan, it's revocable and amendable while you're living and fully capacitated. Take time every few years to see if it needs to be updated to align with your current situation. Getting married or divorced, having children, and other life transitions can change how you allocate assets. Keep the five-year window in mind and you can update the plan when it's necessary.
What goes into a comprehensive estate plan?
A comprehensive estate plan includes four core documents: a trust, a will, a power of attorney, and a health care directive. If you have a trust-based plan, you also have a will that functions on the side of the trust (typically referred to as a pour-over will). This is to prevent any assets from falling out of your trust.
The other two documents are a financial power of attorney and a health care directive. Financial power of attorney allows you to name a trusted individual to make decisions on your behalf for financial matters if you're incapacitated during your lifetime. If something happens where you can no longer make decisions, this individual can make a bank transaction, sell a piece of property, and act on your behalf for any financial matter.
The health care directive is similar to the financial power of attorney, but you name an individual to make decisions on your behalf for health care purposes. The health care directive is the document whereby you can name someone to make medical-related decisions when you are no longer able to.
These documents name individuals to act on your behalf:
- For the trust, a trustee (doesn’t need to be a lawyer or accountant)
- For the will, an executor
- For the power of attorney, typically referred to as an attorney-in-fact
or an agent
- For the health care directive, also usually referred to as an agent
There are potentially different considerations if you're naming a trustee of a revocable trust or an irrevocable trust. The executor and the attorney-in-fact designations are typically the person you name as your trustee. Where there may be a difference is the healthcare directive because you are delegating someone to make healthcare decisions, which may require a different level of trust or expertise.
What's the difference between revocable trusts and irrevocable trusts?
A revocable trust means you can revoke it at any time. You can amend it whenever you want or you can decide the trust no longer exists. This is the type of trust that's used when you're setting up an estate plan with a trust-based plan.
An irrevocable trust is another type of estate planning tool for more complex planning. Irrevocable trusts are usually used to help minimize estate and gift taxes or for other more advanced matters. In this case, you can establish a trust for somebody else.
A prime example is when a parent might want to establish a trust for their children when the parent is still alive. They take a certain type of asset and put it into this trust so that the asset is no longer in the parent’s estate for estate tax purposes. The asset is now owned by an irrevocable trust, but since it's irrevocable, the trust can’t be changed. The trade-off is that the asset is no longer within the parent’s control.
While there are various types of irrevocable trusts, conceptually, they are used for mitigating estate taxes and maximizing your lifetime exemption amount.
Again, the key difference is that you can change a revocable trust and it's under your control. Once you make a decision to establish an irrevocable trust, you typically cannot make any changes to it.
How do I put assets into my trust?
One issue that many clients misunderstand when they're setting up an estate plan is that after they've signed the documents, they think they're done.
However, if you have a trust-based plan, the final and most important element is putting assets into the trust.
This is referred to as trust funding, where you're changing the title of the assets you own in your own name into the name of the trust. Depending on the type of asset, there are different ways to do so.
For instance, if you bought your house before you had a trust, you own it in your individual name. To put it into the trust, you have to draft a new deed whereby you're going to transfer the house, or your interest in the house, from yourself to yourself as trustee of your trust.
This administrative step ensures that your trust can hold title to your home. Other accounts, such as bank accounts or brokerage accounts, require you to go to the financial institution and notify them that you have established a revocable trust and want to change the title on your assets or accounts into the name of your trust. Most often, those financial institutions will provide a document that you need to fill out with the help of your financial advisor or attorney.
Funding your trust is the last step. It's important in order to avoid probate, which can only happen if you put your assets into your trust. If you create a trust and you don't have any assets in it, it's not going to fulfill what you’ve intended it to do.
Whichever type of trust you choose, it’s important to speak with a professional to guide you through the process of establishing your estate plan.
What is the unified lifetime gift and estate tax exemption, and what is the limit for 2023?
The keywords are unified credit. It's a dual-purpose exemption that will exempt from estate tax $12.92 million per person and $25.84 million for a married couple in 2023 (up from $12.06 million in 2022).
The gift tax component of these amounts is making gifts during your lifetime to anyone you choose. In 2023, you can use part of your $12.92 million per person exemption to make lifetime gifts.
So for example, if you are single and you gift $2 million while you're alive, as long as your estate is less than $10.92 million at your death, your heirs won’t pay any estate tax.
When are the exemption totals scheduled to change?
The exemption is scheduled to be reduced by more than 50% in 2026 to $6 million per person and $12 million per couple. (Note this could change pending future Congressional control, the White House, budget issues, etc.)
But in 2019, the IRS created the No Claw-Back Rule that says if you make lifetime gifts up to $12.92 million prior to 2026, the higher exclusion amount will be effective if you die after 2025.
However, if you don't use the full exemption (e.g., you only use $7 million), then after 2026, you'll have $0. If you use $5 million, after 2026, you'll have $1 million of exception left. (It’s key to discuss tax implications with your tax advisor.)
How do the annual gifting amounts relate to the lifetime exemption?
In 2023, the annual gifting exemption is $17,000 per recipient (up from $16,000) without you having to file a gift tax return. Above $17,000 per recipient, you do have to file a return. In practice, if you’re above the $17,000 annual exemption, you can dip into the lifetime exemption and end up paying no gift tax.
And for example, two parents or two grandparents can give $34,000 combined to each grandchild every year and not have to file a tax return. So if there are 10 grandchildren, that’s a total of $340,000 yearly removed from a taxable estate.
What three other annual gifting categories don’t require gift taxes?
1. You can pay college tuition for anyone, not just family members, and it can be over $17,000 as long as payment is made directly to the college. You don't have to file a gift tax return because it's not viewed as a taxable gift. However, if you pay the student, it's going to be considered a gift even if the student in turn pays the college.
2. Charitable donations are not taxable gifts and are tax-deductible on your tax return, which reduces your estate tax.
3. Payment for medical expenses for anyone (again, not just family members) is not viewed as a gift if you make the payment directly to the providing medical institution.
How can you accelerate saving for 529 educational plans?
529s can be owned by parents, grandparents, or anyone who wants to save for a child’s education. The plans are powerful tools for making gifts very tax-efficiently. You can front-load a 529 plan by using your annual $17,000 for the next five years, but accelerate it into the first year so that you put $85,000 into a 529. It grows tax-deferred and the withdrawal is not taxable if spent on the qualifying education.
What are some strategies to help mitigate capital gains you might otherwise need to pay?
This is where regular income tax and capital gains tax meet estate planning, estate tax, and gift tax.
People typically think capital gains tax is levied at 15% or 20%. But there is actually a zero rate of capital gains tax for up to $40,000 dollars in taxable income. If there is a capital gain and no other income, the zero capital gains tax band allows someone to recognize capital income – long-term capital gains up to $40,000 – and not pay any tax.
This is the interplay of the gift tax and capital gains tax. The gift tax exemption gives you mobility to move assets around to your family and friends. If there are a lot of gains, there could be strategies that enable you to gift the appreciated asset to someone in a lower tax bracket (0%, 15%, 20%), and you let them take the gain and report it on their tax return.
The quid pro quo is that you no longer have the asset and the person to whom you gifted it now has the asset and the profit, but these strategies assume that's your objective.
Is one of the biggest elements of capital gains tax the step-up in basis?
If you are holding an asset of a very low basis and you want to gift it during your lifetime, you can use one of the structures previous discussed.
Sometimes it might make sense to hold the asset until your death because the asset and the basis get stepped-up to the fair market value. Your beneficiaries can then sell it with no capital gains tax.
What about charitable trust and giving strategies that incorporate income tax and estate tax planning?
- A charitable remainder trust is a vehicle whereby you transfer assets to the trust. The trust (being a tax-exempt entity) then sells the assets, and you are able to access the income from the assets in the trust over the rest of your lifetime.
The charitable component is that what's left inside the charitable trust goes to your nominated charity after your death. In terms of crossover between managing capital gains, income tax liability, and estate tax liability, when you transfer assets to the trust, not only do you get an income tax deduction for a portion of the assets transferred, but those transferred assets are within your taxable estate. Therefore, you don't have to report them for estate tax purposes even though you're able (and required) to access the income from the trust during the remainder of your life.
What investors with concentrated stock positions can do is to transfer the stock to the trust. Based on a $1 million example, you can reinvest the entire $1 million dollars in a diversified portfolio in the trust, versus reinvesting the post-tax amount that might be $650,000 on the sale of stock worth $1 million. You can then access the income over the remaining years of your life and not pay any tax inside the trust.
- Charitable donations give you an upfront tax deduction. There are no gift taxes and whatever you give to the charity is outside your estate. A donor-advised fund receives assets outside of your taxable estate and provides a tax deduction. More complex vehicles such as charitable remainder trusts are where the income tax and the estate tax areas cross over.
As the Director of Estate Planning, Simon Mayali works with clients to identify their estate planning goals and options and helps them understand the complexities of estate and gift taxation. He obtained his LL.M in taxation focusing on estate planning to work with clients on complex estate and gift tax issues.
Gerry O'Connell is Tax Planning Partner and an Enrolled Agent (EA), the premier tax accreditation recognized by the IRS. Areas of special interest include estate planning strategies, retirement planning, real estate tax minimization and US reporting of assets held overseas.