your Will is not properly structured, your estate could end up paying tens of thousands of dollars, hundreds of thousands of dollars, or even millions of dollars of unnecessary state and federal estate taxes.
Insurance Policies As Part of Your Estate
You may not realize that your taxable estate includes any life insurance policies that you own or control. The total value of any such policies raises your taxable estate dollar for dollar.
Estate Tax Exemptions and Estate Taxes
New Jersey’s exemption from estate tax is only $675,000 and New York’s exemption from estate tax is only $1 million. If you die with an estate in excess of your state’s exemption (that does not pass to your spouse or to certain qualifying trusts for his or her benefit), these states will collect estate taxes at rates of between 4% and 16%, respectively.1
In addition, there is a $3.5 million exemption from federal estate tax (the “applicable exclusion amount”). Once your estate exceeds $3.5 million, the combined federal and state estate tax rates rise steeply, peaking at 45%.
Consider the following examples:
If your Wills are not properly structured and you and your spouse pass away in close succession with a net worth of $1.5 million, although no federal estate tax will be owed, on the surviving spouse’s death his or her estate will unnecessarily owe around $65,000 in state estate tax. Thus, if you are married with $500,000 of assets and $1 million of life insurance, properly structuring your Wills can save $65,000.
On the upper end, if your Wills are not properly structured and you and your spouse pass away, as described above, with a $7 million net worth, around $1,455,800 of completely unnecessary federal estate tax will be owed. If the Wills were properly structured, no federal estate tax would have been owed upon the surviving spouse’s death—so the failure to properly structure the Wills results in the unnecessary payment of $1,455,800 of federal estate tax. Thus, for the married couple with $3.5 million of assets and $3.5 million of life insurance, approximately $1.5 million dollars of unnecessary federal estate taxes may be due if Wills are not properly structured.
Let us explore why this happens.
The Marital Deduction
There is no estate tax on property passing between you and your spouse. As a result, often many Wills drafted prior to 2001’s changes in the tax laws leave all property to a surviving spouse. Although these Wills result in no estate taxes being paid on the first spouse’s death, as the above examples illustrate, they can prove very costly for your family on the surviving spouse’s death.
Leaving all property to a surviving spouse wastes the deceased spouse’s exclusion from federal estate tax, resulting in unnecessary estate taxes being due upon the surviving spouse’s death.
Credit Shelter Trusts
Simply including what is often referred to as a “credit shelter trust” in your Will, or drafting your Will to permit your surviving spouse to disclaim property into a credit shelter trust (or “disclaimer trust”) for his or her own benefit (and often also for your children’s benefit) safeguards the decedent spouse’s applicable exclusion amount. This enables both your exemption and your spouse’s exemption to pass estate tax free to the next generation, effectively doubling the amount of assets that pass to your children estate tax free. The surviving spouse can still have access to the property in the credit shelter trust, but upon said spouse’s death, the property will not be included in his or her estate, and such property will pass estate tax-free to your descendants or to the other beneficiaries of the trust.
By giving your spouse the power to disclaim assets into a credit shelter trust, you preserve maximum flexibility in deciding whether to fully fund the credit shelter trust with the applicable exclusion amount, or whether to partially fund the trust with only the maximum state exemption from estate taxes (either $1 million or $675,000 in New York and New Jersey, respectively).
Of course, this same tax savings can be achieved by leaving the applicable exclusion amount directly to your descendants or other beneficiaries (who are not your spouse). This is generally advisable when your spouse will have sufficient assets to live on after your death.
The Necessity of Re-Titling Assets
Often, credit shelter trusts are put in Wills but assets are not re-titled in a manner that enables the credit shelter trusts to be funded upon death. Are your (and your spouse’s) assets titled such that a credit shelter trust can be funded?
In order to achieve the maximum tax savings when the first spouse dies, you and your spouse should have sufficient assets in each of your own individual names to fund a credit shelter trust ($3.5 million in each of your own names, if assets are sufficient to do so—or if assets are not sufficient to do so, the assets should be split such that each of you own one-half of them). This is because jointly owned property, retirement accounts (with designated beneficiaries) and insurance proceeds (that are not payable to your estate) typically cannot be used to fund a credit shelter trust since such assets pass outside of your Will.
Therefore, adjustments with respect to how your assets are titled (e.g. splitting of brokerage accounts or re-titling a home) may be advisable to ensure that a credit shelter trust or a disclaimer trust can be funded upon your and your spouse’s deaths.
Trusts For Children
Once you and your spouse are both deceased it is important to protect assets for your children. I
generally steer clients toward fully discretionary trusts. These trusts grant the trustee(s) flexibility to distribute trust property for a child’s health, education, support and maintenance, or for any other reason that the trustee deems appropriate. Trustees are, of course, forbidden from making any distributions to themselves and are bound to carry out the provisions of the trust—only making distributions for the trust’s beneficiaries pursuant to the trust’s authority, which grants broad discretion to the trustee.
There are three primary protections that such a trust affords to your children and other heirs, the trust protects heirs from: (1) themselves; (2) potential creditors and (3) future ex-spouses.
In addition, in the event that your children or other heirs are successful enough that they never need the money you are leaving them, certain assets can pass to their children free from estate tax (by reason of the generation skipping tax exemption). If you leave them the assets outright, however, they cannot take advantage of this exemption.
Periodically Update Estate Planning
Many people also fail to update estate planning documents to reflect life changing events such as a divorce, remarriage or birth of a child or additional children. It is important for you to ensure that your current estate planning documents (including life insurance beneficiary designations and 401(k) and IRA beneficiary designations) still embody your present wishes.
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In future blogs I will address other simple actions that you can take (and that are often overlooked) to reduce the impact of estate taxes and to avoid unintended and unwelcome consequences for you and your family.
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Naim Bulbulia, is the head of Hartmann Doherty’s Trusts & Estates practice. Before joining the firm, he practiced in New York City, at Dewey Ballantine, LLP and Bingham McCutchen, LLC; and most recently, at Skoloff & Wolfe, P.C. in Livingston, New Jersey. Naim is a graduate of Harvard Law School and is licensed to practice in both New York and New Jersey. Naim was recently named a New Jersey SuperLawyers Rising Star in the area of Trusts & Estates. Naim lives in Short Hills, New Jersey with his wife and three children.
This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.