How Do Taxes and Trusts Fit Into Your Estate Plan?

Estate planning is one of those tasks that makes almost any other job look appealing, no matter how lowly: Cleaning the filter on the vacuum cleaner has more appeal. You may even wonder if your assets are substantial enough to warrant an estate plan. Moreover, estate plans are usually drafted by lawyers, and that means dollar signs. And then there’s the obvious issue: Do you really want to spend time contemplating your own death or disability, which is what estate planning requires you to do?

But Jenny Rozelle, an estate planning attorney, actually makes estate planning seem like something I want to tackle. As she describes it, a well-laid estate plan is a way of lightening the load for my loved ones, easing their logistical challenges and, even more importantly, giving them peace of mind with their decision-making. Doesn’t that sound better?

In this excerpt from my book, How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement, I asked Jenny to discuss how taxes fit into estate planning, as well as when trusts can make sense.

Christine: Taxes are an important component of estate planning. For older adults who are spending from their portfolios and also thinking about earmarking assets for children or other heirs, how should they decide which assets those should be?

Jennifer: That’s a conversation between me, their advisor, and/or their accountant. That is a perfect opportunity for these three professionals to work together and come up with the most appropriate solution for that individual, because it really depends.

For example, if I have a client who wants to make distributions to a charitable organization, that’s a great opportunity to have the charitable organization be a beneficiary on traditional pretax accounts. The charity can receive the full amount and won’t owe taxes, whereas human beneficiaries will owe taxes.

Beneficiaries who receive taxable accounts, on the other hand, benefit from a step-up in cost basis, meaning their cost basis steps up to whatever the value of the asset was when the person died. Assuming the inheritor sells shortly after inheriting the assets, the taxes are usually limited.

Unless the funds in a pretax account are going to charity, someone is going to pay taxes eventually, whether it’s you or your beneficiaries when they inherit the money. The Secure Act requires that beneficiaries take their distributions from pretax accounts within 10 years, unless they fall into one of a few different exemptions. In some instances, the financial planner or tax planner might advise the account owner to start taking bigger distributions from pretax accounts in an effort to minimize the tax burden on the beneficiaries later.

Christine: What about estate tax?

Jennifer: Estate tax is a tax on the estate—the assets that you leave behind—after you die, but before assets are distributed out to the beneficiaries. Not every estate is subject to estate tax; it depends on the size of the estate. There’s a federal estate tax, and some states levy estate taxes, too.

Some states levy what are called inheritance taxes, though the number of states with inheritance taxes is shrinking. Some states—maybe one or two at this point—have both a state estate tax and an inheritance tax. It’s important to clarify the difference between estate tax and inheritance tax; people use those terms interchangeably but they’re very different. Inheritance tax is a tax on the beneficiaries, whereas estate tax is a tax on the estate, before it goes to the beneficiaries.

Christine: Trusts often come up in the estate planning discussion. Can you discuss what a trust is, and what are some of the most common situations when creating a trust might be warranted?

Jennifer: A trust is a legal document that allows you to take assets and put them in the name of the trust. From there it depends on the type of trust and what the trust tells the trustee to do.

This may sound silly, but I often describe a trust as a wagon, and your assets are like toy blocks. You may take some of those toy blocks and put them in your wagon, and when you do that, it changes the ownership of things. To further the analogy, imagine that the wagon has a luggage tag on it with the instructions on what you were supposed to do with the blocks in that wagon at incapacity or death.

In terms of the triggers that I look for when I’m helping individuals with their estate plans, one would be if they have assets where it’s really difficult to add a beneficiary; for example, if they own a business, or multiple businesses. Maybe they have rental properties or out-of-state properties. We can’t easily add a beneficiary to an ownership interest.

In such situations, it’s going to be easier to avoid probate—a legal process for distributing assets after death—by getting a trust into the equation. Trusts provide a way to avoid the probate court process.

Irrevocable trust planning can come into play for tax-planning purposes for moderate-net-worth or high-net-worth people. I also do irrevocable trust planning under my elder law umbrella to help individuals and families plan for long-term care costs and protect their assets if they need Medicaid-provided long-term care.

Christine: I think people hear “trust” and assume they’re just for wealthy people. Is that a misconception?

Jennifer: Trust planning is really goal-dependent. It is not asset-dependent. The appropriateness of a trust depends on what the client is trying to accomplish. From there I think about how we accomplish the client’s goal. Does a trust make sense or can we use a simpler approach like adding beneficiaries? Trusts can make sense for lots of different reasons and for lots of different individuals. They also do not make sense for lots of different reasons and lots of different individuals. It’s always going to anchor back to the goal.

Christine: You mentioned that trusts can make sense for tax reasons for moderately wealthy and higher-net-worth people. How so?

Jennifer: The estate tax exemption—the amount of assets that you can die with and not have the estate be subject to estate taxes—changes. And exemptions from state estate tax also vary by state. The federal estate tax exemption amount is currently high; it’s like we’re going up the hill of the roller coaster. But in the event it’s down in the valley and the estate tax threshold is very low when you pass away, we can put tax-planning provisions in the estate plan, including trusts, to help address that.

I don’t know what the estate tax threshold will be in the future, but I think it’s appropriate to include those provisions. If the estate tax threshold is low when someone passes away, the plan addresses that possibility. The language in the estate planning documents might say that the trustee may activate a tax-planning strategy, not that the trustee shall activate such a strategy. That way you’re not forcing the trustee’s hand. The last thing I’d want to do would be to create extra work. If the estate tax exemption ends up being on the high side at the time of death, the trustee doesn’t need to take further action.

Excerpted with permission of the publisher Harriman House Ltd. from How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement by Christine Benz. Copyright (c) MMXXIV Morningstar, Inc.