Estate Planning: An Important Part of Your Retirement Plan
Building your retirement plan involves some meaningful reflection on where you are in life and what you want to achieve in your retirement years. As you carefully consider your future goals and priorities, it is often a good time to revisit your estate planning documents to ensure that any new priorities are incorporated into these important documents.
In this article, we will discuss different estate planning considerations that are important parts of any estate plan. We hope that by providing some perspective on these key considerations, you can feel more comfortable and confident as you begin your estate planning process. Let’s get started by discussing what your estate plan will involve.
What is Estate Planning
Estate planning involves the creation of several key legal documents that address many important medical and financial considerations. In your Estate Plan, you will legally define your wishes as it relates to:
Who will make medical decisions for you if you cannot
How you will fund medical care later in life
Who will help you pay your bills, file your taxes, manage your investments as you age
Where you want your assets to go at death
Who will manage the financial affairs of your estate
How you plan to reduce any taxes that might be owed at death
Key Estate Planning Documents
One unique aspect of the estate planning process is that much of your “estate planning” is actually focused on your own future healthcare and financial needs.
Since your estate planning will play a critical role in maximizing your quality of life and ensuring your financial security as you age, it is important for everyone, regardless of your level of wealth, to possess certain key legal documents. Let’s review those documents now.
Healthcare Power of Attorney
Your healthcare power of attorney is a legal document that establishes who is responsible for making medical decisions on your behalf if you are unable to make these decisions for yourself. It will also define the scope of this person’s authority.
Advanced Directive (Living Will)
A living will, or an advanced directive, is a legal document that defines your wishes for end-of-life care. This will generally include your wishes as it relates to life support, do not resuscitate orders, etc.
Financial Power of Attorney (POA)
A financial power of attorney, or a POA, is a legal document that establishes who is responsible for making financial decisions on your behalf if you are unable to make these decisions for yourself. However, it is important to note that a Power of Attorney’s authority ends at death at which time an Executor’s authority to act on behalf of your estate would begin.
Last Will & Testament
The last will and testament is a legal document that details the people or charities that will receive your Probate Assets at death. This document will also name your Executor who will be tasked with managing the financial affairs of your estate.
Summary of Accounts & Assets
A detailed summary of your accounts and assets is an informal but critically important document to create. Be sure to include where each account is located (ex. JP Morgan, Charles Schwab, PNC safe deposit box), the approximate value of each account, and whether any beneficiary designations might apply to a specific account.
How Assets Transfer At Death
In the typical Hollywood script, the trusted family lawyer of the wealthy patriarch reads the terms of the Will to a room full of family members who nervously wait to learn whether they will receive a share of the family fortune. While this makes for a dramatic movie scene, it isn’t all that realistic as a wealthy person would never transfer his or her fortune in this manner. Let’s now discuss the different ways in which assets can be transferred at death.
Probate Assets vs. Non-Probate Assets
When someone passes away, their estate is composed of two types of assets: probate assets and non-probate assets.
What is a Probate Asset?
A probate asset is any asset owned by a decedent that does not pass to its intended beneficiary via specific contractual terms, state law, or the terms of a funded trust. Any asset that does transfer through one of these alternative legal processes will transfer to the recipient(s) named in the decedent’s Will as part of a court-supervised probate process. Therefore, the terms of your Will only addresses who will receive your probate assets at death.
Most commonly, a decedent’s probate assets often includes personal property such as clothing, jewelry, artwork, and cars. However, it is not uncommon for personal real estate and financial accounts to also end up in one’s probate estate.
How probate works:
As part of the probate process, a state court will legally recognize a decedent’s Will and then legally appoint the Executor named in the Will to act on behalf of the decedent’s estate. The executor is then tasked with gathering a decedent’s assets, paying any final debts or taxes, and then distributing any remaining assets to the beneficiaries listed in the Will.
What if you die without a will?
If a Will does not exist, the state court would appoint an administrator to perform a similar role as that of an executor. Once all assets are gathered and all final debts and taxes are paid, the administrator would then distribute any remaining assets to different groups of beneficiaries as detailed in each state’s intestate succession laws. Simply put, if you don’t have a Will, state law will determine who receives your assets and what each person will receive.
Why probate is frequently bypassed
Most estate planning professionals try to avoid transferring a client’s assets through the probate court system. The reason is that probate court is a formal court proceeding that takes time and is often more costly. The probate court process is also a public process which makes it impossible to protect the privacy of the decedent’s affairs. Lastly, any asset that passes through probate can only be distributed after all final debts and taxes of the decedent are settled. This means that probate assets are unprotected from creditors should a decedent pass away with substantial debts or outstanding litigation pending.
Now that we have a better sense for how probate works and the type of assets addressed by a Will, it is much easier to see why the wealthy patriarch in the Hollywood script would be unlikely to transfer his family fortune through the use of a Will alone.
Let’s next discuss the most common ways that assets transfer to beneficiaries outside of the probate court process.
Non-Probate Assets
If a decedent uses an alternative legal process to transfer an asset at death, the asset involved is often referred to as a non-probate asset. Here are the three ways assets can transfer at death outside of a probate court proceeding.
Certain Assets Transfer via Contract
The quickest and most cost-effective way to transfer an asset is by naming a beneficiary on an insurance or investment account. When you name a beneficiary on a life insurance policy, annuity contract, IRA, Roth IRA, or 401(k) retirement plan, you are establishing a contractual arrangement that dictates how that particular asset will be distributed at death.
For most modern-day retirees, your retirement accounts will represent a large share of your overall net worth. This means that valid beneficiary designations will serve an important role in transferring your assets at death.
Certain Assets Transfer via State Law
Another quick and cost-effective way to transfer an asset at death is to utilize state law. A common example of this type of transfer would be the use of jointly owned property in which each owner possesses a right of survivorship in a particular asset. This might include jointly owned bank accounts or jointly owned real estate that is retitled to include a right of survivorship amongst the joint owners.
With that noted, joint ownership of an asset can be structured in several different ways and some jointly owned assets may still need to pass through probate. Since the joint ownership of any asset can involve some legal nuance, it is important to have a qualified professional review any jointly owned assets to ensure each asset is properly titled .
Certain Assets Transfer via the Terms of a Funded Trust
The final way that an asset can be transferred at death is through the terms of a funded trust. Since the use of a trust will generally involve greater cost and complexity, it is important to understand the benefits you will realize from using a trust to ensure it is an appropriate planning technique for your needs.
Let’s now discuss trusts in more detail.
Understanding Trusts
A trust is a separate legal entity that you create to take ownership of certain assets while you are living or upon your death. While trusts are often viewed as a tool for the ultra-wealthy, the reality is that trusts are used by many Americans to achieve several important objectives, irrespective of their level of wealth.
Personal Privacy
Any assets that are transferred via probate are part of a public court procedure. This means that the details of your finances and the terms of your Will are accessible to the public. By using a trust to transfer one’s assets, you can direct your assets to the intended recipients in a private process.
Asset Protection
All debts of a decedent must be settled by your estate before the remaining assets can be distributed to beneficiaries. If a decedent is heavily indebted, involved in litigation, or subject to elevated medical expenses prior to one’s death, your probate assets can be used to settle these debts. Therefore, trusts are often used to protect a decedent’s assets from the negative impact of future debts, litigation, medical costs, etc.
Greater Control
The most common reason that trusts are created relates to a decedent’s desire to continue exercising control over their wealth after death. By spelling out detailed trust terms for your Trustee to follow, a decedent can dictate how trust assets should be managed, who is entitled to certain assets, and when certain distributions can be made. For an individual with substantial wealth or complex assets such as a business, the ability to exercise this level of control is often an major priority. And of course, the importance of this priority is only heightened if a beneficiary is unable to properly manage the inherited assets on their own.
Creating Your Trust
After careful deliberation and consultation with your attorney and CPA, you might decide that a specific trust design is the good choice for your planning needs. So how do you go about creating your trust?
Creating your Trust Document:
The first step in the trust creation process is the design of your Trust Document. Your Trust Document will be a lengthy legal document that names the Trustee of your Trust and spells out all the specific terms of your trust. Once your Trust is funded, your Trustee will then become responsible for managing your Trust based on the specific terms of your Trust Document.
Since your Trust Document serves as your instructions to your Trustee, it should include detailed terms as to how trust should be managed. However, it is also important to recognize that you cannot anticipate every future event that might unfold. Therefore, a well-drafted trust document will generally provide your Trustee with some level of discretion to navigate future changes in the tax code, financial markets, and the needs of beneficiaries.
Once your Trust Document has been drafted and executed, the next step is funding your trust.
Funding your Trust:
A trust can be funded while you are living, it can be funded at death, or it can funded while living and then again at death. Deciding when to fund your trust will ultimately relate to the specific objectives that you are looking to achieve through the use of that trust.
What if you fund a trust and then change your mind?
You can structure a trust to be revocable or irrevocable. When a trust is established as a revocable trust, the trust grantor (you) retains the right to remove assets and change key trust terms at any time. Upon one’s death, a revocable trust would become irrevocable and the trust document would detail how the assets are to be managed in the future. The most common use of a revocable trust is retitling one’s home into the name of a revocable trust. This technique would enable you to continue living in your home while ensuring that your home can bypass probate at death.
A trust can also be established as an irrevocable trust. This means that any asset transfer into the trust is final and cannot be revoked. While every trust becomes irrevocable at death, irrevocable trusts are also frequently funded when a trust grantor (you) is living. The primary reason that irrevocable asset transfers are made during one’s lifetime is to shield the transferred asset from the risk of future taxation, medical expenses, or creditors.
How an Estate is Taxed
When it comes to estate-related taxation, two different types of taxation can apply. The first tax is an estate tax which is based on the value of the assets you transfer to others. The second tax is the taxation of any income earned from the ongoing use or sale of inherited assets after the date of death.
Federal Estate & Gift Tax
The Federal Estate & Gift Tax is a tax assessed on the value of all lifetime asset transfers to others (excluding your spouse) that exceeds $13.6 million (2024). This means that any individual can transfer up to $13.6 million to others while you are living or at death and incur no federal estate or gift tax on the transfer. For a married couple, this lifetime exemption doubles to $27.2 million. With such a sizable lifetime exemption, very few Americans are currently subject to the federal estate and gift tax.
New Jersey Estate and Inheritance Tax
Historically, the State of New Jersey assessed both an Estate Tax and an Inheritance Tax on the value of a New Jersey resident’s estate. Beginning in 2018, New Jersey eliminated the Estate Tax but retained its Inheritance Tax.
The New Jersey Inheritance Tax is an 11% to 16% tax assessed on any asset transfer above $25,000 to a sibling and any asset transfer above $500 to anyone else such as a cousin, niece, or family friend. This tax would apply to any transfer at death or within three years of one’s death. However, it is important to note that the New Jersey Inheritance Tax is not applied to any asset transferred to your spouse or any lineal descendent such as a child, grandchild, etc.
Income Tax Considerations
After the date of death, any income realized from a decedent’s assets is no longer taxable to the decedent. Instead, this income would be reported by the decedent’s estate or trust on a Form 1041 Fiduciary income tax return or on an individual beneficiary’s personal tax return.
Another key income tax consideration relates to the cost basis on an inherited asset. As a general rule, most assets owned by a decedent at the date of death will be inherited with a tax basis equal to the asset’s value on the date of death. This is often referred to as receiving a stepped-up basis.
To highlight this important concept, let’s assume a decedent bought his home for $200,000 in 1985. In 2024, the decedent passed away and the home was valued at and sold for $800,000. In this scenario, the beneficiaries of the estate would inherit the home with a tax basis of $800,000 and no income tax would be owed on the $600,000 in appreciation.
While the stepped-up basis concept applies to many inherited assets, there are a few key exceptions. The first few exceptions would be any pre-tax IRAs, 401(k) plans, and non-qualified annuities. When you inherit these specific assets, you also inherit the decedent’s original tax basis in these accounts. Therefore, as funds are withdrawn, a beneficiary will report these withdrawals as income on their personal tax return and pay the associated taxes.
The second exception to the stepped-up basis rule would be a scenario in which a decedent makes a gift of an appreciated asset before their death. In such a scenario, the recipient of that gift would assume the decedent’s original tax basis as the stepped-up basis rule does not apply to assets transferred by gift during one’s lifetime.
Even though most Americans are not subject to the Federal Estate Tax, there are still many complex tax considerations that need to be addressed as part of any modern-day estate plan. However, with this complexity comes an opportunity to reduce your estate-related taxes and preserve your wealth for the next generation.
In Conclusion:
Estate planning is not the easiest topic as it involves some difficult thought processes as well as some challenging decisions. For many of us, thinking about who will assist us as we age or who should receive our life savings are all lines of thinking that we would prefer to avoid.
While estate planning can be challenging, taking some time to develop a basic set of estate planning documents that reflect your current wishes and priorities is a great first step. As time goes on, you can always update your documents to reflect changes in your life as well as any new goals or priorities that you might have. Good Luck!