Basics of an Estate Plan
Getting the lay of the land
Estate planning is full of technical language and legal details. But once you get past these obstacles, the concepts aren't difficult. This section provides a brief introduction to some of the most common estate planning terms and concepts.
Note that if you designate someone other than your spouse or a charity as your beneficiary, that amount will be included in the value of your estate and can increase your estate-tax liability.
our two cents
Less than 1 percent of the population has an estate large enough to be affected by estate taxes. In 2009 you won't owe estate taxes unless your estate is worth more than $3.5 million (or $7 million for a married couple). Note that your taxable estate includes all of the following:
- Your entire investment portfolio.
- Your cash.
- The current market value of any property you own.
- The total value of all of your IRAs, 401(k)s and pensions.
- The value of any life insurance policy you own as long as you have an "incident of ownership," allowing you the right to name a beneficiary or borrow against it.
Ten states (Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin) use a community property system instead, in which all property acquired or earned during a marriage is owned equally by both spouses. Any property that was owned by one spouse prior to marriage (as well as an inheritance) remains separate property unless it is commingled with other marital assets. In community property states, each spouse is free to leave his or her half of the community property to whomever he or she chooses. There is no requirement to leave it to a surviving spouse.
our two cents
Although probate can help guarantee that your assets will wind up in the right hands, the process can be both time-consuming and costly. In addition, probate documents are public records, which can compromise privacy. Whenever possible, it is generally desirable to minimize (or even better, avoid) this process. In fact, a good portion of estate planning is about how best to avoid probate.
On the other hand, when you give away appreciated property at your death, the recipient will inherit your cost basis along with the property. In the example above, your daughter would only pay taxes on $1,000 or the difference between $2,000 and the sale value. This is known as a stepped-up basis.
This effect is compounded for spouses in community property states. As an example, let's say that you and your husband purchased a home for $100,000. At his death, forty years later, the home is valued at $1 million. Had you sold the home prior to his death, you would have had to pay taxes on the $900,000 gain (minus the homeowner's exemption if it is your primary residence). Upon his death, however, the basis is "stepped up" to its current value of $1 million, avoiding all capital gains. On the other hand, if you live in a non-community-property state, the stepped-up basis is only applied to the deceased's interest. In this way, married couples in community property states have a distinct advantage over those in common law states.
Estate taxes, on the other hand, are imposed on the estate; the executor pays the tax out of the estate's funds. The heirs are liable only if the executor fails to pay the tax.
Speaking in broad terms, trusts can be set up either under the provisions of your will (called a testamentary trust) or as a separate legal entity while you are alive (known as a living trust). Since a testamentary trust isn't created until after you've died, it's irrevocable, meaning that it can't be changed. A living trust, on the other hand, becomes effective the moment you sign the document and fund the trust. As a result, a living trust can be either irrevocable or revocable, which means that you can change or cancel it while you are alive and thereby retain complete control of your assets. Note that the moment you die, a revocable trust usually becomes irrevocable.
A common planning tool to avoid estate taxation of life insurance proceeds is the irrevocable life insurance trust (ILIT). With an ILIT, a trust irrevocably owns the policy, and the proceeds are kept outside of the individual's taxable estate (as long as the trust purchases the policy or the original owner lives at least three years after transferring an existing policy into the trust).
Although a trust costs more and takes more time to set up than a will, it can have several advantages. Not only does a trust avoid probate, but it also provides for your potential incapacity. In addition, depending on how it is structured, it can reduce your estate tax bill. You should always consult with a professional estate planner on all trust matters.
There are many ways to prepare a will, but to make sure that your will is legal and binding, you should have it prepared by an attorney who specializes in trusts and estates.