I will start with a disclaimer: I am not an attorney or a certified financial planner. Much of this information is based on recent experience in redoing my wife’s and my personal estate plans.
Clearly, this is an area of extreme technical complexity that must be handled exactly right, and it is critical to seek the advice of your estate planner and attorney. I believe that a portion of the cost of estate planning may be deductible from income tax.
Everyone needs a will regardless of the size of his or her estate. Dying without a will necessitates probate of the estate, which can be very expensive and result in your assets being distributed in a manner that you may not have intended. In addition to a will, other items that I consider essential are a directive to physicians, or "living will," health care power of attorney, a statutory durable power of attorney, and documents designating your choice of guardians for your minor children.
Currently, the U.S. Tax Code allows a $5 million–per person estate tax exemption. When combined with the unlimited marital deduction (which states that an individual can leave an unlimited estate to their spouse without tax consequences), this allows up to $10 million to be passed to heirs without estate taxes.
Most estate planners suggest a will that leaves an amount to the surviving spouse up to the exempt amount in a trust (bypass trust), which then passes untaxed to the heirs if not spent. Growth in the trust is also outside estate taxes. The remainder of the estate passes to the surviving spouse under the unlimited deduction. Most advisers suggest that, if possible, the surviving spouse should live on this money rather than the bypass trust since it remains within the taxable estate. The amount of the current exemption can then be passed by the surviving spouse to the heirs – again, without estate taxes.
The remainder of the estate will be subject to estate taxes based on the law at the time of death. The current $5 million exemption will allow a very high percentage of estates to pass down without taxation.
This exemption is scheduled to expire at the end of 2012, when it will return to $1 million. Most experts expect that the $5 million exemption will not be renewed, but they believe something more than $1 million will be allowed.
Several individuals have approached me with ideas for avoiding estate taxation. If you find yourself in a similar situation, I would advise extreme caution. Check out any suggested "tax avoidance schemes" with your attorney or estate planner.
The likely change in the estate tax exemption presents either a dilemma or an opportunity for estate planning. Any gifts given during 2012 will be within the current exemption, but giving away assets to avoid estate taxes may not always be the best plan.
To qualify for exemption, gifts must be irrevocable. Individuals may make gifts of $13,000/year per person, which do not apply to the lifetime exemption. This means that a couple can give $26,000/year to each child and grandchild (or parent). Gifts that directly pay educational or health care expenses are also exempt.
Another vehicle for transfer of wealth without estate taxes is an insurance trust. A trust is established that is outside the estate of the donor that benefits specified persons. The trust can then purchase insurance, which passes free of estate and other taxes, to the beneficiaries upon the death of the donor. (Note that estate taxes will increase from the current rate of 35% to 55% at the end of 2012, if the law is not changed.)
A relatively low-cost vehicle to fund such a trust is a "second-to-die" life insurance policy that covers the life of both of the donors and pays at the time of the second death. Depending on the amount of the premium, that can be paid by gifts that are within the annual exclusion of the beneficiaries, or this amount can be exceeded in 2012 and applied to the $5 million exemption.
Titling of assets is another potentially important issue. If you hold significant assets in an account with right of survival, upon your death, the assets pass to the survivor outside your will. This may mean that those moneys are not subject to the estate tax exemption mentioned above.
Finally, you must decide what to do with assets that may exceed the exemption and will be subject to estate taxation. Is it better to give 40%-50% of your assets to heirs and 50%-60% to the government, or give a significant amount free of taxes to a charity or charities of your choice? My personal feeling is that it may be a bad idea to make my children "wealthy" after my death. It is my goal to provide for the education of my children and possibly grandchildren. Endowing a scholarship or chair or building may provide an enduring legacy.