Estate planning is about transfer of assets after one’s death and the taxes and fees related to the transfer, including gift taxes, if gifts were used while one is alive.
Methods to transfer assets at death are by contract (Revocable Trusts or Irrevocable Trusts, insurance proceeds or Qualified Retirement Account beneficiary designation) or by a Will. Also, if none of the above applies then assets pass by court proceedings.
Taxes and fees are: Probate fees charged by the court for assets passing by probate. In California this can be $48,000 for a $1,000,000 asset like a house, even if the asset has been “hollowed out” with a cash-out refinance and has no equity. IRD tax is “Income in Respect of the Decedent” which is income on the income earned in final year of life. Finally estate tax is a tax based on net worth, not on assets. So an estate may pay state and federal estate tax, a court probate fee and IRD state and federal income tax. Also expensive real estate city and county transfer taxes may apply if the deceased person’s home is sold.
Using a Revocable Living Trust is a way to make assets transfer by contract and thus avoid probate, saving probate fees, time and privacy. It does not save on estate tax or income tax. When someone dies the revocable trust splits into an A Trust and a B trust with the deceased exemption amount in one trust and the excess in the other trust. That way the exemption amount is preserved free of tax to be sent downstream to the children. However, while the surviving spouse is alive, the spouse gets to draw on the income generated by the exemption trust.
Doing Charitable Gifting is a way to reduce estate tax and income tax. This would need integrated financial planning to determine how much tax would be saved and whether one would be able to afford to give the gifts.
Qualified Retirement Accounts such as 401k, 403b, IRA, etc. pass by contract based on the beneficiary designation statement, which can’t be overruled by court order or by a Will. This is why it is vital to do a full financial plan and examine estate planning issues. As a rule of thumb it is far more flexible and more reliable for estate planning purposes to have assets in an IRA than in an employer sponsored retirement plan like a 401k because of the benefits of “stretch IRA” and the freedom and control that an IRA gives to the owner to have a sophisticated beneficiary designation.
Everyone can give $14,000 annually without Gift tax, so to avoid Inheritance tax parents should give this amount away to their children. However this $14,000 limit should be used carefully because it is best to use it to give shares in FLP’s to reduce estate tax, rather than to fund a 529 Plan. Regarding integrated financial planning, 529 Plan future contributions should be examined to see how they affect estate planning. This is because contributions are subject to the annual $14,000 tax-free gift limit and it may be best for high net worth clients to refuse to give funds to a 529 Plan and instead give each year $14,000 of FLP units to their heirs. Anyone can gift funds for tuition without gift tax if they write the check payable directly to the college, instead of to a 529 Plan.
Now that the exemption amount is over $5,000,000 many couples don’t need and shouldn’t use a FLP. People who have these should contact a qualified attorney specializing in Estate Planning to see if they should change these.
One way to reduce net worth so as to reduce estate tax is to buy lots of expensive cash value Whole Life insurance with the heirs named as beneficiaries. The problem is that an incidents of ownership of a Life insurance policy may cause the policy proceeds to be deemed by the IRS to be part of the estate. So the solution maybe to create an irrevocable life insurance trust (ILIT) and fund it with an annual $14,000 gift and to annually issue a “Crummey letter” (named after a Mr. Crummey) inviting the beneficiary to feel free to withdraw funds from it in order to qualify as a completed gift, which is vital to removing the asset from the estate. The problem is that whole life insurance (not cheap term insurance) is very expensive and the insured may not be able to get it if his health is poor. Another problem is that this uses up the $14,000 annual gift exemption, which may be better spent on gifting of FLP shares.
Another technique is for the parents to sell distressed assets to their kids at fire sale prices, thus reducing the parent’s estate while they are alive. The sale must be at fair market value which should be verified with an appraisal. The need for an appraisal is determined by an estate planning attorney. Another technique is for the parents to liquidate assets and loan the proceeds to the children at the Short Term Rate of 1.11% AFR (as of April, 2017) using an interest-only loan and then the children invest in stocks and hope to make a long run return of roughly 8 to 10%. This is estimate is based on the past performance of broad market indexes and is not guaranteed for the future. To prevent the children from being spoiled the assets should be controlled by a Trustee.
California residents need to be careful about gifting or bequeathing a house to heirs because if not done correctly the heir will lose the low cost Proposition 13 property tax base. If the house is the only asset and it is to be shared by two grown children where one will keep it and the other will sell his half interest then the parents should ask their attorney about strategies such as bequeathing it to only one child after first getting a cash-out refinance and then bequeathing the cash to the other child. That way each child would get the same amount of net worth. If an inherited house is titled in the names of two siblings and one sells or quit claims his share then that negates Proposition 13 low tax base benefit and it may trigger expensive real estate city and county Transfer Taxes.