The Basics of Estate Planning A White Paper by Manning & Napier www.manning-napier.com Unless otherwise noted, all fi gures are based in USD. 1
The Basics of Estate Planning A White Paper by Manning & Napier Introduction Estate planning is the process through which individuals plan for incapacity and the personal and tax consequences of death. A comprehensive estate plan can help individuals accomplish the following: Plan for incapacity. This includes, but is not limited to, designating individuals to handle financial affairs and establishing how family members and doctors should handle certain medical situations. Select the appropriate guardian for minor children. Provide financial guidance and asset protection for surviving spouses, children, and other heirs. Design an asset distribution plan. Establish trusts to minimize estate taxes, facilitate estate administration, protect assets, and accomplish other goals. Unfortunately, many individuals are unaware of the benefits of estate planning and lack an updated comprehensive estate plan. The following pages will (1) highlight some basic estate planning documents, (2) discuss the transfer tax system, (3) discuss a few of the most commonly used and simplest estate planning vehicles, and (4) define several commonly used estate planning terms. Estate Planning Documents There are several key documents which are frequently used in the estate planning process, including wills, living wills, health care proxies, powers of attorney, and trusts. The Will A will is a versatile cornerstone of any estate plan. It can appoint a guardian for minor children, name an executor to administer the estate, and identify a plan for transferring a portion of an individual s estate. Often times, the most important aspect of estate planning for young families is the naming of a guardian to care for minor children. If individuals do not name a guardian in their will, a judge will typically appoint someone, sometimes after a protracted legal battle, who may not have been the parents first choice. It is important to note that in most states naming a guardian in the will does not guarantee that the judge will appoint the named person, but judges will typically follow this guidance unless there are important reasons not to. A guardian s duties are straightforward: they act as a substitute parent and are responsible for children s personal care. Amongst other things, a guardian decides where the child will live, how the child is to be educated, and what religious affiliation they will have (if any). Individuals typically select guardians who share their values and are close to their children. Within a will, individuals can also name an executor, the person who represents and manages the estate. The executor must first be appointed by the court before he can act. The duties of the executor include filing an inventory of the decedent s assets with state courts, paying outstanding bills and liabilities, preparing the estate tax return, and finally distributing the decedent s property. Once these steps are completed, the executor must close the estate by filing a report with the court detailing all transactions made. Given the complexity of these tasks, an executor should be responsible and have an understanding of how the decedent wished to have their estate distributed. Finally, the will determines how a portion of an individual s estate known as the probate estate, is distributed at death. The probate estate is any property or asset that does not have a beneficiary designated or does not otherwise transfer automatically by operation of law (such as tenancy with right of survivorship property). If an individual dies without a will, their probate assets are transferred according to their state s laws of intestacy. Assets typically will be divided between a spouse and the children in some manner, in most states. If the decedent was not married and did not have any children, the estate will often go to their parents. Grandparents, grandchildren, aunts and uncles are typically next in line, and if the individual lacks any blood relatives, the assets may be passed on to the state. Because of life s many uncertainties, it is easy to see why a will is a critical element of any estate plan. Once it is executed, it is also important for clients to review and update it as their situation changes. Some important life changes that may necessitate revising a will are divorce, birth of children, substantial changes in net worth, changes in family situations, or a need or desire to designate a new guardian or executor. Such changes may be handled through a codicil, a separately written document used to amend or revoke a prior will. 2
The Basics of Estate Planning A White Paper by Manning & Napier Living Will and Health Care Proxy The living will and health care proxy are two estate planning tools that determine what medical actions will be taken when individuals are unable to make decisions for themselves. As discussed below, the living will and health care proxy are functionally very different. Currently, some states utilize living wills and others make use of health care proxies, while only a few states recognize both. The living will details what exact instructions should be followed by medical personnel if specific life-threatening medical situations arise. The instructions are communicated in writing to the state by the Principal the individual that executed the document. Oftentimes, these decisions involve life and death and without a living will, disagreements may arise amongst family members and between family members and medical care providers that will be difficult to resolve. In addition, absent a signed living will, the Principal s wishes may not be followed because the Principal did not formalize anything in advance. In contrast, a health care proxy grants the power to make medical decisions to an Agent (chosen by the Principal). The Agent, once chosen, should discuss with the Principal several potential scenarios that may occur in order to be able to follow the Principal s wishes. In general, the Principal should choose an Agent who understands their needs, is close to the Principal, and is comfortable making difficult decisions. Having a living will or a health care proxy is clearly a vital part of a complete estate plan to ensure that an individual s wishes are met, family disputes do not arise, and the proper person is authorized to make important health care decisions. Power of Attorney A complementary document to the health care proxy or living will is the power of attorney. This document names an Agent who handles the legal and financial affairs of the Principal. There are three types of powers of attorney: non-durable, durable, and springing. The non-durable power of attorney temporarily assigns control of the Principal s financial and legal affairs, although this control can be relinquished at any time. The non-durable power of attorney s control is terminated when the Principal becomes incapacitated. A durable power of attorney provides the same powers as a non-durable power of attorney, but the key difference is that the ability to handle financial and legal matters remains intact once the Principal becomes incapacitated. Finally, a springing power of attorney does not allow control until a specific predetermined event occurs, such as incapacitation. The appointed Agent typically has to certify that the Principal is incapacitated in order for the springing power of attorney to come into effect. This hurdle is eliminated with a durable power of attorney. Overall, the powers given to an Agent can be very broad or specific, according to the Principal s wishes. In addition, while the Agent can control the Principal s finances, they do not gain title to the Principal s property. Given this description, it seems apparent that an individual who knows and understands the Principal s needs, has the ability to handle finances, is responsible, and is trusted by the Principal would be a good choice. The will, living will or health care proxy, and power of attorney are each individually important parts of a thorough estate plan. However, these documents are only a piece of the much bigger puzzle. In addition to these documents, several estate planning vehicles can be used to minimize estate taxes and to see that assets are passed on to appropriate heirs. Transfer Tax System Tax planning is an important part of any estate plan. In order to begin planning, individuals should first understand how assets will be taxed upon transfer. Generally speaking, there are five basic taxes that individuals need to be concerned with when transferring assets to their heirs: estate, gift, generation-skipping, income, and capital gains taxes. Estate taxes are levied on the value of the decedent s estate transferred at death. The gift tax applies to transfers during lifetime. Meanwhile, the generation-skipping transfer tax typically applies when assets are transferred (i.e., either during life or at death) to a person who is more than one generation younger than the decedent (e.g., to grandchildren, great-grandchildren, etc.). In addition to these types of transfer taxes, income taxes may apply as well. When certain types of assets (e.g., qualified retirement plans, IRAs, and annuities) are transferred, income tax may be levied on the beneficiaries of these assets. Capital gains taxes are generally not a concern for heirs that inherit property due to a step-up in cost basis upon death to the date of death value. Estate Tax All assets (e.g., investments, real estate, life insurance proceeds, collectibles, etc.) will be subject to the federal estate tax upon an individual s passing, although the federal 3
The Basics of Estate Planning A White Paper by Manning & Napier estate tax structure provides taxpayers with the ability to transfer an amount of their assets estate tax-free (refer to the Exemptions section on the next page for greater detail). The federal estate tax is progressive in nature. As of the signing of the American Taxpayer Relief Act of 2012 (i.e., the 2012 Act) into law on January 2, 2013, the federal estate tax rate is permanently set to 40%. Gift Tax In general, the person making a gift (i.e., the grantor) is responsible for paying the gift tax liability resulting from the transfer. Like the estate tax, the gift tax is progressive in nature. The 2012 Act served to permanently reunify the estate tax credit and the federal gift tax credit that allows individuals to make limited tax-free transfers (refer to the Exemptions section for greater detail). As such, the federal gift tax rate is also permanently set to 40%. Generation-Skipping Transfer Tax The generation-skipping transfer tax (GSTT) applies to transfers made to the decedent s grandchildren or to other persons who are more than one generation younger than the decedent (when the individual who receives the gift is not a relative, they are deemed to be more than one generation younger if the age difference is more than 37.5 years). It should be noted that GSTT is in addition to any estate or gift taxes that may be due. Given the severity of this tax, individuals are allowed to make limited tax-free transfers of this nature during their lifetime or at death (refer to the Exemptions section for greater detail). The generation-skipping transfer tax rate is also set at 40% for transfers that trigger the tax. Income Tax In addition to the above mentioned transfer taxes usually imposed on the donor/decedent, the transfer of certain types of assets also may prompt the beneficiary of those assets to be subject to an income tax liability. Specifically, qualified retirement assets (including IRAs) and annuities may subject the beneficiary of these assets to income taxes upon withdrawal, since the assets were permitted to grow on an income tax-deferred basis during the decedent s lifetime. However, a carefully structured beneficiary designation may allow for continued income tax deferral, albeit with annual required minimum distributions. Capital Gains Tax Currently, assets transferred at death are eligible for a step up in basis, which means that the cost basis of property inherited at death is generally equal to the fair market value of the property at the date of death, or at the alternate valuation date within six months of death. This allows individuals to pass low-cost basis property to their heirs at death and virtually avoid capital gains tax on potentially significant asset appreciation. Exemptions As the previous section indicated, taxes can significantly erode the amount of assets that individuals are able to pass to their heirs. In recognition of this, the federal estate tax/ gift tax structure provides certain exemptions that allow individuals the ability to make limited tax-free transfers. In fact, these exemptions will more than likely provide the foundation for an estate tax savings plan. Unlimited Marital Deduction Generally speaking, individuals are able to claim an estate tax/gift tax deduction for assets transferred to their spouse during their lifetime or at death. Basically, this means that individuals can leave their entire estate to their spouse without incurring any estate tax liability. While the Unlimited Marital Deduction allows individuals to pass their assets to their surviving spouse estate tax-free, the assets will be included in their spouse s estate when he/she dies. Thus, the Unlimited Marital Deduction does not actually eliminate estate taxes, but rather defers them until the second spouse s death. Therefore, leaving all of an individual s assets to a surviving spouse can be a less than optimal estate planning decision in some instances. Applicable Exclusion Amount The federal estate tax structure affords each individual a credit to offset the tax due on a stated amount of assets transferred during their lifetime or at death. This is known as the Applicable Exclusion Amount. In addition, as a result of the 2012 Act, the Applicable Exclusion Amount is permanently portable between spouses, as a surviving spouse is allowed to use any unused portion of the deceased spouse s exclusion amount upon the surviving spouse s death. The Applicable Exclusion Amount is set at $5,340,000 for transfers in 2014, and as a result of the portability feature, spouses may be able to together pass up to $10,680,000 in 2014 as a couple to their heirs federal estate tax-free regardless of the titling of those assets. The 2012 Act made the exclusion amounts permanent and includes future increases for inflation. Additionally, the 2012 Act made the reunification of the gift and estate tax permanent so that an individual may either give away $5.34 million during life or at death or a combination of the two. Reunifying these two taxes allows 4
The Basics of Estate Planning A White Paper by Manning & Napier an individual to remove not only $5,340,000 during his or her lifetime from his or her taxable estate, estate and gift tax-free, but also allows that individual to remove the potential future growth on those assets during his or her lifetime. Generation-Skipping Transfer Tax (GSTT) Exemption This exemption allows individuals to transfer a specified amount of assets to grandchildren or other persons more than one generation younger than the decedent without incurring the GSTT, although estate or gift taxes may still apply. Additionally, direct transfers to a grandchild whose parent has already passed away are generally exempt from the GSTT. Similar to the changes to the gift and estate tax structure, the GSTT exemption is set at $5,340,000 per spouse for 2014 (adjusted for inflation in the future), allows for portability of the exemption between spouses, and set the GST tax rate for transfers over the exemption amount at 40%. Annual Gift Tax Exclusion Individuals and their spouse are each allowed to give up to $14,000 per year (annually indexed with inflation) to as many individuals as they wish without incurring gift tax and without reducing their Applicable Exclusion Amounts. Spouses are allowed to split gifts, allowing them to make annual gifts of $28,000 as a couple to one individual. For example, a couple with two children and four grandchildren can gift up to $168,000 per year, gift tax-free. In addition to the amount currently removed from the couple s estate, future appreciation of the gifted asset is also removed from the couple s estate. (It is worth noting that gifts do not necessarily have to be made to only family members in order to qualify for the annual gift tax exclusion.) Furthermore, an unlimited gift tax exclusion is allowed for direct payments made on behalf of a donee to educational organizations for tuition payments and healthcare providers for medical services. The following table below summarizes the estate, gift, and GST tax rates and exemptions for 2014. Estate, Gift, GST Overview of Exemptions and Rates Total Lifetime Gift & Estate Tax Exemption Maximum Gift & Estate Tax Rate 40% Estate Tax Exemption Portability $5,340,000 YES Total Lifetime GST Tax Exemption $5,340,000 GST Tax Rate 40% GST Tax Exemption Portability YES Common Estate Planning Vehicles The following section provides an introduction to three of the more commonly used basic estate planning vehicles available under current tax law. For each of the various estate planning options addressed, a general description of its advantages and disadvantages is provided. Generally speaking, these estate planning vehicles involve the use of various types of trusts. Each of the Trusts outlined below is created at the death of the account owner. Beyond these three Trust structures, several additional estate planning techniques are available for individuals with larger estates, business interests, split interests, charitable desires, etc. While these advanced topics are not discussed here, they can be an effective way for high net worth individuals and business owners to minimize estate tax. Credit Shelter Trust/Bypass Trust/Family Trust/A-B Trust What it is: A trust that can be used to allow an individual to take advantage of their total Applicable Exclusion Amount (an amount that an individual can shelter from federal estate tax). In the case of a married couple, the assets are not transferred to the surviving spouse, but may benefit the survivor during their life. As such, the assets are not included in the surviving spouse s estate at death. 5
Basics of Estate Planning A White Paper by Manning & Napier When it is appropriate: When an individual wishes to limit estate taxes, transfer assets to the next generation, and to an extent provide for their surviving spouse, if they are married. Advantages: Maximizes the amount that an individual uses of their total Applicable Exclusion Amount. Removes future appreciation of assets from the surviving spouse s estate. Provides greater or equal estate tax savings when compared to a Disclaimer Trust (discussed below). Disadvantages: The Trust is funded at the first spouse s death whether or not it is advantageous. For married couples with estates meaningfully below the current combined threshold of $10,680,000 it may not provide a benefit as these individuals may not have owed estate tax due to the portability rules. There will be attorney s fees to establish the trust and potential trustee fees to administer the trust, although the fees may be inconsequential compared to the potential tax savings of the trust. The surviving spouse loses full control of the assets. Disclaimer Trust What it is: A trust that can be used to allow an individual to take advantage of their total Applicable Exclusion Amount (an amount that an individual can shelter from federal estate tax). Unlike a Credit Shelter Trust, a Disclaimer Trust is created at death of one spouse only if the surviving spouse determines that they do not need full access to the assets. With the help of an attorney, the surviving spouse must determine whether or not to keep assets that they inherit, of if they want to disclaim the assets, therefore funding a trust. If done correctly, assets that are disclaimed into a trust are not included in the surviving spouse s estate at death. When it is appropriate: When an individual wishes to limit estate taxes, but also wants to balance this goal with an equal goal of ensuring that their surviving spouse has sufficient assets to meet their expenses over their remaining lifetime. Advantages: Provides flexibility to the surviving spouse. Allows the surviving spouse to choose at the first spouse s death whether or not it makes sense to fund the Trust. Because of this flexibility individuals may not need to update their estate plan as often. Disadvantages: There will be attorney s fees to establish the trust. If the surviving spouse uses any of the assets prior to disclaiming them, then they may lose the ability to disclaim assets into the Trust. Qualified Terminal Interest Property Trust (QTIP Trust) What it is: A marital trust that qualifies for the Unlimited Marital Deduction, but does not give the surviving spouse full control over the assets. Under the terms of a QTIP Trust, the surviving spouse is entitled to all of the income generated by the trust and the assets in the trust cannot be distributed to anyone other than the surviving spouse while they are alive. When it is appropriate: When an individual wants the surviving spouse to benefit from the assets, but not have control over how the assets will ultimately be distributed. This can be especially useful when an individual has children from a prior marriage that he/ she ultimately wants to leave the assets to, but wants to ensure that his/her current spouse is provided for over their lifetime. Advantages: May allow assets to avoid estate taxes at the first spouse s death and the original owner of the assets retains control over how they are ultimately distributed. Disadvantages: There will be attorney s fees. In addition, the surviving spouse s use of the assets is limited. 6
Basics of Estate Planning A White Paper by Manning & Napier Definitions of Key Terms Administrator A court appointed personal representative who represents and manages the estate when an executor is not named in the will, or during intestacy. Agent An individual appointed through a Power of Attorney or Health Care Proxy document. Beneficiary An individual, institution, or trustee which receives, or may become eligible to receive, benefits under a will, trust, insurance policy, annuity, or other contract. Codicil A separately written document used to amend or revoke a prior will. Decedent A deceased person. Durable Power of Attorney An agent who has control of the Principal s legal affairs until death or until the power is relinquished, whichever happens first. Estate Tax A tax paid on all of one s assets (e.g., including investments, real estate, life insurance, personal property, etc.) at death. Executor A personal representative nominated through the decedent s will who performs the primary duties in representing and managing the estate. Fiduciary A person who is selected to act out a role in place of another individual. Examples of fiduciaries include executors, Trustees, and agents. General Power of Appointment The power to decide who should receive assets, and is able to name himself, his creditors, and/or his estate. Assets with a general power of appointment are typically included in the estate of the agent that holds the power. Generation-Skipping Transfer Tax A federal or state tax levied on certain property transferred to persons more than one generation below the deceased, or if not family, more than 37.5 years below the transferor. Gift Anything with monetary value given from one person to another, with the ability to use the gift immediately, and the donor receiving nothing (or less than fair value) back in return. Grantor The person who establishes a trust. Guardian An individual who is in charge of caring for the decedent s minor children. Health Care Proxy A document that puts the power to make medical decisions in the hands of an agent. Incompetence Includes all individuals who lack legal capacity to act for themselves. This includes minors to an extent. Intestacy The situation where an individual dies without a will in place. Inter vivos A transfer made or a trust created while the transferor is still alive. Irrevocable Trust A trust that cannot be cancelled or changed once it is set up without the consent of the beneficiary. Joint Tenancy with the Right of Survivorship (JTWROS) Two owners share control of the property, and the property passes to the remaining owner when one person dies. Limited Power of Appointment Similar to a General Power of Appointment, but without the ability to appoint the assets to himself, his estate, or creditors. Assets with a Limited Power of Appointment are generally not included in the estate of the agent that holds the power. Living Will This document details what instructions should be followed if specific medical circumstances occur. Non-Durable Power of Attorney An agent who is assigned control of the Principal s legal affairs until this power is relinquished or the Principal is unable to make decisions for himself (e.g., coma, terminal illness). Non-Probate Property Any asset that currently has a beneficiary designation or any asset that is held in joint tenancy. Per Capita A scheme of distribution in a will or trust which stipulates that all eligible descendants receive an equal amount of the decedent s property. Per Stirpes A scheme of distribution in a will or trust which stipulates that those descendants who are closer to the decedent than those who are further removed may receive a larger distribution of the decedent s estate. Personal Property All things that are in existence, have value, are not real property, and are in an individual s name. 7
Basics of Estate Planning A White Paper by Manning & Napier Personal Representative The individual who is responsible for performing the primary duties in representing and managing the estate. If this person is appointed through the will they are known as the executor. However, if they are appointed by the state their official title is administrator. Principal For the purposes of estate planning, a person who signs a Power of Attorney or Health Care Proxy. Probate Property Any good not classified as non-probate property (see definition of non-probate property). Trustee The person, group, or institution that is in charge of managing the assets held in the Trust in line with the Trust Agreement. Unlimited Marital Deduction An estate planning tool that lets an individual leave all of their assets to their spouse estate tax-free. Will A multi-purpose document that determines what happens to a decedent s probate estate at death and can name a guardian or executor. Real Property Includes all land, real estate, and buildings. Revocable Trust A trust that can be changed or terminated during the grantor s lifetime. Settlor The creator of a Trust. This individual can also be known as a Grantor or a Trustor. Springing Power of Attorney This agent does not gain control of the legal affairs until a certain circumstance occurs (e.g., terminal illness). Tenancy by the Entirety Similar to joint tenancy, although this must be between husband and wife and none of the property may be gifted or sold without consent of both parties. Tenancy by Sole Ownership An individual who has complete control of the assets. Tenancy in Common Each owner holds a specific portion of the asset (e.g., 70%/30% of a house) and each tenant owns undivided interest in their portion of the asset. Moreover, each tenant pays taxes on their portion. Testamentary A transfer made or trust created, by will, at death. Testator/Testatrix A person who creates a Will. Total Applicable Exclusion Amount The amount that is excluded from the combination of gift and estate taxes throughout an individual s lifetime. Trust A legal document that is intended to hold property for the benefit of others and based on terms as were initially laid out by the creator of the Trust. Approved CAG-PUB024 (1/14) 8