Reassessing Your Risk Tolerance? Don't Overlook Estate Planning

    by Ellen J. Boling

    Reassessing Your Risk Tolerance? Don't Overlook Estate Planning Splash image

    With the recent downturn in the economy, many people have focused on trying to protect their assets from further decrease in economic value. For most individuals, this has consisted of a reevaluation of their risk tolerance for loss, which may have necessitated a change in investment strategy or even an investment advisor.

    However, the same people may not be considering the risk of a decrease in their economic value by failing to have an adequate estate plan. Many people do not see an estate plan as necessary. Others recognize the need to plan, but have no idea whom to contact or how to begin.

    Estate planning encompasses much more than simply protecting one’s assets; it provides peace of mind that your assets will pass according to your wishes at the least cost and administrative burden. Whatever one’s reasons for taking the risk of not planning, there is no doubt that it is a risk that one should not take.

    Why Have an Estate Plan?

    By neglecting to have even the most basic estate planning document—a will—you leave your estate planning to your state government, with possible adverse results. A local court may have to appoint an administrator to manage your estate. This person, possibly a stranger to you, must be paid. Even if the administrator named is your surviving spouse, a bond is generally required. The amount of time required to settle your estate may be unnecessarily long. Additionally, part of your estate may pass to the federal and state governments in the form of avoidable taxes. Finally, if you have children, then the court will have to appoint a guardian to care for them after you die, which will add emotional and financial burdens for the legal proceedings. Clearly, one imperative of estate planning is: Don’t die without a will.

    While most people understand that a will is necessary to transfer assets at their death, they may not know its limitations. Property can actually be transferred several ways:

    • By a properly executed will or trust,
    • By contract, or
    • By operation of law.
    Table 1 provides some examples of how different assets are transferred at death.

    Transfer by Will
    As a general rule, a will provides for the transfer of property owned by an individual, including his or her interest in community property titled in the name of the other spouse. Specific bequests of tangible personal property (e.g., jewelry, furniture), may also be addressed in the will or in a separate memorandum referenced in the will, if permitted by state law. However, a will does not dispose of assets governed by contract or operation of law.

    Transfer by Contract
    Examples of assets that are governed by contract include annuities, IRAs, employee benefit programs or life insurance. A properly executed beneficiary designation form is necessary to ensure that these assets will pass to the intended persons. Regardless of what your will says, these assets will go to the person listed as the contract beneficiary. Additionally, your beneficiary designation may have both estate and income tax ramifications, particularly for IRAs or employee benefit programs. Therefore, it is important that the designations agree with your overall estate and financial plan.

    Transfer by State Law
    State law also may affect the disposition of your assets. Assets that pass by operation of law include anything that can be held in joint title, such as a bank account or a house. If you hold a house jointly with right of survivorship, then the house will automatically pass to the other person on the title at your death, regardless of what is stated in your will. In some states, you may be prohibited from disinheriting a spouse or other close relative. Additionally, if you reside in a state that follows the community property system of asset ownership, then state law will supercede the terms of your will in disposing of assets held with a spouse.

    TABLE 1.
    Preserving and
    Transferring Your Wealth:
    Property Disposition

    Other Estate Documents

    Additionally, an estate plan includes more than disposition of your assets at death. It should also include the possible need to administer your assets or make health care decisions if you are temporarily incapacitated. Most financial planners recommend having sufficient savings to fund up to six months of your living expenses, but who would pay your bills if you are unable to do so? If you do not give someone explicit authority to do so, then even a spouse may need to seek court permission to act on your behalf. This again would cause unnecessary emotional and financial burdens at an already stressful time.

    For these reasons, in addition to a will, you should consider establishing two types of powers of attorney:

    1. A durable general power of attorney to delegate the ability to make and implement financial decisions, and

    2. A health care power of attorney to delegate the ability to make and implement health care decisions. The powers that can be delegated in these documents and the form of the documents differ greatly by state. A living will (sometimes called an advance directive) should also be considered to describe the type and extent of life-sustaining medical treatment that you prefer in the event that you are unable to communicate those wishes.

    What is the Estate Tax?

    Estate taxes do not apply only to the very wealthy. Even relatively modest estates may be subject to estate taxes without proper planning. A typical individual with a house, a retirement plan, and life insurance is very likely to have assets that exceed the amount that is exempted from estate tax. For 2002 that amount is $1.0 million, the threshold at which you should think about doing estate planning. Therefore, it is important to understand not only federal estate and gift taxes, but also possible state estate, gift, and inheritance taxes.

    The estate tax is really a transfer tax, because it applies to property transfers during lifetime (such as gifts) and at death (such as inheritances). Transfer taxes are progressive, which means that all lifetime taxable gifts are cumulative, so that over time you are subjected to higher tax brackets. Therefore, as the value of your estate increases, planning becomes more important.

    The marginal gift and estate tax rates currently range from 18% to 49%. Certain credits and deductions are available to offset the tax. For example, every individual taxpayer can transfer a certain amount of property either during life or at death without paying estate or gift tax, due to a lifetime exemption amount. The lifetime gift exemption amount is currently $1 million. Additionally, transfers to grandchildren and certain other individuals are subject to another tax called the generation-skipping transfer (GST) tax that is imposed at the highest estate tax level.

    The tax rates and exemption amounts are currently scheduled to change under the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA). The most controversial aspect of EGTRRA was the possible repeal of the estate tax. Congress and President Bush compromised on a protracted repeal that would ultimately be effective for those who die in 2010.

    It is extremely important to note that EGTRRA includes a “sunset provision” that results in all of its provisions being repealed as of December 31, 2010. As a result, the estate, gift and generation-skipping transfer provisions in effect in 2001 will become the law once again on January 1, 2011, if Congress does not take any intervening action. Table 2 explains the phase-in of the new tax rates and exemption amounts.

    For the gift tax, the top rate will decrease 1% a year until 2007, and remain at 45% until 2010. At that time, the gift tax will remain in place with a maximum rate of 35%. The lifetime exemption amount remains constant at $1 million. Additionally, any transfer in trust after 2009 will generally be deemed to be a taxable gift unless:

    1. The trust is treated as a wholly grantor trust to the donor or the donor’s spouse, thus causing the income (including any capital gains) to be subject to income tax to the donor or donor’s spouse; or

    2. The transfer is exempt from such treatment under regulations to be prescribed by the Treasury secretary.
    The gift tax annual exclusion is indexed annually for inflation; for 2003 it is $11,000.

    For the estate tax, the top tax rate will follow the gift tax and decrease 1% a year until 2007. It will then remain at 45% until full repeal of the estate tax in 2010. Additionally, the exemption amount for transfers at death increases to $1.5 million in 2004, $2 million in 2006, and $3.5 million in 2009—with a full repeal in 2010. However, concurrent with the decrease in federal estate tax rates, is a decrease in the federal credit for state death taxes. The credit is reduced 25% in 2002, 50% in 2003, and 75% in 2004, before being repealed in 2005.

    Historically, many states defined their estate tax as being equal to the federal credit for state estate taxes paid. With a decrease in the credit, many states anticipate a revenue shortfall, and are responding by decoupling their estate tax system from the historical “pick-up” system. Once the credit is repealed, there is still an estate tax deduction for state death taxes paid. However, it is now necessary to understand the state law where you live or where you own property, as your estate may be subject to state estate taxes.

    The GST tax will correspond to the highest marginal estate rate in that year. The GST exemption remains at the current inflation-adjusted amount of $1.1 million for 2003. In 2004, the GST exemption will be the same as the estate tax exemption of $1.5 million. It will continue to increase as the estate tax exemption increases.

    In the event of estate tax repeal, EGTRRA introduces a carryover basis regime under which a beneficiary will acquire either the decedent’s basis or the fair market value of inherited property on the decedent’s date of death, whichever is less. Currently, a beneficiary gets an increase in basis to the fair market value of the property on the date of the decedent’s death, regardless of whether or not estate taxes are actually paid. EGTRRA does allow for some transfers to qualify for a step-up in basis to fair market value. An estate can increase the basis of assets transferred to one or more beneficiaries by a total of $1.3 million. The amount of unused capital losses, net operating losses, and certain “built-in” losses of the decedent may also increase the $1.3 million cap. An estate can increase the basis of assets transferred to a surviving spouse by an additional $3 million if the assets are left outright. The $1.3 million and $3 million amounts will be adjusted annually for inflation after 2010. In no case can an asset take basis in excess of its fair market value. The executor must elect which assets get a step-up in basis. Therefore, a will may be helpful to give guidance and avoid conflict between heirs on that issue.

    TABLE 2. Estate, GST and Gift Examptions and Rates Under the 2001 Tax Act
      2003 2004 2005 2006 2007 2008 2009 2010
    Estate Tax
    Top Rate 49% 48% 47% 46% 45% 45% 45% Repeal
    Exemption $1.0 mil $1.5 mil $1.5 mil $2.0 mil $2.0 mil $2.0 mil $3.5 mil Repeal
    Generation-Skipping Tax
    Top Rate 49% 48% 47% 46% 45% 45% 45% Repeal
    Exemption $1.1 mil $1.5 mil $1.5 mil $2.0 mil $2.0 mil $2.0 mil $3.5 mil Repeal
    Gift Tax
    Top Rate 49% 48% 47% 46% 45% 45% 45% 35%
    Exemption $1.0 mil $1.0 mil $1.0 mil $1.0 mil $1.0 mil $1.0 mil $1.0 mil $1.0 mil

    How Do I Start Planning?

    Estate planning does not need to be seen as a complex set of questions. Instead, it can be a relatively easy process of six steps:

    1. Identify the goals,
    2. Gather the data and make assumptions,
    3. Evaluate the feasibility of your goals,
    4. Develop your strategies,
    5. Implement the decisions, and
    6. Review your progress.
    In the estate planning process, these steps can be summarized as follows:

    Identify the Goals
    The starting point of a successful estate plan, as with any area of financial planning, is identifying and defining your goals. Here are some questions you should answer that will help you identify your goals:

    • What is the most appropriate way to dispose of your assets at your death?
    • Who will receive what, and when will they receive it?
    • Will assistance in the management of the assets be required?
    • If you have minor children, who will care for them the way you would, and with what financial resources?
    • How can the costs of administering your estate, including taxes, be minimized?
    • Have you appointed an agent to act on your behalf in the event of your disability?
    • Will your family be adequately provided for in the event of your premature death?
    Gather the Data and Make Assumptions
    After you have identified your goals, you can begin to gather data. You will need to collect your current estate planning documents, including wills and trust instruments, beneficiary designations on retirement plans and insurance policies, and title documents that set out the ownership of major assets such as your home. In addition, you need to quantify the value of your assets and your liabilities. You must also consider non-financial issues, such as asset management and protection and the timing of when you want your assets to ultimately pass to your heirs.

    Evaluate the Feasibility of Your Goals
    Most goals dealing with the disposition of assets can be accomplished with estate planning. However, you cannot completely control how your heirs spend their inheritance. Similarly, in large estates, some amount of estate taxes may be incurred, even with planning. It may not be possible to meet goals of complete control or elimination of taxes.

    Develop Your Strategies
    Identify the planning documents that must be drafted or revised. Determine which tax planning strategies may be appropriate. Consider the individuals or entities to which you want to entrust your assets after your death. Assess the needs of your family members—including your spouse, parents, children, and grandchildren—in light of your death. Consider the financial security of your survivors and the adequacy of your life insurance coverage.

    Implement the Decisions
    Your decision is meaningless until you turn your words into deeds. In this step, you implement the strategies you developed and execute legal documents. Assign specific tasks to yourself and other family members, and determine whether professional assistance is needed.

    Review Your Progress
    This final step is easy to ignore, but it is among the most critical. Few decisions are static; we base our choices on a series of events and circumstances that can and do change. Every few years or after a major life event—a marriage, adoption or birth of a child, death of a child or spouse, disability, serious illness, inheritance, divorce, retirement or career change—you should reconsider the various aspects of your plan. Have your goals changed? Has the law changed? Have new or better options become available?


    Once you have recognized the risks of not having an estate plan, and how relatively simple it can be to establish one, then perhaps you will be motivated to go through the process outlined above. At a minimum, a will and powers of attorney, coordinated with the proper titling of assets and beneficiary designations, can help you to administer your assets during life and at death.

    If you may be subject to gift, estate or GST tax, then you may want to implement more sophisticated estate planning techniques, which would probably require consultation with a professional.

    There is no doubt that estate planning can force some difficult decisions. However, if you ignore these issues, then you are risking not only unnecessary taxes, but also unnecessary administrative burdens or anguish for those you leave behind.

    Ellen J. Boling, CFP, is director of Private Client Advisors for Deloitte & Touche, LLP, in Cincinnati, Ohio. Tracy Tinnemeyer, JD, is a manager of Private Client Advisors for Deloitte & Touche, LLP, in Pittsburgh, Pennsylvania.

    This article includes excerpts from “Seeds of Change, The 2001 Tax Cut,” published by Deloitte & Touche, 2001.

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