A year ago, Congress dramatically raised the federal estate tax exemption, which for 2013 was $5.25 million (or $10.5 million for a married couple). And that caused some people to mistakenly believe that they no longer need to think about estate planning if their assets are less than $5 or $10 million. However, nothing could be further from the truth. And people who don't keep their estate plan up-to-date are making a big mistake that could still be very costly to them and their families.
Many of the techniques that people have used in the past to avoid estate taxes - such as trusts - have lots of other purposes in addition to saving taxes.
For instance, leaving assets to someone in a trust can protect them over the long term if they're not good at managing money. Trusts can also shield children from losses in the event they get divorced, face a lawsuit, or start their own business. And if you have children from a former marriage, a trust can be a way to care for your new spouse if something happens to you, while still protecting your children.
Trusts can also protect children and grandchildren if they should ever have a problem with gambling or other addictions, or if they have special needs. All of these benefits still exist regardless of the level of the federal estate tax exemption.
While the federal estate tax is less of a problem, other taxes - such as income and capital gains taxes - have increased recently. There's also a new 3.8% surtax on investment income.
So you should know that techniques such as trusts, LLCs, and family limited partnerships, which in the past were used primarily to avoid estate taxes, can also be used to reduce these kinds of taxes, by giving you the flexibility to funnel income and capital gains to family members in the lowest tax brackets. Techniques such as charitable remainder trusts can also be used to shift income taxes from current years until post-retirement, lower-bracket years. And with capital gains taxes going up, it's increasingly important to use estate planning to adjust your heirs' basis in the property they inherit.
Most of the time, if a person dies owning assets that have appreciated in value, his or her heirs receive the assets with a new, "stepped-up" basis as of the date of death. Suppose Martha buys some stock for $50,000, and many years later it's worth $90,000. If Martha sells it, she'll have to pay tax on a $40,000 capital gain. But if she dies and leaves the stock to Lou, then Lou will have a "stepped-up" basis of $90,000, and if he sells it right away, he won't owe any tax. While capital gains basis is typically stepped up at death, it isn't always, so it's important to engage in estate planning to make sure your heirs aren't stuck with a large and unnecessary tax bill.
If you're not super-wealthy, health care costs in later years can be a bigger destroyer of wealth than the estate tax ever was. It's critical to consider health care in retirement as part of a complete estate plan.
While the federal estate tax is now a problem only for the very wealthy, many states impose their own estate taxes, and these often kick in at much lower thresholds. New Jersey, for instance, imposes a tax on all estates with assets of more than $675,000. Six other states have estate tax thresholds of $1 million or less. It's still important to plan around avoiding these taxes.
In addition, some states impose inheritance taxes. Inheritance taxes are different from estate taxes, because estate taxes are paid by a dying persons estate, while inheritance taxes are paid by the dying person's heirs. Inheritance taxes don't depend on where the heir lives; they're based on where the dying person lived or owned property. So if you live in Florida but you inherit assets from a relative in Arizona who owned property in Iowa, you might owe Iowa inheritance tax.
In some states, the inheritance tax rate varies depending on the heir's relationship to the dying person - so a child might pay one rate, a cousin might pay another, and a lifelong friend might pay yet another.
It's important to plan for this, too, if for no other reason than to compensate your heirs if you're going to saddle them with unexpected taxes after you die.
Estate planning has always been about more than just taxes, or even just financial assets. It's about family. What will happen to your family home, or a beloved vacation home? What will happen to a family business? If you have minor children, how will they be taken care of? Who will receive possessions that have sentimental value? Will your children feel that they've been treated fairly, and be encouraged to get along and use their legacy in accordance with your values? All these issues can (and should) be dealt with in a complete estate plan.
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