What you don’t know about estate planning could hurt you

While the federal estate tax may seem like it would affect only the ultra-rich, it’s just one of a few factors to consider as you make financial arrangements for your heirs.

  • By Colin Dodds,
  • From the publisher of Investopedia and The Balance
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We’re all going to leave this world, but what happens with your estate after you die can vary greatly depending on how well you plan in advance. Among the many considerations is the probate process, resolving any outstanding debts and distributing assets to your heirs — never mind the administrative fees. And perhaps one of the most important considerations in estate planning is how best to minimize tax liabilities.

“The reality of how your estate will be taxed isn’t so simple,” cautions Terence Ricaforte, an attorney with Landskind & Ricaforte Law Group in New York. “A variety of factors can complicate things for your heirs and divert more of your estate to taxes than you might have expected.”

Probate and what happens to your assets first

Before digging too deeply into the weeds, we should first point out that when someone passes away, there’s a probate process that often kicks in. Probate is the legal process whereby a person’s assets are moved into an estate and the executor of the estate can begin the steps of resolving debts and distributing assets to the heirs. It’s important to note, however, that each state has different laws and thresholds for when it’s necessary to go through the probate process.

As part of the probate process, the executor will help sort out which of your assets will be included or excluded. For example, your personal savings may become part of your estate while jointly owned assets might not. This process will have a direct bearing on your estate’s and heirs’ tax liabilities.

In most cases, federal estate tax isn’t a major concern. In 2022, it applies only to estates worth more than $12.06 million, or $24.12 million for couples. But there are still some key issues that people fail to consider.

States also tax estates and inheritances

One factor that people often overlook is that before your assets can be distributed, your state may impose estate taxes and inheritance taxes. “In fact, the threshold determining when your estate and heirs are taxed by the state is often much lower than the federal limits,” Ricaforte points out.

Sixteen states and the District of Columbia currently impose such taxes. And some states, like Oregon and Massachusetts, have much lower thresholds than the federal government, taxing estates of $1 million or more. The net result is that state taxes are imposed on more estates and heirs than the federal tax.

What’s more, the federal estate tax is due to change. Do you remember that $12.06 million threshold for federal tax exemption discussed earlier? The good news is that this limit is expected to increase annually until 2026. Still, there’s a rub — without U.S. congressional action, the threshold will automatically snap back to inflation-adjusted pre-2018 levels within the next four years or so — estimated to be around $6 million. So rather than paying federal estate taxes when the size of your estate reaches $12.06 million, federal tax liabilities will kick in a lot sooner.

There’s some hope that Congress may act to prevent the estate tax threshold from reverting to those earlier levels, though some lawmakers have also floated proposals to tax estates worth as little as $3.5 million. Suffice it to say, the landscape is uncertain. And given that the estate tax rate can be as high as 40%, the stakes are high.

Growth can sneak up on you

A changing legal landscape isn’t the only reason why people mistakenly overlook the potential impact of estate taxes. Your investments are often growing. If your holdings earn average annual returns of 6%, the value of your portfolio will double in a dozen years, assuming you’re not drawing it down. So, while your existing estate plan might have been fine back in 2009, by now your portfolio might have outgrown it.

“Another issue is that people often don’t have a clear idea of the total combined value of what they own,” Ricaforte points out. This can be the case with ownership stakes in family-held or privately held businesses, but it’s also quite often a result of rising real estate values. Many people are unaware that even though their state may not include personal real estate when calculating the size of their estate, the federal government does.

“Real estate creeps up on people and can put their estates over the edge,” warns Ricaforte. “And in the case of real estate or other illiquid assets, this could put your heirs in the position of having to sell that property or other assets to pay estate taxes.”

To stay on top of those changes in value, he recommends having any real estate or other assets professionally appraised on a regular basis.

Retirement accounts are not in your will

While you may think you have most of your estate covered by your will, it’s critical to remember that certain insurance and retirement accounts fall outside a will and are covered by separate beneficiary designations.

“Even people with well-considered estate plans may neglect to update the beneficiary forms of their IRA and 401(k) plans,” says Nick Khalifeh, an attorney with Lurie Strupinsky LLP, in Brooklyn, New York. Because these are long-term accounts, you may not revisit those designations very often. And because many diligent savers and investors have seen their IRAs and 401(k)s balloon in value, these accounts can end up being the largest portion of your estate.

For these accounts, your beneficiary designations will take precedence over anything you say in your will. All of your estate plan’s carefully thought-through percentage apportionments could be undone by IRA beneficiary choices you made 20 years ago. And if your IRA beneficiary is someone other than your spouse or a minor child, that person will have to withdraw all the money from the account — which is taxable income in the case of a traditional IRA — within 10 years (a few other exceptions apply). Note that under Federal law a 401(k) will automatically go to your spouse unless you designate another beneficiary (and your spouse signs a waiver).

It’s important to note, too, that while IRAs and 401(k)s are not apportioned by your will, they are part of your larger, taxable estate. Life insurance policies, on the other hand, are not, as a rule, taxable and fall entirely outside of your estate. In addition, some bank account and investment accounts can have beneficiaries that will supersede your will, so be sure to check on that and update as needed.

Your estate plan should be revisited — often

An estate plan can seem like it’s written in stone. After all, you’re creating it for the long term. But the fact is that your estate plan should always be evolving, as do the federal and state laws that it will be subject to. And those aren’t the only things that change.

“Your assets will change over time and so will your relationships. Make sure that your will or your trust reflects that,” suggests Khalifeh. “You should revisit your estate plan every few years, or sooner if your personal or financial circumstances change.”

Whether it’s taxes, the growth of your assets, life events (e.g., divorce), the birth of a grandchild, the death of a loved one or a change in your priorities, there’s no bad time to evaluate your estate plan and make the changes that will do the greatest good for the people and causes you care about the most.

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