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SMART ESTATE PLANNING:
Do You Have the Necessary Tools?
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SMART ESTATE PLANNING:
Do You Have the Necessary Tools?
Let's face it - most married couples in their 20's, 30's and 40's do not like to think about death, especially their own. Their inability to cope with mortality may, among other things, adversely affect their children's economic well being. Forget the Grim Reaper - young (and not so young) couples should really be worried about the evil specter of Federal estate taxes!
Take the example of a typical young husband and wife. Husband is a successful architect and aspiring breakdancer who recently opened his own practice (architectural, not break dancing). Wife has a master's degree in behavioral therapy, and works part time. The couple has a three year old son. Husband has a $2,500,000 life insurance policy under which Wife is the beneficiary. Wife has a $500,000 life insurance policy under which Husband is the beneficiary.
After years of procrastination, Husband and Wife recently decided to bite the bullet and execute wills. Husband, known around town for his "penny wise, pound foolish" propensities, refused to consult with an estate planning attorney or accountant, and picked up two copies of a standard, do-it-yourself will at the local stationary store. On January 1, 2008, in the privacy of their apartment, he and Wife signed their wills in the presence of the requisite number of witnesses. Satisfied with what he thought was a remarkable display of financial acumen (after all, he spent only $19.98 for both will forms), Husband tucked the signed and witnessed wills under his mattress.
We should take a moment to examine two relevant paragraphs contained in both wills:
I hereby give, devise and bequeath to my beloved wife [husband], all of my property, both real and personal, and mixed, of every nature and description whatsoever and wheresoever situated and of which I may be possessed or be entitled to at my death, to be hers absolutely and forever.
In the event my wife shall predecease me or if we shall die simultaneously or under such circumstances that the evidence is not sufficient to determine the question of survivorship between us, then I give, devise and bequeath all the rest, residue and remainder of my estate to Son and any other children later born to or adopted by my wife and me.
At first glance, the foregoing provisions may seem perfectly suited to the couple's financial situation. After all, why shouldn't Husband direct that all his property go to Wife, unless Wife should predecease him, in which case all his property would go to Son and any future children. What Husband and Wife neglected to consider was the Federal estate tax implications of these seemingly innocuous provisions.
First, one should note that upon death, property that passes from the deceased spouse to the surviving spouse effectively does so without incurring Federal estate taxes (the "marital deduction"). Second, the United States Internal Revenue Code has a concept of the "unified credit" which currently permits a decedent to pass $2,000,000 without estate tax consequences. However, amounts over the first $2,000,000 would, in fact, be subject to estate tax consequences unless there is an appropriate deduction or credit. The unified credit (which is not technically a credit) will escalate periodically to $3,500,000 in the year 2009. In 2010, federal estate taxes will be repealed, only to be replaced in 2011 with a $1,000,000 unified credit (this is known as a "sunset provision"), unless Congress changes the law.
Returning to the couple's scenario, assume for a moment that several months after signing his will, Husband is killed in a bizarre breakdancing accident during an appearance on "Star Search". He is survived by Wife and Son. His $2,500,000 of life insurance proceeds passes to Wife free of Federal estate taxes because of the marital deduction. So too do all stocks, cash, real estate and other property held by Husband individually (let's assume those items have an aggregate value of $500,000). Husband's entire $3,000,000 estate passed to Wife outright. Wife now is the owner of cash and other property having a value of $3,000,000, all of which passed free of Federal estate taxes. Looking down from Heaven, Husband is satisfied that through amazing foresight, he was able to save his family a load of cash.
But did he really? As fate would have it, several months after Husband's death, Wife passes away (also in 2008). The $3,000,000 she had received after Husband's death has grown to $3,300,000 (after paying income tax and Wife's and Son's living expenses). One would think that Son should inherit $3,300,000 directly from Wife and should receive $500,000 as the sole beneficiary under Wife's insurance policy (a total estate having a value of $3,800,000). But this is not the case because Husband and Wife failed to do proper estate planning. Since Wife died in 2008 (when the estate tax exemption is $2,000,000), only the first $2,000,000 of Wife's estate is passed on to Son free of federal estate taxes. The remaining $1,800,000 of Wife's estate is subject to federal estate taxes (totaling approximately $690,800). As a result of poor planning, Son's $3,800,000 inheritance is reduced by over 18%.
But what could have the couple have done differently? Well for starters, they should have spoken to an estate planning attorney or accountant. These professionals would have told the couple about a fairly simple technique that is commonly known as the "Credit Shelter Trust". The Credit Shelter Trust allows both spouses to take advantage of the unified credit. Here is how it works: Husband could have made his estate, as opposed to Wife, the beneficiary of his life insurance policy. His will should have contained a provision creating, upon Husband's death, a Credit Shelter Trust that would contain a sum equal to the largest amount that effectively can pass free of Federal estate tax by reason of the unified credit (currently $2,000,000). The trustee of the Credit Shelter Trust is directed to distribute all net income of the trust to Wife. Upon Wife's death, the trustee is directed to pay to Son all funds held in the Credit Shelter Trust (or to further hold such funds in trust until Son reaches adulthood).
Applying these techniques to our fact pattern, let's see what would have happened if the couple had done things differently. They could have arranged that upon Husband's death, a total of $2,000,000 of life insurance proceeds and other assets would go to fund the Credit Shelter Trust created in his will. The remaining $500,000 of his insurance proceeds, as well as his $500,000 in other separately held property (stocks, cash, real estate, etc.) would pass to Wife directly, free of Federal estate tax because of the marital exemption.
Due to astute investing by the trustee, upon Wife's death, the $2,000,000 Credit Shelter Trust established by Husband's will has grown in value to $2,200,000 (after payment of all income taxes). Let's say that Wife invested the $1,000,000 she had received outright as the beneficiary of Husband's estate, and at her death it was worth $1,100,000 (again, after payment of all income taxes). Upon her death, the cash value of Wife's estate, including the $1,100,000 remainder of what she received from Husband's estate as well as her $500,000 life insurance policy, has a total value of $1,600,000.
What would Son get? The entire $1,600,000 from Wife's estate would pass to Son free of Federal estate tax because of the $2,000,000 exemption. Of the $2,200,000 from Husband's Credit Shelter Trust, $2,000,000 would pass to Son free of Federal estate tax because of the exemption, and $200,000 would be subject to federal estate taxes (totaling approximately $54,800). Thus Husband's and Wife's collective $3,800,000 estate is reduced by only $54,800. In percentage terms, slightly less than 1.5% of Son's $3,800,000 inheritance from his parents would go to the Federal government.
The foregoing example is obviously a simplification and does not apply in every situation or take into account all contingencies such as applicable state estate taxes.
This article is not intended to be legal advice, and it should not be relied upon when planning your estate. Proper estate planning requires the advice of qualified attorneys, accountants and other advisors.