What Is Estate Planning?

Estate planning is the preparation of tasks that serve to manage an individual's asset base in the event of their incapacitation or death. The planning includes the bequest of assets to heirs and the settlement of estate taxes. Most estate plans are set up with the help of an attorney experienced in estate law.

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Estate Planning Basics

Estate Planning Explained

Estate planning involves planning for how an individual’s assets will be preserved, managed, and distributed after death. It also takes into account the management of an individual’s properties and financial obligations in the event that they become incapacitated.

Assets that could make up an individual’s estate include houses, cars, stocks, paintings, life insurance, pensions, and debt. Individuals have various reasons for planning an estate, such as preserving family wealth, providing for surviving spouse and children, funding children and/or grandchildren’s education, or leaving their legacy behind to a charitable cause. The most basic step in estate planning involves writing a will. Other major estate planning tasks include:

  •  Limiting estate taxes by setting up trust accounts in the name of beneficiaries
  • Establishing a guardian for living dependents
  • Naming an executor of the estate to oversee the terms of the will
  • Creating/updating beneficiaries on plans such as life insurance, IRAs and 401(k)s
  • Setting up funeral arrangements
  • Establishing annual gifting to qualified charitable and non-profit organizations to reduce the taxable estate
  • Setting up a durable power of attorney (POA) to direct other assets and investments

Writing a Will

A will is a legal document created to provide instructions on how an individual’s property and custody of minor children, if any, should be handled after death. The individual expresses their wishes through the document and names a trustee or executor that they trust to fulfill the stated intentions. The will also indicates whether a trust should be created after death. Depending on the estate owner’s intentions, a trust can go into effect during their lifetime (Living Trust) or after the death of the individual (Testamentary Trust).

The authenticity of a will is determined through a legal process known as probate. Probate is the first step taken in administering the estate of a deceased person and distributing assets to the beneficiaries. When an individual dies, the custodian of the will must take the will to the probate court or to the executor named in the will within 30 days of the death of the testator.

The probate process is a court-supervised procedure in which the authenticity of the will left behind is proven to be valid and accepted as the true last testament of the deceased. The court officially appoints the executor named in the will, which, in turn, gives the executor the legal power to act on behalf of the deceased.

Appointing the Right Executor

The legal personal representative or executor approved by the court is responsible for locating and overseeing all the assets of the deceased. The executor has to estimate the value of the estate by using either the date of death value or the alternative valuation date, as provided in the Internal Revenue Code (IRC).

A list of assets that need to be assessed during probate include retirement accounts, bank accounts, stocks and bonds, real estate property, jewelry, and any other items of value. Most assets that are subject to probate administration come under the supervision of the probate court in the place where the decedent lived at death. The exception is real estate. You must probate real estate in the county in which it’s located.

The executor also has to pay off any taxes and debt owed by the deceased from the estate. Creditors usually have a limited amount of time from the date they were notified of the testator’s death to make any claims against the estate for money owed to them. Claims that are rejected by the executor can be taken to court where a probate judge will have the final say on whether or not the claim is valid.

The executor is also responsible for filing the final personal income tax returns on behalf of the deceased. Any estate taxes that are pending will come due within nine months of the date of death. After the inventory of the estate has been taken, the value of assets calculated, and taxes and debt paid off, the executor will then seek authorization form the court to distribute whatever is left of the estate to the beneficiaries.

Planning for Estate Taxes

Federal and/or state taxes applied on an estate can considerably reduce its value before asset distribution is made to beneficiaries. Death can result in large liabilities for the family, necessitating generational transfer strategies that can reduce, eliminate, or postpone tax payments.

During the estate planning process, there are significant steps that individuals and married couples can take to reduce the impact of these taxes. For instance, married couples can set up an AB trust that divides into two after the death of the first spouse. Or a grandfather may encourage his grandchildren to seek college or advanced degrees and, therefore, transfer assets to an entity for the purpose of current or future education funding.

That may be a much more tax-efficient move as opposed to dying, having those assets transferred, and finally having the same assets fund college when the beneficiaries are of college age. The latter may trigger multiple tax events that can severely limit the amount of funding available to the kids.

Another strategy an estate planner can take to minimize the estate’s tax liability after death is by giving to charitable organizations while alive. The gifts reduce the financial size of the estate since they are excluded from the taxable estate, thus, lowering the estate tax bill. As a result, the individual has a lower effective cost of giving, which provides additional incentive to make those gifts. And of course, an individual may wish to make charitable contributions to a variety of causes. Estate planners can work with the donor in order to reduce taxable income as a result of those contributions and/or formulate strategies that maximize the effect of those donations.

Estate freezing is also a strategy that can be taken to limit death taxes. It involves an individual locking in the current value and thus, tax liability, of his or her property, while attributing the value of future growth of that capital property to another person. Any increase that occurs in the value of the assets in the future is transferred to the benefit of another person, such as a spouse, child, or grandchild. This method involves freezing the value of an asset at its value on the date of transfer. Accordingly, the amount of potential capital gain at death is also frozen, allowing the estate planner to estimate his or her potential tax liability on death and better plan for the payment of income taxes.

Using Life Insurance in Estate Planning

Life insurance serves as a source to pay death taxes, pay expenses, fund business buy-sell agreements, and fund retirement plans. If sufficient insurance proceeds are available and the policies are properly structured, any income tax arising on the deemed dispositions of assets following the death of an individual can be paid without resorting to the sale of assets. Proceeds from life insurance that are received by the beneficiaries upon the death of the insured are generally income tax-free.

Estate planning is an ongoing process and should be started as soon as one has any measurable asset base. As life progresses and goals shift, the estate plan should shift in line with new goals. Lack of adequate estate planning can cause undue financial burdens to loved ones (estate taxes can run higher than 40%), so at the very least a will should be set up even if the taxable estate is not large.