The basics of estate planning

• Constance J. Fontaine
• On 6:00 am EDT, Friday October 23, 2009

Many people believe they don't need estate planning because they think they don't have an estate. Or they think the value of their estate is not great enough to cause estate taxation, so what's the point?

But with few exceptions, everyone has an estate -- even the young child with a custodial account in his name and the granddaughter who received a lovely piece of jewelry for her 16th birthday.

Bottom line: If you own something of value that you would pass on to someone else upon your death, you have an estate. Whether you know it or not, you also have an estate plan. The state has one for you free of charge (well, sort of) if you don't get around to writing a will or designing a plan of your own.

Broadly speaking, an estate plan encompasses the accumulation, conservation and distribution of an estate. A good plan will enhance and maintain the financial security of individuals and their families.

Wills: the cornerstone of all estate plans

A will is a personal declaration of your intentions about the disposition of your property at death. Everybody should have one.

Because a will does not become legally enforceable until your death, it may be changed at any time before the maker's (testator's) death or mental incompetence. A properly drafted will contains instructions for your personal representative, the executor. The executor is responsible for administering your estate.

A will offers many advantages, enabling you to control, to a large extent, what happens after you're gone.

A person who dies without a will dies "intestate." Dying intestate can be unnecessarily costly for your heirs and leaves you with no specific say about who receives your assets or in what proportion they should be distributed.

Some assets, such as IRAs and life insurance proceeds, bypass a will entirely and go directly to the beneficiaries listed and filed with the financial firm that handles those products. Otherwise, the state decides who gets what. Each state has a prescribed order for the distribution of property of those who die with no will.

It's a rigid default distribution scheme that predetermines specific percentages of your estate assets that will go to your closest blood relatives -- the state's way, not yours.

Whether or not you have a will, your property will go through probate, the state court's system for monitoring its distribution.

Trusts as a complement to wills

You establish trusts during your lifetime. They involve the transfer of your property to a person or corporate trustee who manages the assets within the trust's control for the benefit of one or more others -- the beneficiaries.

A living (or inter vivos) trust is one that is effective during your lifetime; a testamentary trust is a provision in your will and does not become operative until your death.

Because the will can be changed prior to death, the trust terms are also amendable. Living trusts can be created to be revocable or irrevocable. With a revocable trust, the creator (grantor) has access to the trust corpus (a fancy word for "principal") while alive; the trust assets within an irrevocable trust, however, no longer belong to the grantor. They are owned by the trust entity.

The reasons for trusts are as varied as their creators. These are some motives behind their creation:

The estate tax system: how it works

Estate and gift taxes are part of a transfer tax system that is separate from the income tax system we all know and love so well each April. Gift taxes apply to certain transfers of assets or interests in property that a person (donor) makes to another (donee) while still alive. Estate taxes come into play after a person's death.

Currently, a deceased's estate is not subject to estate tax at the federal level until the value of the taxable estate passing to others exceeds $3.5 million. That means the majority of taxpayers don't have to worry about estate tax diminishing what they leave to their loved ones.

Before you summarily dismiss the federal estate tax, be aware there are some types of property you may not consider part of your estate but the government does. A prime example is life insurance that you or your employer own on your life. Yes, that seems unfair because you will not live to receive the insurance proceeds ... but we are talking about the "value passing to others as a result of your death" concept.

Other sometimes-overlooked assets that can significantly increase an estate are pension and retirement plan funds and the value of sizable gifts you made over time. Estate values exceeding $3.5 million are taxed at a (gulp) 45 percent tax rate.

Quirky rule change coming up

The value of property the government allows to pass free of estate tax is called the exclusion. Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (fondly called EGTRRA), the exclusion amount is $3.5 million in 2009, and in 2010 the estate tax (but not the gift tax, which we discuss in a minute) completely disappears ... for that one year only.

Then in 2011 and beyond, the exclusion amount decreases to $1 million unless Congress changes that in the interim. Clearly, after 2010, many more estates will meet the threshold and be subject to estate tax.

Gift tax on generosity

Gifts are gratuitous transfers you make during your lifetime. The hitch with the gift tax, though, is that you are limited to making gifts with an aggregate value of "only" (ahem ... ) $1 million before transfer tax kicks in ... again at a 45 percent rate.

The annual gift tax exclusion, however, is a thick silver lining to the gift tax rules. In 2009 you can make as many gifts of $13,000 to as many recipients as you can afford without those gifts even being a blip on the gift tax screen. These are completely tax-free transfers. The amount is adjusted for inflation in $1,000 increments, usually every two or three years.

If you "gift-split" with your spouse, $26,000 can pass to each child, grandchild or any other person you choose. The recipients don't have to be related to you. Some people have referred to an annual exclusion gifting program as "the poor man's estate plan" because it effectively reduces the value of your estate without any interference from Uncle Sam.

State death tax may apply

Not surprisingly, many states want a piece of the estate revenue action, too. So, though you may not be concerned about federal estate tax, your estate may have to chip in to state coffers. Some states allow exemptions for closely related beneficiaries; others tax dollar one.

Some states do not have a death tax and most, if not all, do not tax the value of assets left to a surviving spouse.

Estate planning is your personal opportunity to make decisions concerning your assets, finances and health care. Although some individuals narrowly view estate planning as a way to assign their assets to heirs, others see it as a way to perpetuate their legacies.

With an estate plan in place, you can sing (like Frank Sinatra), "I Did It My Way."

Constance J. Fontaine teaches estate planning to aspiring financial planners at the American College.

Buzz up!