The purpose of this article is to provide a brief overview concerning both tax and non-tax issues that should be considered in doing estate planning.
I. What is Estate Planning?
Estate planning is the process of arranging one's affairs so that the transfer of assets at the time of incapacity, illness or death is accomplished in a most efficient manner. In achieving this efficiency, one has to try to control both tax and non-tax factors. Non-tax factors consist of unnecessary expenses such as guardianship proceedings and probate proceedings. Tax factors consist of matters such as federal gift tax issues and federal estate tax issues.
The easiest approach to estate planning is to sit down with a qualified professional for an initial interview and discuss matters pertaining to your objectives and your assets.
A typical estate plan for most clients will consist of the following:
1. "Pour Over" type Will
2. Revocable Living Trust
3. Power of attorney Health Care
4. Power of Attorney for Property.
Depending on the circumstances, there are many other types of documents that may be required, such as insurance trusts, gift trusts, etc.
II. Which is better: a Will or a Trust?
In answering this question, one must understand the three phases that we as human beings go through:
1. The present phase, where we are able to manage our own affairs.
2. A phase in which we are alive but incapacitated due to illness, old age, or trauma.
In determining whether a will or a trust is better, one must understand that a will only deals with the death phase. The will does not even take effect until you are deceased. Thus, if you are looking to do estate planning for yourself you must consider all three phases.
A revocable living trust is more suitable to caring for all three phases. During the present phase a revocable living trust is, for all practical purposes, transparent. It will not affect the way you use your assets. During phases two and three however the revocable living trust can be critical. During phase two in which you are alive but incapacitated, guardianship proceedings are often necessary in order to have a court appointed individual manage your assets for the rest of your life. This should be avoided if possible. You have no control over who will be selected as a guardian. In the final phase of death, the trust acts much like a will, however the assets will pass pursuant to the instructions set forth in your trust and avoid probate. A will on the other hand must be subject to probate in the probate court, thus incurring additional expenses, somewhat similar to those incurred in a guardianship proceeding. Thus for most clients a revocable living trust is preferable. However, it is not recommended for all clients.
III. How are Estates Taxed?
Estates are taxed once your assets exceed $625,000.00. This threshold amount will go to $650,000.00 on January 1, 1999, and increase annually until by the year 2006 one can own $1,000,000.00 in assets before you have to worry about estate taxes. However, you must understand that in computing whether or not you reach the threshold you must add everything that you own together, such as the value of your home, personal possessions, the face value of life insurance policies, the face value of your IRA's and 401k's, etc. Many people are surprised when they add these amounts together and they find themselves in a taxable estate position.
Once the gross estate have been computed, you are allowed to subtract your $625,000.00 free amount from this number. You are also entitled to subtract certain deductions such as charitable deductions, administrative expenses, and the marital deduction. The marital deduction represents anything that you leave to your spouse through a will, a trust, joint tenancy, etc.
Once these subtractions are made, you are left with your taxable estate, and at that point you are taxed at rates beginning at 37=%, going all the way to 55%. These taxes must be paid within nine months of your death.
IV. Estate Planning Strategies.
There are two particular strategies that are employed to minimize estate taxes. First of all, we try to plan so that each spouse can fully utilize a $625,000.000 (soon to be $650,000.00) free amount. If both spouses correctly use these free amounts then that means that they together can have $1,250,000.00 of assets free. But this is where most estate planning breaks down and most clients fail to seek the appropriate counsel concerning how to structure their assets so that these two free amounts may be used.
The second estate planning strategy is to defer any taxes that cannot otherwise be avoided until the death of the second spouse, assuming there is marriage. This is done through the use of the marital deduction. Again however, this is where most clients make mistakes. If not used in an optimal manner, the marital deduction can be overused, thus causing more taxes to be paid at the death of the second spouse than would have otherwise been required to have been paid had both spouses prudently used the marital deduction. Again, this requires the advice of counsel.
Other estate planning strategies consist of trust planning with life insurance, gifting to members of the family, and usage of other more sophisticated techniques.
V. Advance Directives- Caring for an Ill or Incompetent Person.
Advance directives represent the usage of documents that are prepared by yourself in advance of an illness or incompetence so that your wishes can be understood during such a period with incapacity. Specifically, powers of attorney for Healthcare and powers of attorney for property are advance directives. These are documents wherein you describe who you would like to manage your health or financial affairs during your period of incapacity. You also describe when this document is to take effect and under what circumstances it may be executed. This is a very important part of estate planning. Here you have the ability to choose who will handle certain of your affairs.
VI. Types of Ownership.
Assets can be held in many different forms of ownership. Many people readily recognize trust ownership, joint tenancy, and tenancy in common as the most readily used forms of ownership. However, there are many other forms of ownership. Many of these forms of ownership accomplish other objectives, such as creditor protection. Tenancy by the entirety, which is available for usage by both spouses and only with regard to their personal residence is a type of ownership form that can provide some insulation from creditor claims against the personal residence. This is not available at all times, but is available to spouses quite often. Again, the advice of counsel is required in order to determine whether this is available and appropriate for you.
As mentioned above, joint tenancy is a readily recognized form of ownership. In this writer's opinion however it is the most overused form of ownership in the United States. It can result in unintended tax and non-tax consequences that are very negative and harmful. Joint tenancy should be used sparingly. Again, the advice of counsel is necessary in titling assets.
VII. Other Related Legal Considerations.
In talking about estate planning, there are three other areas that must be taken into consideration.
The first area is Medicaid planning. Medicaid planning is fraught with danger because certain transfers that are made in contemplation of a nursing home stay can result in more harm than good. If done early enough and with the appropriate advice, Medicaid planning however is a viable means of protecting one's assets from being totally lost in an extended nursing home stay.
Asset protection planning as briefly discussed above is another area of estate planning that must be addressed. Asset protection planning is the subject of another article.
IRA and 401k usage is the yet another estate planning consideration. In doing estate planning, sometimes adjustments must be made to the beneficiary designations of your IRA's and 401k's so that the disbursement of these accounts is consistent with your overall estate plan. Quite often people assume that your IRA's and 401k's will pass pursuant to the terms set out in your will or your trust. This is not true. The beneficiary designations as stated in your IRA will control the disposition of such an account and therefore careful attention and advice must be obtained in the appropriate titling of such beneficiary designations.
I hope that this article has served as an overview of what some of the issues are that you face in the estate planning process. Everyone's estate planning is different. For some people it is very simple and for other people it is more complex. You will not know what your concerns and requirements are until you sit down and begin the process. I encourage you to do so. You have our best wishes for a happy and healthy and prosperous New Year.
Note: This article is not intended to provide tax or legal advice, but rather should serve as a background for more in-depth discussion with your financial advisors and estate planning counsel. If you have any questions, or if we can be of any assistance, please contact us.
Anthony B. Ferraro, Attorney/CPA, is the Principal of the Law Offices of Anthony B. Ferraro, concentrating in Wills, Trusts, Probate, Estate Planning, Elder Law and Business Taxation. Mr. Ferraro's main office is located in Rosemont, Illinois.
For more information, call 847.292.1220.