Estate Planning Guide
About the Estate Planning Guide
In this guide, we cover the basics of estate planning: what it is; how to protect yourself and your family with life insurance; the importance of having a will, power of attorney, and health care proxy; how trusts and tax-free gifts can be used to reduce the size of your taxable estate; and information about federal and state estate taxes. While this guide provides an overview and general advice, we encourage you to seek the advice of a qualified financial advisor who specializes in estate planning in order to receive specific information about your individual financial situation.
What is Estate Planning
Estate planning is the process of planning for the transition of assets upon the death of the owner. An estate planner attempts to eliminate as many uncertainties about the distribution of assets and the impact the receipt of assets has on a beneficiary. In other words, ownership of everything in your estate – cash, securities, a home, jewelry, etc. – must be transferred to another person upon your death. Depending on the size of the estate, your beneficiary might be required to pay federal or state inheritance taxes on the assets he or she receives. A good estate plan will reduce or eliminate the amount of tax owed.
A comprehensive estate plan will contain the following documents: a will or trust, a durable power of attorney, beneficiary designations for the entire estate, a healthcare proxy, and guardian designations if you have minor children.
To see anwsers to the most common estate planning questions, visit the Estate Planning FAQ.
Having Adequate Life Insurance
As part of an estate plan, a life insurance policy insures both your life and your assets. The death benefit that is paid to a beneficiary is almost always paid tax-free, which means he or she will receive a lump-sum payment that can be used to pay off your debts, put a child through college, or to pay any estate taxes that will be due upon the transfer of assets. This last point is crucial if the amount of your estate exceeds the federal estate exemption limit, which is currently $5,000,000.
Even if your estate is not valued at more than the exemption limit, your heirs will still benefit from the proceeds of a life insurance policy. Other taxes, such as property tax and income tax due on your earned income, might be due after your death. Finally, a death benefit can prevent the disposition of assets at amounts below fair market value.
For more details, visit the Life Insurance page.
Estate Planning Legal Documents
While it's important to have a will, you should also make sure that a durable power of attorney and health care proxy are part of your estate plan. These three documents allow for the smooth passage of assets upon your death and ensure that a person of your choosing is allowed to speak for you if you cannot speak for yourself.
If you die without a will your estate will go through probate and the court will distribute your assets. Probate can be a time-consuming and expensive proposition. In the end, your heirs will more than likely be left with fewer assets. If you have assets in excess of $100,000, consider a trust.
A durable power of attorney allows another person to speak on your behalf, represent you in court, make investment decisions, and pay your bills should you become incapacitated. The first time most of us experience a durable power of attorney document is with an aging parent. Once an elderly parent loses the ability to make proper decisions, someone must step in. If a power of attorney is not in place, a member of the family will have to petition the court to be designated as the guardian or conservator of the estate. Having this document in place will ensure that assets are protected.
A healthcare proxy works similarly to a power of attorney. In the event that you are not able to speak for yourself, your family members will be able to communicate your wishes to healthcare providers.
For more details, visit the Wills page.
Reducing the Size of Your Taxable Estate
There are a number of ways to reduce the size of the taxable estate you leave to your heirs. While all of the options may not be applicable to your specific situation, the ability to utilize at least some of the options will reduce the amount of tax that will be owed by your beneficiaries.
One popular option is to give children and grandchildren tax-free gifts. Currently, you can give $13,000 up to a lifetime limit of $5,000,000 without triggering a taxable event for the recipient. Assuming $13,000 is given to one person each year for 10 years, the size of estate would be reduced by $130,000. If giving gifts to children and grandchildren reduces your estate to a level below the exemption limit, this is definitely a strategy to consider. You might also consider a Uniform Gift to Minors. This works much the same way as a tax-free gift, except the recipient is a minor who takes control of the money once he or she reaches maturity. Transferring money to an approved 501(3)(c) organization will also reduce the size of your taxable estate if you have a favorite charity.
Trusts have become increasingly important in preserving assets. An AB trust transfers all assets to a surviving spouse. The spouse then has use of the assets until his or her death, at which point assets are transferred to the beneficiary. If the value of the trust exceeds the exemption limit, the beneficiary is allowed to use the exemption limit from both of the decedents. In other words, the exemption limit is doubled. A QTIP trust allows the surviving spouse to control disposition of the assets. This type of trust is best suited for those with children from a previous marriage.
An irrevocable life insurance trust involves transferring a portion (the amount that would be equal to the life insurance premium) of assets into a life insurance policy. This allows the beneficiary to receive the assets as a death benefit, rather than an inheritance. Under most circumstances, the death benefit from a life insurance policy is paid tax-free, but it's always wise to check with a qualified agent or tax advisor prior to making this decision.
If you own a business, a family limited partnership allows the transfer of a family-owned business to heirs while protecting the assets from creditors. Unlike an irrevocable life insurance trust, a limited family partnership is revocable. You can also take advantage of a qualified family-owned business deduction if ownership of the business meet IRS criteria. For example, if the decedent and family owners have been involved in the business for five of the past eight years, if the business makes up at least 50% of the decedents estate, the business is located in the United State, and he or she was a resident of the United States.
For more details, visit the Trusts page.
Fair Market Value and Cost Basis and Taxes
In general, the value of an estate is determined by the "fair market value" of all assets at the time of your death. If your house is appraised at $350,000, that's the amount that a beneficiary must claim as the inherited value. This is known as the "stepped-up cost basis" and allows the beneficiary to claim the asset at its current value and not the amount that was paid for it. In other words, it doesn't matter what you paid for the house. Even if you paid $10,000 and it's now worth $350,000, the beneficiary inherits it at $350,000. Almost all other assets are inherited via the stepped-up basis. (The exception is an annuity.) This is an important point to realize because it significantly reduces the capital gains tax the beneficiary will owe when he or she sells the asset. If he or she sells the house for $400,000, capital gains will only be due on the difference between $350,000 and $400,000, not $10,000 and $400,000.
While the current $5,000,000 federal tax exemption has been discussed, depending on where you live, state estate or inheritance taxes may have an impact on the amount your beneficiary receives. Only seven states have inheritance or estate tax. Those that do – Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania – levy the taxes at varying rates on beneficiaries depending on their relationship to the deceased.
For more details, visit the Taxes page.
Regardless of your financial situation, it's a good idea to have at least some level of estate planning in place to protect your spouse, heirs, and beneficiaries. Even if you have a small estate, a life insurance policy, will, durable power of attorney, and healthcare proxy can protect the few assets you do have. If you have substantial assets, have children from a previous marriage, or own a business, you'll want to make arrangements to establish a trust.
While we've covered the basics of estate planning here, there is much more to implementing a solid estate plan. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Estate Planning Guidance
- Wills — Learn how to draft a will, power of attorney, and a health care proxy.
- Trusts and Tax-Free Gifts — Learn how different trusts can reduce tax liability.
- Life Insurance — Learn how life insurance can be used to reduce estate taxes.
- Estate Taxes — Find out how estates are taxed at the state and federal levels.
- Estate Planning FAQ — Frequently asked questions about estate planning.