Most people aren’t currently exposed to the federal estate tax, thanks to the generous unified federal estate and gift tax exemptions. However, there are still good reasons to review your estate plan and possibly update it to reflect the current federal estate and gift tax regime as well as life events. Plus, there’s always uncertainty about the future direction of the federal estate and gift tax rules.
As the end of the year approaches, here are some proactive estate planning moves to consider.
Learn the Essentials
The Tax Cuts and Jobs Act (TCJA) made favorable changes to the federal estate and gift tax regime. For 2020, the unified federal estate and gift tax exemption is $11.58 million, or effectively $23.16 million for married couples. That’s generous by historical standards.
For 2021, the exemption is scheduled to increase to $11.7 million, or effectively $23.4 million for married couples. In 2026, the exemption is set to fall to about $6 million, or $12 million for married couples, after inflation adjustments — unless Congress changes the law sooner. (See “Estate Planning: Why Now?” below.)
Who are your beneficiaries?
It’s important to periodically review your beneficiary designations, especially if you’ve experienced a major life event (such as marriage, divorce, or the birth or adoption of a child). This may seem like common sense, but failure to update beneficiary designations is a common oversight.
Remember: A will or living trust document does not override beneficiary designations for life insurance policies, retirement accounts and so forth. Your estate planning pro can provide a checklist of assets that need beneficiary designations.
As a general rule, whoever is named on the most-recent beneficiary form will get the money automatically if you die, regardless of what your will or living trust document says. So, if you’ve forgotten to update your beneficiary designations — or you erroneously think it doesn’t matter because you have a will or living trust — you’ll need to fix your designations immediately.
Beyond just ensuring that your money goes where you want it to go, another advantage of designating beneficiaries is that it avoids probate. That’s because the money goes directly to the beneficiaries you’ve named by operation of law.
In contrast, if you name your estate as your beneficiary and then depend on your will to parcel out assets to your intended heirs, your estate must go through the court-supervised probate process. (See “Avoiding Probate” at right.)
Update Real Property Ownership
If you’re married and own property with you and your spouse named as joint tenants with right of survivorship (JTWROS), the surviving spouse will automatically take over sole ownership of the property when the other spouse dies.
On the other hand, if you own property with a nonspouse as JTWROS, the surviving joint tenant will automatically take over sole ownership when the other joint tenant dies. That’s great if it’s your intention and you’ve already set up JTWROS ownership. But if that’s what you intend, and you’ve not yet established JTWROS ownership, consult your legal advisor as soon as possible to get this done.
Important: Perhaps the biggest advantage of JTWROS ownership is that it avoids probate. Instead, the property automatically goes to the surviving joint tenant.
Create (or Review) a Will
If you die intestate (without a will), the laws of your state will determine the fate of your minor children and assets. Unless you like being at the mercy of your state, you need a written will to make your wishes known. The main purposes of the will are to name:
- A guardian to care for your minor children (if any) until they reach adulthood, and
- An executor, who will pay the estate’s taxes and any other bills and then deliver what’s left to your intended heirs and charitable beneficiaries.
A will also specifies which beneficiaries (including family members, friends, employees and charities) should get which assets.
Establish (or Update) a Living Trust
For those with significant assets, a living trust can be an effective tool to help avoid probate. Here’s how it works: You establish the living trust and transfer legal ownership of assets for which you wish to avoid probate, such as your main home and your vacation property.
You should also have a so-called “pour-over will” drafted. That document stipulates that assets, which aren’t officially owned by the trust, still belong under its umbrella. Examples might include vehicles, valuable Persian rugs, coin collections and jewelry.
The trust document names a trustee, such as an attorney, professional advisor or adult child, to manage the trust’s assets after you die. The document also specifies which beneficiaries will get which assets from the trust and when. Because a living trust is revocable, you can change its terms at any time, or even unwind it completely, as long as you’re alive and legally competent.
For federal income tax purposes, the existence of the living trust is completely ignored while you’re alive. As far as the IRS is concerned, you still personally own the assets that are legally held by the trust. So, you continue to report on your personal tax returns any income generated by trust assets and any deductions related to those assets, such as mortgage interest on your home. However, for state-law purposes, the living trust isn’t ignored, and, if done properly, it avoids probate.
When you die, the assets in the living trust are included in your estate for federal estate tax purposes. However, assets that go to your surviving spouse aren’t included if he or she is a U.S. citizen (thanks to the unlimited marital deduction privilege).
Important: If you set up a living trust, you must transfer legal ownership of the most important assets for which you wish to avoid probate (typically homes and other real property) to the trust in order to successfully avoid probate. Many people set up living trusts and then fail to follow through by transferring ownership. If so, the probate-avoidance advantage is lost unless your estate’s executor can argue that the problem is cured by your pour-over will.
Set Up an Irrevocable Life Insurance Trust
Life insurance death benefits are generally free from federal income tax. However, the death benefit from any policy on your own life is included in your estate for federal estate tax purposes if you have so-called “incidents of ownership” in the policy. It makes no difference if all the insurance money goes straight to your designated beneficiaries.
It doesn’t take much to have incidents of ownership. For example, you have incidents of ownership if you have the power to:
- Change beneficiaries,
- Borrow against the policy,
- Cancel the policy, or
- Select benefit payment options.
This unfavorable life insurance ownership rule can cause unsuspecting individuals to be exposed to the federal estate tax.
Important: The life insurance ownership rule is more likely to adversely affect single people. That’s because the death benefit from a policy on the life of a married person can be left to the surviving spouse without any current federal estate tax hit, thanks to the unlimited marital deduction privilege (assuming the surviving spouse is a U.S. citizen). In contrast, single people don’t have that privilege, which leaves them without an easy way to remove life insurance death benefit proceeds from their taxable estates.
To avoid this pitfall, individuals with large estates can set up irrevocable life insurance trusts to own policies on their lives. The death benefits can then be used to cover part or all of the estate tax bill. This is accomplished by authorizing the trustee of the life insurance trust to purchase assets from the estate or make loans to the estate. The extra liquidity is then used to cover the estate tax bill.
The irrevocable life insurance trust is later liquidated by distributing its assets to the trust beneficiaries (your loved ones). Then, the beneficiaries wind up with the assets purchased from the estate or with liabilities owed to themselves. And the estate tax bill gets paid with money that wasn’t itself subject to the federal estate tax.
Various rules and restrictions apply to irrevocable life-insurance trusts. Contact your estate tax advisor to discuss whether this a tax-smart move for you.
More Tax-Smart Planning Moves
Wealthy individuals with estates above the unified federal estate and gift tax exemption should consider other options to lower their exposure to federal estate and gift taxes, including:
Annual gifts. The current annual federal gift tax exclusion is $15,000. Annual gifts help reduce the taxable value of your estate without reducing your unified federal estate and gift tax exemption.
College tuition or medical expense payments. You can pay unlimited amounts of college tuition and medical expenses (but not room-and-board expenses) without reducing your unified federal estate and gift tax exemption. However, you must make the payments directly to the college or medical service provider.
Gifts of appreciating assets. In 2020, you can give away up to $11.58 million worth of appreciating assets, such as stocks and real estate, without triggering federal gift tax (assuming you have never tapped into your unified federal estate and gift tax exemption in prior years). If you’re married, your spouse is entitled to a separate exemption.
Cumulative gifts during your life up to the exemption amount are gift-tax-free and can be on top of 1) the annual gift tax exclusion, and 2) cash gifts to directly pay college tuition or medical expenses. When it comes to gifts of appreciating assets, using up some of your exemption can be a tax-smart move, because the future appreciation is kept out of your taxable estate.
Things change. You may win the lottery, lose loved ones, and gain children or grandchildren. Major life events could require changes in your estate plan. Plus, the federal and estate and gift tax rules, along with state death tax rules, have proven to be unpredictable.
For all these reasons, you should review your estate plan. If you wait, your current estate plan with all its flaws, or your completely missing estate plan, will be locked in when you die. Contact your estate planning professional to schedule a meeting.