What Is Federal Estate Tax Exemption, and Does It Matter?

Why should most of us be worried about losing an estate tax exemption, when most people’s estates are nowhere near $12.06 million? This recent article, “Don’t Throw Away a $12.06M Estate Tax Exemption By Accident” from Kiplinger explains it all.

Despite the Congressional gridlock over many estate tax issues, whether Congress moves forward or not, on January 1, 2026, the federal estate tax exemption will sink from $12.06 million to approximately $6 million. There was a Democrat proposal during the presidential campaign to reduce it even less, to $3.5 million.

Suddenly, the federal estate tax exemption will matter again to a lot more people. However, don’t wait for that 2026 date, since you could miss a big exemption.

If you are married and your spouse passes, you could take advantage of the current $12.06 million estate tax exemption, even if your estate is nowhere near this value. The exemption is a “use it or lose it” tax planning alternative. Use it.

In most estate plans, one partner leaves most or all of their estate to the surviving spouse. Assets left to a surviving spouse qualify for what is known as “an unlimited marital deduction.” If there is no taxable estate on the death of the first spouse because all assets have gone to the surviving spouse, who qualifies for the marital deduction, the deceased spouse’s unused exemption does not have to be lost.

A deceased spouse may transfer any unused portion of their exemption to the surviving spouse, known as “portability.” Many families may find themselves with an unnecessary tax burden in the near future, if they fail to take advantage of this because they think it won’t apply to them.

Consider a family with a $10 million estate, owned as community property, where each spouse owns one half. If one spouse dies tomorrow, the family probably thinks they don’t need to worry about the federal estate tax, as there’s $12.06 million exemption for the wife and $12.06 million exemption for the husband. However, this would be an expensive mistake.

If the family files a portability election on the timely—filed estate tax return for the first spouse to die, the second spouse’s lifetime exemption of $12.06 million goes to the second to die spouse’s estate.

If the second spouse lives to at least January 1, 2026, and the estate is worth $10 million, the taxable estate after the exemption is $4 million. With an estate tax of 40%, the estate tax liability is $1.6 million, which needs to be paid in full nine months after the date of death. The portability exemption could have prevented this tax liability.

A portability-only estate tax return can be filed up to two years from the date of death, which your estate planning attorney will be able to help you with. There is a fee for the filing, but the savings to be had make this a worthwhile fee to pay. Consider this a form of tax insurance. Any families with a net worth of $2 million or more should be talking now with their estate planning attorney about how to manage the changing estate tax exemption.

Reference: Kiplinger (April 14, 2022) “Don’t Throw Away a $12.06M Estate Tax Exemption By Accident”

What Does Estate Plan Include?

The will, formally known as a last will and testament, is just one part of a complete estate plan, explains the article “Essential components of an estate plan” from Vail Daily. Consider it a starting point. A will can be very straight-forward and simple. However, it needs to address your unique situation and meet the legal requirements of your state.

If your family includes grown children and your goal is to leave everything to your spouse, but then make sure your spouse then leaves everything to the children, you need to make sure your will accomplishes this. However, what will happen if one of your children dies before you? Do you want their share to go to their children, your grandchildren? If the grandchildren are minors, someone will need to manage the money for them. Perhaps you want the balance of the inheritance to be distributed among the adult children. What if your surviving spouse remarries and then dies before the new spouse? How will your children’s inheritance be protected?

Many of these questions are resolved through the use of trusts, another important part of a complete estate plan. There are as many different types of trusts as there are situations addressed by trusts. They can be used to minimize tax liability, control how assets are passed from one generation to the next and protect the family from creditor claims.

How a trust should be structured, whether it is revocable, meaning it can be easily changed, or irrevocable, meaning it is harder to change, is best evaluated by an experienced estate planning attorney. No matter how complicated your situation is, they will have seen the situation before and are prepared to help.

A memorandum of disposition of personal property gives heirs insight into your wishes, by outlining what you want to happen to your personal effects. Let’s say your will leaves all of your assets to be divided equally between your children. However, you own a classic car and have a beloved nephew who loves the car as much as you do. By creating a memorandum of disposition, you can make sure your nephew gets the car, taking it out of the general provisions of the will. Be mindful of state law, however.

Note that some states do not allow the use of a memorandum of disposition, let alone permit such “titled” assets to be transferred by such an informal memorandum. Consequently, you must clarify how this situation will be handled in your state of residence with your estate planning attorney.

You will also need a Power of Attorney, giving another person the right to act on your behalf if you should become incapacitated. This is often a spouse, but it can also be another trusted individual with sound judgment who is good with handling responsibilities. Make sure to name a back-up person, just in case your primary POA cannot or will not serve.

A Medical Power of Attorney gives a named individual the ability to act on your behalf regarding medical decisions if you are incapacitated. Make sure to have a back-up, just to be sure. Failing to name a back- up for either POA will leave your family in a position where they cannot act on your behalf and may have to go to court to obtain a court-appointed guardianship in order to care for you. This is an expensive, time-consuming and stressful process, making a bad situation worse.

A Living Will is a declaration of your preference for end-of-life care. What steps do you want to be taken, or not taken, if you are medically determined to have an injury or illness from which you will not recover? This is the document used to state your wishes about a ventilator, the use of a feeding tube, etc. This is a hard thing to contemplate, but stating your wishes will be better than family members arguing about what you “would have wanted.”

Reference: Vail Daily (Feb. 15, 2022) “Essential components of an estate plan”

What are the Most Common Estate Planning Mistakes?

There are so many estate planning horror mistakes, it’s hard to know which is the worst. One is the woman who had an estate plan created, but only named one guardian for her teenage daughter. When the guardian declined to serve, the girl was moved into foster care. Many estate planning attorneys recommend not one, but two alternate guardians, according to the article “Don’t get tripped up by these common estate planning pitfalls” from MarketWatch.

Joint ownership of bank accounts leads to a tangled mess. Seniors often add one of their adult children to ownership of their bank accounts, so the child can manage their affairs or keep an eye open for financial elder abuse. However, when the parent dies, the account is the sole property of the child, and siblings have no say over what the new owner does with the money. Even if the children agree to split the money evenly, the federal gift tax exemption is limited to an annual gift, gift tax returns have to be filed and a simple idea becomes expensive and time consuming.

If joint ownership of an account is necessary, it may be better to add all of the children or have in a separate writing the intention that this is an asset you want divided equally among the children. Easier still: create a new account dedicated to paying bills and maintain a small balance. Even better, if the institution allows you to arrange for the account to “pay on death,” then designate all of your children as beneficiaries. This approach will avoid probate, while treating all children equally and not exposing your account to any potential divorces, lawsuits, or bankruptcies during your lifetime.

Giving money to grandchildren directly. Putting a minor as a beneficiary of a percentage of an estate requires the involvement of a judge approving the bequest and the appointment of a custodian over the account until the minor becomes an adult. An estate planning attorney would likely recommend the use of a trust for the benefit of the minor. Alternatively, limit bequests to adult children and adult grandchildren.

An adult child or surviving spouse living in the house. A man created a property trust to allow his second wife to remain in the house he owned before their marriage. The couple had jointly paid off the mortgage. The man named his daughter from a prior marriage as the successor trustee. The daughter began making unreasonable demands on the surviving spouse to make expensive improvements. Years of bad blood between the two erupted into years of litigation. The parties finally agreed to revise the trust terms and name a professional trustee, but not after an expensive and stressful battle.

When one of the children is living in the house and the will says the home is to be divided among the siblings equally, what happens? Does the child who lives in the house get first right of refusal to buy out their sibling’s shares? Are they paying rent to siblings? What if the child living in the house decides to sell, after they personally have invested a lot of money improving the house?

Estate planning attorneys bring up these kinds of situations with clients not because they want to scare people, but because they have seen firsthand what happens when an estate plan fails to anticipate a variety of situations. The estate planning attorney needs to know about the family’s dynamics in detail, in order to create the best plan to achieve the desired outcome and prevent as many twists and turns as possible.

Reference: MarketWatch (Jan. 6, 2022) “Don’t get tripped up by these common estate planning pitfalls”

What Happens to IRAs and 401(k) when Spouse Dies?

For married couples who own large IRA and 401(k) accounts, the question is often whether the couple should consider paying all or a portion of their accounts to a bypass trust to benefit the surviving spouse. This takes the designated portion of the IRA or 401(k) proceeds out of the surviving spouse’s taxable estate and helps with asset distribution, according to the article “Estate Planning for Married Couples’ IRAs And 401(k)s” from Financial Advisor.

In 2013, the portability election became law. Portability allows the surviving spouse to use the unused federal estate tax exemption of the deceased spouse, thereby capturing not one but two estate tax exemptions. Why would a couple need a bypass trust?

The portability election does not remove appreciation in the value of the assets moved from the surviving spouse’s taxable estate. A bypass trust removes all appreciation. An estate planning attorney will review your entire situation to determine the optimal path.

There are also situations when the portability election does not apply. One is if the surviving spouse remarries and then the new spouse predeceases them. With a bypass trust, remarriage does not matter (although estate planning documents do need to be updated).

The portability election also does not apply for federal generation-skipping transfer tax purposes. In other words, the amount that could have passed to an estate and generation-skipping transfer tax-exempt bypass trust, including appreciated value, could now be subject to federal transfer tax in the heir’s estate.

If you use the portability election, those assets are subject to potential lawsuits against the surviving spouse and, if remarriage occurs, to any potential claims of a new spouse. A bypass trust provides better protection from lawsuits and claims.

Using the portability election may result in the first spouse to die losing the option to control where those assets go upon the death of the surviving spouse. A bypass trust provides more control for asset distribution.

The calculations for each situation must be considered, but the bypass trust can help reduce the taxable estate for children, after the surviving spouse has passed. It may also make sense for a portion of the IRA or 401(k) plan proceeds to go to the bypass trust and another portion to the surviving spouse outright. The use of the beneficiary designation may allow for a full or partial disclaimer by the surviving spouse. However, the bypass trust could provide more flexibility than keeping assets in the original accounts.

Reference: Financial Advisor (Jan. 7, 2022) “Estate Planning for Married Couples’ IRAs And 401(k)s”

How Do You Split an Estate in a Blended Family?

Estate planning attorneys know just how often blended families with the best of intentions find themselves embroiled in disputes, when the couple fails to address what will happen after the first spouse dies. According to the article “In blended families, estate planning can have unintended issues” from The News-Enterprise, this is more likely to occur when spouses marry after their separate children are already adults, don’t live in the parent’s home and have their own lives and families.

In this case, the spouse is seen as the parent’s spouse, rather than the child’s parent. There may be love and respect. However, it’s a different relationship from long-term blended families where the stepparent was actively engaged with all of the children’s upbringing and parents consider all of the children as their own.

For the long-term blended family, the planning must be intentional. However, there may be less concern about the surviving spouse changing beneficiaries and depriving the other spouse’s children of their inheritance. The estate planning attorney must still address this as a possibility.

When relationships between spouses and stepchildren are not as close, or are rocky, estate planning must proceed as if the relationship between stepparents and stepsiblings will evaporate on the death of the natural parent. If one spouse’s intention is to leave all of their wealth to the surviving spouse, the plan must anticipate trouble, even litigation.

In some families, there is no intent to deprive anyone of an inheritance. However, failing to plan appropriately—having a will, setting up trusts, etc.—is not done and the estate plan disinherits children.

It’s important for the will, trusts and any other estate planning documents to define the term “children” and in some cases, use the specific names of the children. This is especially important when there are other family members with the same or similar names.

As long as the parents are well and healthy, estate plans can be amended. If one of the parents becomes incapacitated, changes cannot be legally made to their wills. If one spouse dies and the survivor remarries and names a new spouse as their beneficiary, it’s possible for all of the children to lose their inheritances.

Most people don’t intend to disinherit their own children or their stepchildren. However, this occurs often when the spouses neglect to revise their estate plan when they marry again, or if there is no estate plan at all. An estate planning attorney has seen many different versions of this and can create a plan to achieve your wishes and protect your children.

A final note: be realistic about what may occur when you pass. While your spouse may fully intend to maintain relationships with your children, lives and relationships change. With an intentional estate plan, parents can take comfort in knowing their property will be passed to the next generation—or two—as they wish.

Reference: The News-Enterprise (Dec. 7, 2021) “In blended families, estate planning can have unintended issues”

What Taxes Have to Be Paid When Someone Dies?

The last thing families want to think about after a loved one has passed are taxes, but they must be dealt with, deadlines must be met and challenges along the way need to be addressed. The article “Elder Care: Death and taxes, Part 1: Tax guidance for administering a loved one’s estate” from The Sentinel offers a useful overview, and recommends speaking with an estate planning attorney to be sure all tasks are completed in a timely manner.

Final income tax returns must be filed after a person passes. This is the tax return on income received during their last year of life, up to the date of death. When a final return is filed, this alerts federal and state taxing authorities to close out the decedent’s tax accounts. If a final return is not filed, these agencies will expect to receive annual tax payments and may audit the deceased. Even if the person didn’t have enough income to need to pay taxes, a final return still needs to be filed so tax accounts are closed out. The surviving spouse or executor typically files the final tax return. If there is a surviving spouse, the final income tax return is the last joint return.

Any tax liabilities should be paid by the estate, not by the executor. If a refund is due, the IRS will only release it to the personal representative of the estate. An estate planning attorney will know the required IRS form, which is to be sent with an original of the order appointing the person to represent the estate.

Depending on the decedent’s state of residence, heirs may have to pay an Inheritance Tax Return. This is usually based on the relationship of the heirs. The estate planning attorney will know who needs to pay this tax, how much needs to be paid and how it is done.

Income received by the estate after the decedent’s death may be taxable. This may be minimal, depending upon how much income the estate has earned after the date of death. In complex cases, there may be significant income and complex tax filings may be required.

If a Fiduciary Return needs to be filed, there will be strict filing deadline, often based on the date when the executor applied for the EIN, or the tax identification number for the estate.

The estate’s executor needs to know of any trusts that exist, even though they pass outside of probate. Currently existing trusts need to be administered. If there is a trust provision in the will, a new trust may need to be started after the date of death. Depending on how they are structured, trust income and distributions need to be reported to the IRS. The estate planning attorney will be able to help with making sure this is managed correctly, as long as they have access to the information.

The decedent’s tax returns may have a lot of information, but probably don’t include trust information. If the person had a Grantor Trust, you’ll need an experienced estate planning attorney to help. During the Grantor’s lifetime, the trust income is reported on the Grantor’s 1040 personal income tax return, as if there was no trust. However, when the Grantor dies, the tax treatment of the trust changes. The Trustee is now required to file Fiduciary Returns for the trust each year it exists and generates income.

An experienced estate planning attorney can analyze the trust and understand reporting and taxes that need to be paid, avoiding any unnecessary additional stress on the family.

Reference: The Sentinel (Dec. 3, 2021) “Elder Care: Death and taxes, Part 1: Tax guidance for administering a loved one’s estate”

What is the Purpose of an ILIT?

Life insurance falls into two categories: life insurance and death insurance. Life insurance is used to take advantage of the tax-free returns that qualifying insurance products enjoy under federal income tax laws. There is a death component. However, the main purpose is to serve as a tax-deferred investment vehicle. Death insurance is used to provide financial security for loved ones after the owner passes, with little or no regard for tax and investment benefits.

Using both types of life insurance in estate planning can be a complicated process, but the resulting financial security is well worth the effort, as reported in a recent article “Keeping an Eye on ILITs” from Financial Advisor.

The Irrevocable Life Insurance Trust is a somewhat complex trust structured under state trust law and tax strategies under federal income tax laws. ILITs have been tested in court cases, audits and private letter rulings, so an estate planning attorney can create an ILIT knowing it will serve its intended purpose.

Life insurance in an ILIT is owned outside of the estate and enhances the after-estate tax wealth for the surviving spouse and heirs. Because the trust is irrevocable, the transfer of ownership is permanent.

The annual insurance premium is typically paid by the insured to the ILIT, subject to “Crummey” withdrawal powers, named after a famous case, which gives named people the power to withdraw all or a portion of the contributed premium amounts within specified periods. The time frame depends on the trust—usually it’s 30 or 60 days, but sometimes it’s annually.

There are many nuances and details.  The ILIT lets an insured buy life insurance “outside of their estate” for estate tax purposes, lets the person treat insurance premiums as non-taxable gifts under the annual exclusion provisions and provides safety and security to the beneficiaries.

The ILIT is often used as part of a buy-sell agreement for privately held family businesses to make it possible for the business itself or business partners to buy out the equity of a deceased partner. The payment obligations may be funded by the proceeds from life insurance. In some cases, each partner buys a traditional insurance policy in an ILIT. The estate planning attorney working on a succession plan can provide advice on the most effective way to use the ILIT.

Another use for the ILIT is for wealthy families with illiquid assets, like an art collection or a large real estate portfolio. An ILIT holding a life insurance policy with a death benefit lets the beneficiaries use the proceeds to pay estate tax liabilities, without dipping into their own or the estate’s assets. The investment returns of the ILIT increase the policy owner’s wealth substantially, without increasing their taxable estate.

Reference: Financial Advisor (December 1, 2021) “Keeping an Eye on ILITs”

When Should a Trust Be Reviewed?

Life changes, and laws change too. The great trust created two decades ago may not be a good idea today and may no longer be suitable for you or your beneficiaries. As a general rule, you should review your estate plan and trust every other year, according to the article “Revisit trust on a regular basis” from the Santa Cruz Sentinel.

Start with the Table of Contents, if there is one. There should be language concerning “Successor Trustees.” Are the trustees you named still alive? Are they still part of your life, and do you still trust them? How are their money skills? If they don’t get along with the rest of the family, or if they have been embroiled in a series of petty disputes, they may not be appropriate to manage your trust. Don’t be afraid to make changes. Your estate planning attorney will know how to do this smoothly and properly.

Next, find the paragraph that discusses “Disposition on Death” or “Disposition on Death of Surviving Spouse.” Does it still make sense for your loved ones? Have any children or family members who are listed as receiving benefits died? Are any heirs disabled and receiving government benefits? Have any of your children developed addictions, problems handling money, married people you don’t trust, or are preparing to divorce their spouses? Changes can be made to protect your children from themselves and from others in their lives.

Look for a “Schedule of Trust Assets.” When was the last time this was updated? If you’ve moved and the trust still lists your last residence, you need to change it. Is your new home in the trust? Are retirement accounts correctly listed? Do you have new assets you’ve never placed in the trust? This is a common, and costly, oversight.

If married, how does the trust address what occurs between the death of the first spouse and the surviving spouse? Do you have an A/B trust to divide everything between a Survivor’s Trust and a Bypass Trust or Exemption Trust? Maybe you don’t need or want an A/B trust anymore. Talk with your estate planning attorney to be sure this is structured properly for your life right now.

How is your health? If you or a spouse are in a nursing home or if one of you is ill and likely to needs nursing home care, it may be time to start planning for a Medicaid Asset Protection Trust.

While you’re reviewing your trusts, trustees and beneficiaries, don’t forget to review the people named as beneficiaries for your retirement accounts and life insurance policies. These should be reviewed regularly as well.

Reviewing your trust and estate plan on a regular basis is just as necessary as an annual physical. Leaving your accumulated assets unprotected is easily fixed, while you are alive and well.

Reference: Santa Cruz Sentinel (Nov. 20, 2021) “Revisit trust on a regular basis”

How Much can You Inherit and Not Pay Taxes?

Even with the new proposed rules from Biden’s lowered exception, estates under $6 million won’t have to worry about federal estate taxes for a few years—although state estate tax exemptions may be lower. However, what about inheritances and what about inherited IRAs? This is explored in a recent article titled “Minimizing Taxes When You Inherit Money” from Kiplinger.

If you inherit an IRA from a parent, taxes on required withdrawals could leave you with a far smaller legacy than you anticipated. For many couples, IRAs are the largest assets passed to the next generation. In some cases they may be worth more than the family home. Americans held more than $13 trillion in IRAs in the second quarter of 2021. Many of you reading this are likely to inherit an IRA.

Before the SECURE Act changed how IRAs are distributed, people who inherited IRAs and other tax-deferred accounts transferred their assets into a beneficiary IRA account and took withdrawals over their life expectancy. This allowed money to continue to grow tax free for decades. Withdrawals were taxed as ordinary income.

The SECURE Act made it mandatory for anyone who inherited an IRA (with some exceptions) to decide between two options: take the money in a lump sum and lose a huge part of it to taxes or transfer the money to an inherited or beneficiary IRA and deplete it within ten years of the date of death of the original owner.

The exceptions are a surviving spouse, who may roll the money into their own IRA and allow it to grow, tax deferred, until they reach age 72, when they need to start taking Required Minimum Distributions (RMDs). If the IRA was a Roth, there are no RMDs, and any withdrawals are tax free. The surviving spouse can also transfer money into an inherited IRA and take distributions on their life expectancy.

If you’re not eligible for the exceptions, any IRA you inherit will come with a big tax bill. If the inherited IRA is a Roth, you still have to empty it out in ten years. However, there are no taxes due as long as the Roth was funded at least five years before the original owner died.

Rushing to cash out an inherited IRA will slash the value of the IRA significantly because of the taxes due on the IRA. You might find yourself bumped up into a higher tax bracket. It’s generally better to transfer the money to an inherited IRA to spread distributions out over a ten-year period.

The rules don’t require you to empty the account in any particular order. Therefore, you could conceivably wait ten years and then empty the account. However, you will then have a huge tax bill.

Other assets are less constrained, at least as far as taxes go. Real estate and investment accounts benefit from the step-up in cost basis. Let’s say your mother paid $50 for a share of stock and it was worth $250 on the day she died. Your “basis” would be $250. If you sell the stock immediately, you won’t owe any taxes. If you hold onto to it, you’ll only owe taxes (or claim a loss) on the difference between $250 and the sale price. Proposals to curb the step-up have been bandied about for years. However, to date they have not succeeded.

The step-up in basis also applies to the family home and other inherited property. If you keep inherited investments or property, you’ll owe taxes on the difference between the value of the assets on the day of the original owner’s death and the day you sell.

Estate planning and tax planning should go hand-in-hand. If you are expecting a significant inheritance, a conversation with aging parents may be helpful to protect the family’s assets and preclude any expensive surprises.

Reference: Kiplinger (Oct. 29, 2021) “Minimizing Taxes When You Inherit Money”