Estate-planning advisers often point to revocable trusts — particularly living trusts, discussed in Book 5, Chapter 3 — as
“the perfect way to totally avoid probate.” Put all your property into revocable trusts and you can have control over that property, the pitch goes, and because none of your property is now in your probate estate (that is, it’s all held in trust), your estate doesn’t have to go through the probate process because your probate estate is “empty!” And, by avoiding probate, you avoid the costs of probate, the lack of privacy, and the other disadvantages to the probate process discussed in Book 5, Chapter 3.
Not so fast. True, you can avoid probate costs, but do you really think setting up and maintaining trusts is free? No way!
Your costs to set up a revocable trust vary depending on attorney fees and other costs, but be prepared to pay to have your trust managed.
You also need to make sure that everything you own is held in trust form. If you fail to include any part of your estate in your trust(s), then you have a probate estate that is subject to the probate process. So every time you buy a new home, open a new brokerage account, or make any changes to your estate’s inventory, you need to make sure that you transfer that property into your trust(s). And that can be a pain.
Remember also that probate isn’t always bad, either. The probate court, which has the responsibility of making sure that property in your probate estate is disposed of properly with no behind-the-scenes funny games, supervises your probate estate. Without the probate court’s supervision, part or all of your estate that is held in trust or other nonprobate form (joint tenancy with right of survivorship, for example) can be in for problems if someone close to you in a position of authority has, shall we say, a lack of ethics. Eventually, all the beneficiary problems may get straightened out but quite possibly because of prolonged, costly legal battles.
Also keep in mind that you may be required to file state or federal estate or inheritance tax returns, even though you have no “probate estate” (or “probate assets”). At the state level, at least, those returns are usually considered to be public
records. Therefore, if privacy concerns are important to you, your desire for privacy may be defeated.
Chapter 5
Minimizing Estate-Related Taxes
IN THIS CHAPTER
Assessing your current financial picture and potential tax liability Looking ahead to understand your possible future tax liability Deciding on your estate-planning strategy
Coming up with a comprehensive estate-related tax plan
If you enjoy games and puzzles like chess and the good ol’ Rubik’s Cube, then you may feel at home when it comes to planning for estate-related taxes. But if you always lose at chess and were never able to solve a Rubik’s Cube, and if you prefer a jigsaw puzzle that comes with a label that states “suitable for ages five and up,” then don’t worry. This chapter boils down the steps you need to take for estate-related tax planning into a concise, comprehensive action plan.
Notice the phrase estate-related taxes, and not estate tax, federal estate tax, or even the slang term death tax. Just as you do when you play your annual income tax fun and games, you likely find yourself dealing with more than one type of tax. You run into the federal income tax, state income taxes, local income taxes, property taxes, as well as state inheritance and estate taxes. As a result, when dealing with estate planning, you need to think about estate-related taxes, not just the federal estate tax.
This chapter helps you to focus on the estate-related taxes that will most likely impact your estate
— and to not worry about taxes that don’t.
Figuring Out Where You Are Today
Your first step in minimizing your estate-related taxes is to conduct a snapshot analysis of your current situation. Ask yourself: “Would I have any estate-related tax liability if I died today?”
To determine your estate-related tax liability, you need to perform the following activities:
Determine your estate’s value.
Conduct an inventory of what estate-planning steps you’ve already taken.
Consult the appropriate tables and charts to understand preliminary federal and state tax liability.
Look for tax traps that may unnecessarily cost you money.
After completing the preceding list of activities (this section shows you how), you’ll have a good idea which of the following categories you fall into with regards to estate-related taxes:
Significant tax-related concerns, which means you have a lot of work to do with your estate- planning team
Modest tax-related concerns, meaning you have some exposure, but with some fairly simple tactics, you can minimize your estate-related tax liability — or perhaps make that liability disappear altogether
No tax-related concerns, meaning your estate’s value is so far below the tax radar and you live in a state without any estate or inheritance taxes that you don’t need to worry at all about
estate-related taxes
Determining your estate’s value
Book 5, Chapter 2 describes how you need to have a good idea of your estate’s value and gives you the tasks and steps you need to assess that value. So if you haven’t completed this estate
valuation activity, get to it! This section, purely for example, assumes that your estate right now is worth $900,000 after subtracting out liabilities, such as the remaining mortgage on your home, an automobile loan, and credit card debt.
Totaling your gifts to date
The federal estate tax and gift tax are part of a unified tax system. In that system, you have a set of magic numbers that you can use in a mix-and-match manner to transfer property from your estate to others. Beyond nontaxable gifts, such as those with amounts lower than the annual exclusion
amount or that are otherwise free of gift tax, your taxable gifts reduce the amount of property that you can leave to others free of federal estate taxes after you die.
You need to compile a comprehensive list of any gift giving as well as the tax impact of those gifts. Take that amount and set it aside (you use it in the next section). Also, write down your estate’s value. You use the two figures to get an idea of estate-related tax liability if you were to die today.
For example, suppose you’re generous and have given $250,000 worth of taxable gifts through the years and haven’t paid gift taxes along the way. Instead of paying the gift taxes, you filed your gift tax returns as required and are holding off on gift taxes until those amounts are settled up against federal estate taxes after you die.
Checking the tax tables
Assume, God forbid, that you were to die today. You want to compare the exemption amount magic numbers for this year (that is, the year in which you’re doing your estate-related tax planning) with the answers to the questions you’ve asked according to the steps in the “Figuring Out Where You Are Today” section (“How much is my estate worth?” and “What have I done so far?”).
Make sure you use official tax table sources, such as those available on the Internal Revenue Service website at www.irs.gov and the tax-related pages you find on the website
for your state.
The federal estate tax exemption magic number for 2018 is $5.6 million. But suppose, for the sake of simplicity, that the exemption amount magic number is a nice, round $1 million, as it was in 2003. From the previous example, if your estate is worth $900,000, then you don’t have to worry about federal estate taxes, right?
Wrong! Because (again, according to the previous example) you’ve already used up $250,000 of your exemption amount through taxable gift giving. Therefore, you have a potential federal tax liability. Specifically, you may have to pay estate taxes on $150,000, calculated as follows:
1. Take the $1 million exemption amount.
2. Subtract out the $250,000 you’ve already used up through gift giving.
You have $750,000 left.
3. Take the $900,000 value of your estate and subtract the $750,000, leaving approximately
$150,000 of your estate that may be subject to federal estate taxes.
Why “approximately”? Well, you have several available deductions to further reduce your estate’s value when it comes to tax liability, such as probate costs, funeral expenses, and appraisal fees.
So that $150,000 figure may be further reduced before applying any tax rate calculations.
Even more importantly, regardless of your estate’s value, you can make two deductions that enable you to avoid having to pay any federal estate taxes. Specifically, you can use the marital deduction and charitable deduction to transfer significant amounts of property to your spouse or your favorite charities free of taxes. So if you leave most or all of your estate to your spouse or to one or more charities, then at least from a federal estate tax perspective, you don’t have any concerns right now.
Even rather modestly valued estates that are way beneath the amounts at which federal estate taxes become applicable may face significant tax liability in certain states that have fairly high estate or inheritance tax rates. So don’t forget to check your state’s tax rates.
In some states, the estate and inheritance tax system has different rates that apply to different
people to whom you leave property. Those rates vary by the relationship of those people to you: a relatively low rate for your children, for example, but a fairly high rate for someone unrelated to you. Additionally, your state may have various rates that increase the more your estate is worth (in technical terms, a graduated tax system).
Therefore, you need to take a look at the answer to yet one more question — “Who gets what?” — as you’ve specified in your will and as set up in various will substitutes (see Book 5, Chapter 3), such as joint tenancy with right of survivorship, or payable on death bank accounts. The answer to this “who-gets-what?” question, in concert with “What is my estate worth?” and “What have I done so far?” helps you obtain an accurate picture of your total estate-related tax liability if you were to die today.
Looking out for tax traps
To assess your current estate-related tax liability, look for tax traps in how your estate is structured. One of the most common tax traps that can whack even the most modest estate with unanticipated and unnecessary tax liability is your life insurance policy.
Depending on how you’ve structured your life insurance — specifically, who owns your life insurance policy — the insurance’s death benefit (that is, the amount of money that will be paid to one or more beneficiaries upon your death) may be added on top of your estate’s value for federal estate tax calculation purposes.
For example, suppose your estate is valued at $500,000 and you live in a state that has neither an estate nor inheritance tax, and you’ve never given any taxable gifts before. Most likely, you have no estate-related tax liabilities — or so you hope. But suppose the following three items occur:
You have a term life insurance policy (see Book 3, Chapters 1 and 2 for more on life insurance) with a death benefit of $2 million.
You haven’t taken steps to negate the federal estate tax bite, such as setting up a life insurance trust.
You die in a year when the federal exemption amount for estate taxes is $1 million.
Guess what. You essentially have died with $1.5 million subject to federal estate taxes (the $500,000 value of your estate plus the $2 million life insurance death benefit minus the
$1 million exemption amount) — even though your estate is really only worth $500,000 until you die!
So make sure that as you inventory your estate to determine its value, you work with your estate- planning team to look for tax traps in the following areas:
Life insurance (the previous example being a painful case in point)
Pensions, particularly any guaranteed future amounts that may be considered part of your estate even if you don’t have the right to take distributions right now
Other guaranteed future payments that may be considered part of your estate, such as future payments on deferred compensation, royalties, patents, monthly payments and balloon payments on money you’ve loaned out, and so on
Fortune-Telling: Picturing the Future as Best
You Can
Taking a snapshot of where you are today is fairly easy if you follow the suggestions given earlier in the chapter. But most estate planning is based on some future scene — your circumstances in 5, 10, 20, 50, or even 100 more years. Impossible, you say? Far-out tax planning is much more possible than you may imagine if you take care to do the following:
Predict (as best you can) your estate’s future value when you die.
Cross-reference your life span possibilities (that is, various scenarios on how much longer you may live) against future estate-related tax liability, paying special attention to the exclusion (or exemption) amount magic numbers.
Understand the tax impact of estate-planning strategies you already have in place.
Consider the tax impact of likely or inevitable changes to your family situation.
Make your best guess at future estate-related tax exposure.
Predicting the future
No, you didn’t suddenly wind up at the state or county fair, walking down the midway and finding yourself beckoned over to the palm-reading booth. But estate planning does involve making some educated guesses about what may happen in the future.
Specifically, you need to make a rough guess about how much your estate will be worth when you die. Of course, few people know when they’ll die, other than those who have a terminal illness and who have received a medical opinion as to how much longer they have to live.
For most other people, the best course of action is to look ahead to whatever an average life span is and how many years are left between now and then. For example, suppose you’re a 35-year-old female, in fairly good health, and with a family medical history that doesn’t have a lot of your relatives dying at relatively young ages. You may reasonably expect to live until 75, 80, or maybe even older, meaning that you can predict the future and settle on one particular target age — say 80 years old.
Hopefully, you already have a general-purpose financial plan (and if you don’t, please consult with your accountant to develop one) that takes into account factors, such as
Your property’s value
Your property’s expected future earnings, such as interest on your bank accounts and growth in your stocks, annuities, and mutual funds
Your current and anticipated future income
Anticipated significant future family expenses, such as your children’s college education or weddings for your three daughters
Additional expenses that are likely, such as caring for your own aging parents and your own anticipated medical expenses (as well as those of your spouse, if applicable)
The age at which you plan to retire
Some rough idea of ordinary living expenses during your retirement years, based on the lifestyle you anticipate and your retirement-versus-estate philosophy. (Do you specifically want to leave certain amounts of property behind for your children, grandchildren, or charities, or do you plan to spend as much of your money as possible during your retirement years?) If you’re looking at a span of 30, 40, or more years between now and the age at which you’re trying to predict your estate’s value, your calculations may be way off. But that’s okay, because all you’re trying to do is get a rough idea of whether your future estate may be worth, say, $1 million or $10 million when it comes to estate-related tax planning.
If, however, you’re close to retirement age — or maybe already in your retirement years — and you have a fairly accurate idea of how much of your estate you already are or soon will be spending during your retirement, then you can predict whether your estate’s value will be
About the same as it currently is
More than it currently is (you’re earning more in interest and retirement-years income than you’re spending, meaning that your estate continues to grow in value)
Less than it currently is because you’re gradually drawing down your estate’s value to provide retirement-years living expenses
Regardless of your current age and your particular situation, you need to have some idea of your estate’s future value so you can perform the next step — tax liability analysis — with some degree of accuracy.
Looking at several scenarios for the federal estate tax
The 2001 tax law made tax planning the financial equivalent of skeet shooting. The exemption amount magic number changed frequently between 2002 and 2009, disappeared along with the estate tax in 2010, and then came back at a lower amount in 2011. It’s been climbing ever since.
How can you possibly do any tax planning in such a volatile environment?
You should set up three different comparison numbers that feed into the steps that follow.
Specifically, you want to look at The best-case scenario
The in-between scenario The worst-case scenario
The best-case scenario
You can hope that the federal estate tax is repealed, meaning that no matter how much your estate is worth, you won’t have any federal estate tax liability. So if that’s the case, why do any tax planning at all?
Don’t get complacent. Your state may still have estate or inheritance taxes that don’t go away, either temporarily or permanently. Or Congress may decide to keep the federal estate tax repealed but still apply the gift tax and generation skipping transfer tax (GSTT). Another concern: If you receive certain government-provided medical care, your estate may get whacked for big dollars under the Estate Recovery Act.
So in the best-case scenario, you can put a big fat zero in the column titled “federal estate tax I may owe” because you won’t have an estate tax or an exemption amount. But don’t forget to consider other estate-related taxes and any related exemption amount magic numbers and other details.
The in-between scenario
The second scenario to consider — the in-between scenario — is one in which the federal estate tax hovers right around where it is now: around five and a half million dollars. Under the in- between scenario, you may find yourself having to worry about federal estate taxes, but only if your estate is worth more than that.
Again, as with the best-case scenario that has no federal estate tax, don’t forget to check your state’s estate-related taxes.
The worst-case scenario
The last scenario to consider is that the federal estate tax exemption amount will be lowered back to $1 million, meaning that if your taxable estate’s value exceeds that amount, say hello to federal estate taxes.
You should use the worst-case scenario because many people may find themselves susceptible to federal estate taxes, simply because of the possibly low exemption amount.
Blending your present strategies into the future
So far, from the preceding steps in this chapter, you have some key pieces of information with regards to estate tax planning and your future. Those keys are
Your future estate’s likely (or at least possible) value
Some raw data with regards to three different taxation scenarios that you can cross-reference against your estate’s value to predict future tax liability
Chances are, though, that if you’re not a newcomer to estate planning, you are already using some of the strategies discussed in this book, such as
Below-the-radar tax-free gift giving Various types of trusts