- An estate plan is important for everyone, regardless of income, to ensure your assets are distributed smoothly, fairly, and tax-efficiently to heirs.
- Two immediate estate-planning strategies to do include naming beneficiaries for retirement accounts and powers-of-attorney if you're incapacitated and unable to make decisions.
- Other estate-planning strategies include establishing trusts and lifetime gifts to avoid or diminish estate taxes.
Without an estate plan, it can be more difficult, time-consuming, and expensive for heirs to handle your financial accounts, property, and other assets, making sure everything is distributed in the way you wanted it.
Making a will is a good first step. But an "estate plan" — really just a fancy term for getting your affairs in order — goes beyond that. It not only communicates your wishes, it organizes your finances to ensure that your estate — essentially, everything of value that you own — is handled as fairly and tax-efficiently as possible.
Estate planning doesn't just involve what happens after death, either. It can also cover a situation in which you are severely incapacitated, either physically or mentally, and unable to make decisions.
Here are five estate-planning strategies and key moves to keep in mind for your funds and your family.
1. Select key players to carry out your estate plan
If you've drawn up a will, you've named an executor to it. But an important part of your estate planning process is deciding who will help you fulfill your wishes potentially while you are still living, as well as after death. These roles include appointing a:
- Durable power of attorney (POA). This person steps in to make financial decisions on your behalf if you are temporarily or permanently unable to make those decisions independently.
- Health care power of attorney. This person steps in to make medical decisions on your behalf if you are temporarily or permanently unable to make those decisions yourself. It can be the same individual as the regular POA, or a different person.
- Guardian. If you have minor children when you pass away, the guardian will raise your children and make decisions about where they live, go to school, and other activities.
Carefully consider who you want in each role and discuss it with them to ensure they are willing and able to step into the role when needed. Then have a document officially naming them drafted, signed, and notarized.
2. Select or review the beneficiaries on your retirement accounts
The bulk of many people's holdings are in retirement accounts, like 401(k) plans and IRAs. A beneficiary is a person (or persons) who inherits the money in the account after your death.
Naming a beneficiary might seem like a formality. It's not.
It's a legal designation that directs the account's custodian/administrator (the financial firm holding or managing it) how to release the funds. Part of the contract between you and the custodian, your beneficiary designation trumps anything or anyone named in your will. So selecting your beneficiary is important.
You may well have named a beneficiary when you established your account — it's usually part of the paperwork. But it pays to review it, and update any time you have a major life event, such as a marriage, divorce, or death in the family. If you leave as a beneficiary a now-ex-spouse, your heirs will have a major battle to stop the funds from going to them, and they'll still probably lose.
If you don't have any living beneficiaries named when you die, your retirement account can wind up in probate court, and the court will decide how to distribute it — a messy, time-consuming procedure.
3. Familiarize yourself with the federal and state "death taxes"
The federal estate tax impacts a very small (and wealthy) segment of the population, but it's still a good idea to familiarize yourself with it — especially since the regulations are changing in the not-too-distant future.
When someone dies, the federal government imposes a tax on their estate's value. In the eyes of the IRS, the estate includes all the cash, real estate, investments, business interests, and other assets owned by the deceased person when they passed away. The tax applies to, and is paid by, the estate — not those who inherit it.
The estate tax only kicks in for estates of a certain size — above a certain exemption amount, in IRS-speak.
For 2021, the federal estate tax exemption is $11.7 million per individual estate ($23.4 million for a married couple's, if they die together). However, the current exemption expires on Jan. 1, 2026. At that point, it will revert to its pre-2018 level of $5 million for individual estates ($10 million for married couples), adjusted for inflation.
It still sounds like a lot, but bear in mind that an estate encompasses all your assets. If you've a business to bequeath, a six-figure life insurance policy, or property that's appreciated a lot, your taxable estate could well hit that $5 million.
In addition to the federal estate tax, 12 states and the District of Columbia impose an estate tax.
Six states also impose an inheritance tax, which directly taxes heirs rather than the estate. So it's a good idea to familiarize yourself with the estate or inheritance tax laws and exemptions in any state where you live or own property.
4. Take advantage of the annual gift tax exemption
One way to avoid the estate tax when you die is to give away money while you're living.
The annual gift tax exclusion allows you to give up to $15,000 per person per year free of – no need to report the gift. Married couples can give $15,000 each, meaning together they can give a total of $30,000 per person per year.
If you give more than that amount, you don't necessarily have to pay taxes on those gifts, but you do have to file a federal gift tax return. Also, those gifts count toward your lifetime estate exemption limit. For example, if you give someone a $30,000 gift, your lifetime exemption amount would be $15,000 lower because that's how much of your gift exceeds the annual exclusion.
If you want to make a bigger gift, you can contribute up to $75,000 to a 529 college savings plan in one year and elect to treat it as if you made it over five years.
Other ways you can give money to loved ones without triggering the gift tax include:
- Gifts to your spouse (capped at $159,000 in 2021 if your spouse is not a US citizen)
- Tuition payments made directly to the educational institution
- Medical expenses paid directly to the medical facility
5. Establish a trust
Another way to pass wealth smoothly to your heirs and bypass taxes is to establish a trust. Tailored to meet different estate planning needs or goals, the major types of trusts include:
- Revocable trust: A revocable trust, aka a living trust, can be altered or canceled at any time. When you put your assets in a revocable trust, you get to keep any income they earn, and control over them. After your death, assets transfer directly to the beneficiaries you name in the trust — they won't have to go through probate, as they would if bequeathed in a will. They will count as part of your taxable estate, however.
- Irrevocable trust: An irrevocable trust works the same as a revocable one, but it can't be modified or terminated without the permission of your beneficiaries. After transferring assets into the trust, they are no longer part of your estate, so they won't be subject to estate tax.
- Grantor retained annuity trust (GRAT): If you own stock that you expect to increase in value, you can put it in a grantor retained annuity trust. This gives you the right to receive an annuity over the trust's term, typically two to five years. After that, the stocks in the trust are distributed tax-free to your beneficiaries. However, if you die during the GRAT term, the assets are still included in your estate.
- Irrevocable life insurance trust (ILIT): You fund an ILIT with a life insurance policy, and the trust is both the owner and beneficiary of the policy. When you die, the trust collects the policy's death benefit and pays it out to your beneficiaries. Life insurance benefits are always free of income tax; putting them in a trust also effectively frees them from counting towards estate taxes as well.
- Charitable remainder trust (CRT): A charitable remainder trust allows you to get a partial tax deduction for contributions to the trust. While you're living, you can receive income from the trust. At the end of the trust's term, any remaining trust assets are distributed to one or more charities or non-profit organizations that you name.
The financial takeaway
Some estate-planning strategies are simple to execute. Others, such as establishing trusts, need to be done carefully and precisely — with the help of a trusts-and-estate attorney or another financial professional.
The important thing is to get started now. And remember: Estate planning isn't a one-and-done proposition. The decisions you make this year may not meet your situation five years from now.
Even if your life or finances haven't federal and state laws and exemption amounts do. That's why it's important to review your estate plan regularly.