The primary purpose of estate planning is to ensure an orderly transfer of property to whomever you see fit. Without a strategy to accomplish this, your heirs might encounter problems including an inappropriate distribution of your assets, the care for minor children left in the hands of a court, settlement costs and administrative fees that deplete the value of your estate.
A common error people make is to assume that estate planning only refers to dying. In fact, an important part of estate planning is to take the appropriate steps to ensure management of your financial affairs if you become disabled or terminally ill.
Giving gifts - either to loved ones or to a loved charity - is not only fulfilling, but also an important strategy for maximizing your legacy. Charitable giving techniques can potentially eliminate capital gains taxes and/or lower your income and estate taxes.
Estate Planning Basics
Marital Deduction
The Internal Revenue code ("IRC") grants an unlimited gift and estate tax deduction for all transfers to a spouse whether made during life or death. Thus, any one may give or leave his or her entire estate to the surviving spouse without gift or estate taxes.
The following qualify for the marital deduction: Outright gifts and bequests, jointly-held property, life insurance, joint and survivor annuities, certain life estates in real estate, and trusts of which the surviving spouse is sole income beneficiary for life.
Annual Exclusion
A tool commonly used to minimize federal gift and estate taxes. Any individual is allowed to gift up to $12,000 per year in 2006 to any person without incurring a gift tax. This is known as the annual exclusion amount. A restriction on annual exclusion gifts is that the recipient must be allowed the right of immediate use and enjoyment of the gift. If the recipient cannot enjoy or use the gift immediately, it will be considered a gift of future interest and will not qualify for the annual exclusion.
Unified Credit
A credit is an amount that eliminates or reduces tax. A unified credit applies to both the gift tax and the estate tax. You must subtract the unified credit from any gift tax that you owe. Any unified credit you use against your gift tax in one year reduces the amount of credit that you can use against your gift tax in a later year. The total amount used during life against your gift tax reduces the credit available to use against your estate tax.
Under prior law, the same unified credit amount applied to both the gift tax and the estate tax. Under current law, however, the unified credit against taxable gifts will remain at $345,800 (exempting $1 million from tax) through 2009 while the unified credit against estate tax increases during the same period.
Using Trust in Estate Planning
Although different kinds of trusts serve different purposes, various kinds of trusts can allow you to:
- Protect your financial interests in the event of a disability
- Control the disposition of your assets both during your life and after you die
- Avoid the probate process if all assets are in trust or governed by a beneficiary designation
- Keep your affairs private
- Reduce estate taxes and settlement costs
- Augment a gift to your favorite charity
Types of Trust
Revocable Living Trusts
A revocable living trust is created during your lifetime. You, then, are considered the grantor of the trust. Only the grantor may alter, amend, or revoke the trust. In conjunction with the creation of this type of trust, you transfer the title but you still keep all the control over the assets. Typically, you will transfer assets that would ordinarily pass through probate (i.e. assets that you own outright, such as savings and checking account balances, real estate). It does not provide the grantor with any tax benefits, but it does help avoid probate on any assets transferred into it. It can also provide for management of your assets during your lifetime if you become mentally or physically disabled. It becomes irrevocable or terminates at the grantor's death.
Marital and Credit Shelter Trusts
Marital and Credit Shelter Trusts (also know as A/B Trusts or Marital/Bypass Trusts) are estate-planning tools used to reduce the combined estate taxes of a married couple. At the death of the first spouse, the estate is divided into two parts. One part (Credit Shelter or 'B' Trust), equal to the Applicable Exclusion Amount ($2,000,000 in 2006), is placed in a trust that may provide income for the life of the surviving spouse but is not included in his or her estate. The other part of the first spouse's estate either passes outright to the surviving spouse, or is placed in a Marital Trust ('A' Trust) to take advantage of the Unlimited Marital Deduction for the spouse's benefit. Those assets, in trust or not, are taxable in the survivor's estate when that spouse dies.
Irrevocable Life Insurance Trusts
With an Irrevocable Life Insurance Trust (ILIT), the grantor completely gives up all rights in an insurance policy and other assets transferred to the trust. It is typically used in estate planning to shelter the insurance death benefit from estate taxes and may help provide the liquidity to help pay estate taxes and settlement costs. Ideally, the trust is created first, then it purchases and owns the policy. Upon death, the insurance proceeds are paid out in accordance with the terms of the trust.
Charitable Remainder Trusts
Charitable Remainder Trusts (CRTs) are irrevocable trusts that allow you (the donor) to increase your current income and potentially reduce income and estate taxes, while providing a substantial benefit for the charity of your choice.
After creating this trust, you would make a gift of financial or real property to it (ideally these will be highly appreciated assets) and receive a charitable income tax deduction. Once this is done, the trust can sell the asset (and avoid the capital gains taxes that you would have paid if you sold it) and distribute an income to you for a term of years or for the remainder of your life. When the trust term expires, a named charity receives the trust principal (the remainder), and your estate gets a deduction for the amount of the gift to charity. Often, a way to replace these assets is to use part of the additional income stream to purchase life insurance, preferably outside the estate in an irrevocable trust.
Charitable Lead Trusts
Charitable Lead Trusts (CLTs) are exactly the inverse of Charitable Remainder Trusts. Again, you will create a trust and make a gift of financial or real property to it (for which you may or may not receive a charitable income tax reduction, depending on the design of the trust, but a taxable gift of the remainder interest is created). When the trust sells these assets, it will avoid the capital gains taxes that you would have paid on the sale. In this case, however, the income that the trust generates is paid to the charity of your choice for the remainder of your life or for a term of years. At the end of that time, the remainder of the trust principal is paid to a non-charitable beneficiary (typically your children or grandchildren).
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The information above is to be of a general nature. It is provided with the understanding Nathan Simmons Wealth Solutions is not engaged in providing tax or legal services. Consult with your attorney, accountant, and/or tax advisor for advice concerning your particular circumstances.