Nearly everyone should consider updating his or her estate plan. This is smart advice even if you're not currently exposed to the federal estate tax. Year end can be a convenient time to reflect on major life changes and plan for the future, including devising strategies to minimize taxes.
Reasons to Review Your Plans
For 2019, the unified federal estate and gift tax exemption is $11.4 million (effectively $22.8 million for married couples). Thanks to these generous exemptions you may not currently be exposed to the federal estate tax.
However, there's a distinct possibility that today's favorable estate and gift tax exemptions won't last. They're set to expire in 2026 under current law, unless Congress extends them. However, some lawmakers have expressed interest in ending them sooner, along with other unfavorable tax changes. So, depending on what happens in Washington, you could be exposed to the federal estate tax in the near future, after all. Plus, lower exemption amounts may apply at the state level if you live in a state with a death tax.
You also might need to update your estate plan for nonfinancial reasons. Examples include changes in marital status, the birth or adoption of a child, the death of a loved one, the launch of a business venture, the acquisition of new assets (or debts) via a purchase or inheritance, and even a lottery windfall. Here are some steps to consider.
Establish Your Will
First and foremost, it's essential to have your last will and testament drafted. If you die intestate (without a will), the laws of your state will determine the fate of your minor children and who will inherit your assets. A written will makes your wishes known.
There are three main purposes for putting together a will:
- To name a guardian for any minor children and other nonchild dependents,
- To name an executor (and an alternate executor, in case your first choice is unable or unwilling to serve) for your estate, and
- To specify which beneficiaries (including charities) will get which assets.
The guardian's job is to take care of your nonchild dependents (such as a disabled sibling) and your kids until they reach adulthood (age 18 or 21 in most states). The executor's job is to pay your estate's bills, including any taxes, and deliver what's left to your intended heirs and charitable beneficiaries.
Create a Living Trust
For people with significant assets, a fundamental estate planning goal is to avoid probate, if possible. Probate is the court-supervised process of:
- Identifying and valuing the assets of an estate,
- Paying off the estate's debts (including any federal estate tax, state death tax, and unpaid federal and state income taxes), and
- Distributing the remainder to the rightful heirs and beneficiaries.
Probate can potentially involve multiple court appearances by the estate's attorney, lots of paperwork and lengthy delays before an estate's assets can be distributed. The process can be expensive, time consuming and frustrating for heirs.
A living trust can 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 primary residence and vacation property.
Note: You should also have a so-called “pour-over will” drawn up. This document stipulates that assets that aren't officially owned by the trust still belong under its umbrella. Items such as vehicles, artwork, jewelry and collectibles may be covered.
The trust document should 1) name a trustee to manage the trust's assets after you die, and 2) specify 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).
For state-law purposes, the living trust isn't ignored. That's why, if set up properly, a living trust avoids probate.
When you die, the assets in the living trust are included in your estate for federal estate tax purposes. However, thanks to the unlimited marital deduction privilege, assets that go to your surviving spouse aren't included if he or she is a U.S. citizen.
Important: If you set up a living trust, you must transfer to the trust legal ownership of the most important assets for which you wish to avoid probate (typically homes and other real property). Many people set up living trusts and then fail to actually transfer ownership of their assets. When this happens, the probate-avoidance advantage is lost unless your estate's executor can argue that the problem is cured by your pour-over will.
Update Your Beneficiary Designations
A will or living trust document doesn't override beneficiary designations for:
- Life insurance policies,
- IRAs and other tax-favored retirement accounts,
- Employer-sponsored benefit plans,
- 529 college savings accounts, and
- Bank and brokerage firm accounts.
Review your designations at year end. If you need to make changes, your financial and legal advisors can help you complete the appropriate forms.
Important: It's also important to consider naming one or more secondary (contingent) beneficiaries to inherit these accounts in the event the primary beneficiary dies before you do.
As a general rule, whoever is named on the most-recent beneficiary form will get the asset automatically if you die, regardless of what your will or living trust document might say. So, if you've failed to update your beneficiary designations, don't assume that your will or living trust will protect your heirs. Fix the problem now while it's on your mind.
Beyond 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. Your intended heirs, those you intended to get little or nothing, and other interested parties can make objections and create roadblocks during this process. Probate can become time-consuming, expensive and downright ugly.
Review Real Property Ownership
Owning property (like your home) with another party (such as a spouse) as joint tenants with the right of survivorship (JTWROS) also protects the property from probate in case one joint tenant dies.
For example, John owns a home with his adult daughter Jane as JTWROS. John unexpectedly dies. The surviving joint tenant (Jane) automatically takes over sole ownership of the property — without becoming embroiled in the probate process.
If you haven't already established JTWROS ownership, contact a real estate attorney to discuss whether this type of ownership makes sense for your situation.
Things change. You may win the lottery, lose loved ones to death, and gain children or grandchildren. Such events could require changes in your estate plan. Plus, the federal estate and gift tax rules — as well as the state death tax rules — have proven to be unpredictable. For all these reasons, it's a good idea to get into the habit of reviewing your estate plan at the end of each calendar year. Your financial and legal advisors can help you make changes as needed.