Step 1) Calculate your estate’s value.
Knowing whether your estate is (or may become) large enough to trigger estate taxes may influence your planning strategies.
- Do the math.
- Add up the current market value of all your assets (equity in your home, stock portfolios, retirement assets, personal property, etc.).
- Add up all of your debts (mortgages, loans, etc.1).
- Subtract your total debts from your total assets.
- The difference equals the value of your estate.
Note that this calculation can be straightforward if you’re single and everything is in your name only. If you’re married, what you include in your calculation will depend on 1) whether an asset or debt belongs just to you or to you and your spouse, and 2) how your state treats marital property.
- Consider taxes. In 2012, you could pass on as much as $5.12 million ($10.24 million for a married couple) free of federal estate taxes.2 State estate or inheritance taxes may kick in at lower levels. Keep in mind that even if your estate is not at a taxable level today, long-term investment growth could bump it up into taxable territory. It’s also possible that the estate-tax exemption will be lower in future years.
Step 2) Balance two important goals.
Plan for a comfortable retirement and a meaningful legacy.
- Consider your retirement income needs. Will Social Security, pensions and annuities provide enough? Or will you need income from individual retirement accounts (IRAs) and taxable accounts?
- Protect the assets you plan to pass on. If your income plan does not include your entire traditional IRA balance, consider limiting withdrawals to “required minimum distributions” (RMDs). Or minimize required distributions by rolling over traditional IRAs to Roth IRAs. (Conversion to a Roth IRA could subject you to current income taxes.) The untouched balances will have an opportunity to continue growing over many years, potentially leaving more for beneficiaries.
- Prepare for health care needs. Health care, including long-term-care needs, can have a significant impact on your finances – and your legacy. Make sure you have adequate medical coverage, disability insurance while working, and an emergency fund for unexpected health care needs. In addition, if you have assets you want to protect for a surviving spouse or other family members, consider purchasing long-term-care insurance.
Step 3) Lower your estate-tax liability...
...While achieving specific estate-planning goals.
- Maximize the exemption amount. If you are married, you and your spouse can both claim the full exemption amount by setting up “credit shelter trusts” in your wills. This strategy can reduce estate taxes for your chosen beneficiaries while providing lifetime income to the surviving spouse. Through 2012, you can add any unused portion of your deceased spouse’s estate-tax exemption to your exemption amount.3
- Gift it away. Gifts shrink your “taxable estate” while allowing you to help loved ones or charities today. You can give up to $13,000 a year to as many recipients as you wish without owing gift taxes. If you want to help with your grandchildren’s education expenses, it’s possible to make five years’ worth of gifts, gift-tax-free, to their Section 529 college savings plan accounts.4,5 You can learn more about Section 529 plans here.
- Create an “irrevocable trust.” You can use this type of trust to make sure your money will pass on to chosen beneficiaries free of federal estate taxes. While this is often an effective strategy to minimize potential estate-tax obligations, be aware that you will no longer have access to your funds and will not be able to change or undo the terms of the trust.
Step 4) Choose a variety of ways to transfer wealth.
- Wills. Wills are a critical wealth-transfer vehicle to make sure your assets are distributed as you wish, and to name guardians for minor children, if applicable. But be aware that many types of assets pass outside a will, according to other arrangements. For example, 401(k) and IRA assets, life insurance proceeds and assets placed in living trusts pass automatically to named beneficiaries. Laws regarding what passes through a will may vary by state.
- Beneficiary designations. Life insurance policies and many types of accounts, including 401(k) plan accounts, pension plans, employee stock ownership plans and individual retirement accounts, allow you to name beneficiaries. It’s important to name contingent beneficiaries in case your primary beneficiaries predecease you. Note that if you are married, your 401(k) plan account balance and any pensions automatically go to your spouse unless he or she waives that right or predeceases you. IRAs offer a variety of beneficiary choices, including the options of naming multiple primary, contingent and/or successor beneficiaries. If you’ve established trusteed accounts or trust accounts to better manage your estate, you can also name those trusts as beneficiaries of your employee benefit plans.
- Trusts. Trusts can eliminate probate and allow for uninterrupted management of assets. There are many types of trusts available to help you achieve a wide range of goals, including leaving funds to charities, domestic partners or children from different marriages.
Step 5) Provide funds for expenses.
Even if you plan carefully, taxes and final expenses (such as funeral and burial costs) may require your beneficiaries to borrow or sell off part of their inheritance.
- Purchase life insurance. In addition to providing for loved ones if something happens to you, life insurance proceeds can be used to pay estate and other taxes and final expenses. The proceeds generally are income-tax-free.
Irrevocable life insurance trust (also Crummey trust): A trust that owns a life insurance policy on the grantor’s life and removes the value of the death benefit from the grantor’s estate. When the grantor dies, the insurance proceeds are paid to the trust or the chosen beneficiaries to provide a source of funds to pay estate taxes and final expenses. If the grantor is married and the life insurance is a “second-to-die” policy, after the surviving spouse’s death, the money in the trust passes free of federal estate taxes to children, grandchildren or other chosen beneficiaries.
- Create an ILIT (“irrevocable life insurance trust”). If your life insurance policy is owned by a properly structured and maintained irrevocable trust, proceeds will be free of both income and estate taxes.
Step 6) Prepare loved ones.
Help them understand your goals, expectations and wishes.
- Plan for minor children. If you have minor children, it’s important to name guardians for them in your will and establish trusts for their benefit. Additional planning may be necessary for children with special needs. A special-needs attorney and a Merrill Lynch Certified Special Needs Advisor can help you consider appropriate planning steps.
- Plan for a domestic partner. You’ll need to learn what planning strategies are necessary in your state of residence.
- Prepare for the unexpected. Durable powers of attorney, health care proxies and living wills can guide loved ones in managing your financial concerns and medical care if you become incapacitated.
- Get organized. Share the location of your estate-planning and account-related electronic documents, including passwords and contact information, with the executor of your estate and other trusted parties.
- Introduce loved ones to your current advisors. This will allow your loved ones to become familiar with those advisors and feel comfortable contacting them for guidance and to better understand the plans you have made for your financial legacy.
- Talk about it. A meeting with loved ones to discuss estate plans can be a valuable opportunity to pass on something beyond your wealth. Explaining your values, such as a commitment to support a local charity or ensure that your grandchildren attend college, may be your true lasting legacy.
You’ve worked too hard to leave the distribution of your estate to chance. An estate-planning attorney and a professional financial advisor can help you review your situation and make appropriate decisions.
Contact your Merrill Lynch Financial Advisor or call 1-888-363-2389 for more information about estate planning services.
Case Study
Donna and Mark were about to retire and wanted to make sure they’d be able to leave an inheritance to their children and grandchildren. Their combined estate of $2.5 million would not be subject to federal estate taxes under current law. But they realized that their estate could grow over the years – and that the estate-tax exemption amount might drop to as little as $1 million per person. To protect their loved ones from estate taxes, Donna and Mark planned as though their estates would be taxable. They began by “retitling” assets so each owned half, or $1.25 million. Next, their attorney established credit shelter trusts through their wills. If Mark dies first, an amount equal to the estate tax exemption amount then in effect will be placed in this trust. Income from investments in the trust will be available to Donna. But when she dies, the remaining balance will go to their children free of federal estate or gift taxes. The same strategy will play out if Donna dies first. Later in their retirement years, if Donna and Mark are sure their estates will be taxable, they plan to make five years’ worth of gifts to their grandchildren’s Section 529 college savings plan accounts. That will let them reduce estate taxes while ensuring that their money will be used as they wish, to make a meaningful difference in their grandchildren’s lives.
This case study summarizes a specific transaction and may not be appropriate for all investors.
1 Liabilities also include future estate-settlement costs your heirs would owe, such as funeral expenses and attorney and executor fees.
2 The current estate-tax exemption of $5.12 million will sunset on December 31, 2012. Unless the law is changed before then, the exemption in effect as of January 1, 2013 will drop from $5.12 million to $1 million and the top federal estate-tax rate will rise from 35% to 55%.
3 You must file IRS Form 706, “United States Estate (and Generation-Skipping Transfer) Tax Return.”
4 Any additional gifts made to the same beneficiaries during the five-year period would be subject to gift tax. The annual gift-tax exemption is prorated over the five-year period. If you die during that period, a prorated portion of your gift may be subject to estate taxes.
5 There are other gifting strategies available. For example, paying for a loved one’s education or medical expenses directly does not trigger gift taxes.