Financial Professionals Guide to Estate Planning

Transcription

1 Transamerica Advanced Markets Financial Professionals Guide to Estate Planning A consolidated resource on estate planning for the financial professional Transamerica Resources, Inc. is an AEGON company and is affiliated with various companies which include, but are not limited to, insurance companies and broker-dealers. Transamerica Resources, Inc. does not offer insurance products or securities. This material is provided for informational purposes only and should not be construed as insurance, securities, ERISA, tax or investment advice. Although care has been taken in preparing this material and presenting it accurately, Transamerica Resources, Inc. disclaims any express or implied warranty as to the accuracy of any material contained herein and any liability with respect to it. You should advise your clients to consult and rely upon their own independent advisors regarding their particular situation and concepts presented here. Securities may lose value and are not insured by the FDIC or any federal government agency. They are not a deposit or guaranteed by any bank, bank affiliate or credit union. AMWPGEP0214

2 Transamerica is pleased to provide you with a consolidated reference guide on the basics of estate planning, designed to provide you with actionable concepts and strategies to implement with your clients and prospects. The Advanced Markets group is a sales-oriented business unit of Transamerica Capital, Inc. created to help you serve your clients, and build your business through advanced planning concepts and strategies. The Advanced Markets group is ready to assist you by answering your questions and providing one-on-one case consultation. Contact us through your Transamerica wholesaler. Call or visit: transamerica.com 2

3 Financial Professionals Guide to Estate Planning Table of Contents Probate and Wills 5 Probate Avoidance Strategies Beneficiary Designations 8 Beneficiary Designation Mechanics Common Beneficiary Designation Mistakes Trusts 12 Trust Mechanics Revocable and Irrevocable Trusts Taxation of Trusts Income Taxes and Estate Taxes 16 Income Tax and Estate Planning The Federal Estate Tax Estate Tax Strategies The Gift Tax 19 Gifts Gift Tax Strategies The Generation Skipping Transfer Tax Notes 23 3

4 The Importance of Estate Planning Many people view estate planning as something to be addressed later in life or only when they have accumulated substantial wealth. However, estate planning is important from the day a person buys their first home, contributes to an IRA or seeks the guidance and advice of a financial professional like you. Estate planning is an essential part of every financial plan and employing even the most basic estate planning concepts and strategies can be very beneficial. A basic understanding of estate planning can help your clients leave the legacy they desire, reduce transfer taxes, and avoid inheritance missteps. In addition, making estate planning a focus, or regular point of discussion with clients, can be instrumental in enhancing the service you provide. It can reinforce your value to existing clients, build bridges to your client s heirs, and help you build a professional network and generate referrals. We hope you find this guide to be a useful reference and a tool that you can use to build your business and enhance the financial services you currently provide. This information should not be construed as tax advice. Clients should consult a qualified tax advisor regarding annuity taxation as it applies to their specific situations. 4

5 Probate and Wills The starting point for most estate plans begins with a review of the client s will and consideration of how the probate process may impact the legacy planning intentions of the client. Most individuals understand that a will is drafted to direct how their assets will be distributed upon death, but many people are not familiar with the process of how their assets are actually distributed the probate process. By discussing probate and wills with your clients, you can uncover the basic estate planning intentions of your client and build a foundation for the estate planning objectives to address. Probate The legal process of distributing and settling an estate in accordance with state law is called the probate process. The probate process includes proving the validity of the will, paying all taxes and debts of the estate and executing the provisions of the will. During the probate process the will is used as the primary document to establish the proper beneficiaries of the estate. Also, the probate process allows creditors the ability to step forward and make claims against the estate. After debts are settled, the estate will pay state and/or federal estate taxes, inheritance taxes and may need to pay income taxes before assets are legally transferred to individual beneficiaries. Please note that income taxes are typically the responsibility of the beneficiary when assets are withdrawn. They do not need to be incurred by the estate unless the estate elects a withdrawal. One common aim of estate planning is reducing or eliminating the amount of assets that pass through probate. Probate is generally avoided due to several disadvantages, including: Delays: The probate process does not occur instantaneously and there may be a delay before beneficiaries receive or have access to assets. Expense: Some states assess a probate fee and an attorney may be required to ensure proper disposition of assets from the estate. Lack of Privacy: During the probate process anyone has the opportunity to make a claim against the estate, valid or not. This opportunity to make a claim may be viewed by many as a loss of privacy. Creditors may make claims and receive assets instead of loved ones. More often than not, the proper beneficiaries receive assets through probate, but there is always an element of uncertainty in the process. Disinheritance: Anytime assets go through probate there is the potential that heirs can be disinherited. Directives in the will can be ignored if the will is improperly constructed. Likewise, conflicting wills can arise and the actual intent of the deceased can be superseded. Wills A will is a legal instrument directing disposition of assets after death. The will is the most basic of all estate planning documents and is a primary document to determine who receives assets after death. The will generally applies only to probated assets and is not taken into consideration with regard to certain jointly held assets, accounts with beneficiary designations, and trusts. If someone dies without a valid will, the individual s assets will be distributed via the applicable state s law of intestate succession. These laws follow a prescribed order and priority of who will receive assets from the estate. Wills Three Action Steps Step One: Ensure the client has a will Is it up to date? Request a copy Ensure the executor has a copy Step Two: Review the will Ensure it fits with the financial plan and client intentions Step Three: Identify property that does not pass by will The will may be superseded by the way assets are owned or through beneficiary designations Wills Probate and and Probate Wills The will does not control accounts with beneficiary designations. If there is a conflict between a beneficiary designation and a will, the beneficiary designation will override the directives of the will. The will should be kept up to date with any life changes, such as a divorce, a death in the family, a birth, or a disability in the family. Any significant life changes should trigger a review and update of the will. 5

6 Probate Avoidance Strategies There are arrangements that pass property by operation of law or by contract bypassing the probate process. These arrangements provide specific rights to people to receive the property directly without the necessity of going through the probate process. Ownership Property that is owned jointly with rights of survivorship passes automatically to the surviving joint owner at the death of either owner. Property that is owned through tenancy in common does pass through probate as each owner has a distinct undividable share that can be disposed of as they desire or at their discretion. Types of Ownership Trusts A person may establish a trust for the sole purpose of avoiding probate. Generally these trusts are revocable, but they may also be irrevocable during the life of the grantor. The trust document specifically lists who receives assets and the trustee who is responsible for transferring assets from the trust directly to the trust beneficiary(ies). Joint Tenants with Right of Survivorship Joint ownership structure where each owner s share passes directly to the surviving joint owner at death. This structure provides the convenience of avoiding probate with the property ownership passing automatically to the surviving joint owner. Tenants in Common Joint ownership of property where each owner holds a distinct undividable share. Each owner can sell, exchange, gift or leave their share to anyone they wish without consent from the other owners. At death, the share of the deceased owner does not pass to the other owners, but rather it is passed through probate and transferred to the deceased owner s appropriate heirs. Community Property Under community property rules, property interests acquired during marriage are generally considered to be owned equally by each spouse even if owned individually in title. There are ten states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin, Alaska* that operate under a community property system. The community property laws for each state can vary significantly. *Allows couples to opt into community property. Joint Tenants with Rights of Survivorship (JTWROS) Financial Account Owner: Jack Smith and Jill Smith (JTWROS) Tenants in Common Financial Account Owner: Jack Smith and Jill Smith (Tenants in Common) Jack Dies Account passes directly to Jill without probate Jack Dies Jill assumes her portion of the account; Jack s portion passes to his estate and is probated Jill Smith becomes the sole owner of the financial account Jill retains her interest in the financial account Jack s share of the account passes through probate 6

7 Beneficiary Designations Accounts such as annuities, IRAs, qualified plans, and life insurance pass directly to the beneficiaries listed on the account at death through a beneficiary designation. The asset does not have to pass through probate provided that the owner s estate is not deemed the beneficiary of the asset. A properly crafted beneficiary designation can ensure a timely and smooth transfer of assets to the intended beneficiaries. On the other hand, a neglected or improper beneficiary designation could result in unintended consequences. For this reason, beneficiary designations are a critical part of the estate planning process. Types of Beneficiaries Probate and Wills Spouse For annuities, qualified plans, Traditional IRAs and Roth IRAs, the spouse is the only type of beneficiary that can assume ownership of or transfer the assets in the account while continuing the accounts tax favored status as an owner. Non-Spouse Non-spouse beneficiaries of annuities, qualified plans, Traditional IRAs and Roth IRAs cannot assume an inherited account with full rights of ownership. For these types of accounts, a non-spouse beneficiary must begin liquidating the proceeds of the account in compliance with federal income tax laws and recognize any taxable distributions as income. The manner in which the beneficiary elects to distribute the account post death will dictate the period in which they recognize the income for tax purposes. Estate Trust, or Entity A beneficiary does not have to be a living person. An entity may be listed as the beneficiary of the account. However, an entity may not have the same death benefit distribution options as an individual designated as beneficiary. Estate listed as the beneficiary: Assets pass to the estate and the ultimate recipients of the assets are determined through the probate process. Trust listed as the beneficiary: Assets pass to the trust and avoid probate. Because the death benefit distribution options that are afforded to entities differ from those afforded to individuals, a careful review of the death benefit distribution options available should be carefully reviewed. In some instances, a properly worded beneficiary designation that names individuals as beneficiaries can accomplish the intentions of a trust while offering greater flexibility to the ultimate recipients of the proceeds. Beneficiary designations override directives by will and avoid probate as long as a beneficiary other than the owner or the owner s estate is designated. You may also wish to avoid leaving the beneficiary designation blank as the assets will generally be payable to the owner s estate subjecting the asset to probate. Revocable living trusts are often established for the purpose of avoiding probate. An easy way to identify a revocable trust is that it will often use the social security number of the grantor of the trust. Annuities and qualified plans may restrict the death benefit distribution options that are available to beneficiaries. You should consult the annuity contract or the qualified plan s Summary Plan Description (SPD) document for additional information regarding options available to beneficiaries. 7

8 Beneficiary Designations The way a beneficiary designation is filled out has an impact on who gets the designated assets and in what order. The mechanics of the beneficiary designation can also provide for unexpected contingencies, such as who gets the assets if the owner outlives the primary beneficiary or if one of the beneficiaries is deceased. The following provides an overview of some of the terms and considerations for constructing a proper beneficiary designation. Beneficiary Designation Mechanics Primary Beneficiary The primary beneficiary is the primary recipient of the proceeds at the owner s death. There can be more than one primary beneficiary and there are theoretically no limits on the number of primary beneficiaries that can be listed. Contingent Beneficiary The contingent beneficiary is the party that receives the proceeds at the owner s death if the primary beneficiary(ies) passed away before the owner. Per Capita If there is more than one primary beneficiary listed and one of them predeceases the owner, under a per capita beneficiary designation the proceeds will be split evenly between the remaining primary beneficiaries. Client For example, if a client owns an IRA and designates Andy, Beth, and Chris as beneficiaries and Andy passes away before the client, then when the client passes away the inheritance is split per capita 50% to Beth and 50% to Chris. Andy Deceased Beth 1/2 of Death Benefit Chris 1/2 of Death Benefit Per Stirpes If there is more than one primary beneficiary and one of them predeceases the owner, under a per stirpes beneficiary designation the proceeds that would have been passed to the deceased beneficiary would pass to the offspring of the deceased beneficiary. For example, if the client owns a deferred annuity and designates Andy, Beth, and Chris as beneficiaries and Andy passes away before the client, the proceeds that would have passed to Andy would go to Andy s children instead of Beth and Chris. In this situation, Beth and Chris would receive one-third of the account and the remaining third would pass to Andy s children. Debbie Andy Deceased Client Evan Beth 1/3 of Death Benefit Chris 1/3 of Death Benefit 1/6 of Death Benefit 1/6 of Death Benefit Annuity contracts can be owner driven or annuitant driven depending upon the terms of the annuity contract. On owner driven contracts, the death benefit is payable upon the death of the owner. On annuitant driven contracts the death benefit is payable upon the death of the annuitant. It s worth noting that the death of the owner on an annuitant driven contract may result in the distribution of the cash value of the policy when the owner and annuitant are different. Companies may vary between per capita and per stirpes as their default distribution option in the case of a beneficiary predeceasing the owner. There is a tendency to default to per capita, but it is advisable to verify with the carrier their default option. If one is preferred over the other, it is advisable to designate per capita or per stirpes on the beneficiary designation itself. 8

9 Disclaiming If a designated beneficiary does not wish to claim the asset, they can refuse their interest through a disclaimer. As long as the disclaimer is made as a qualified disclaimer it is treated as if the asset was never inherited by the person disclaiming the asset and there is no federal estate, gift or generation skipping transfer tax ramifications for that person. Qualified Disclaimer Only qualified disclaimers pass free of federal estate, gift or generation skipping transfer taxes from the disclaiment. To be a qualified disclaimer several criteria must be met: The disclaimer must be irrevocable and complete. Disclaiming a portion of an asset will generally not be considered a qualified disclaimer. The disclaimer must be in writing. The written refusal is received within 9 months after death. The disclaimant cannot receive an interest or benefit from the disclaimed asset. The disclaimant cannot direct who receives the disclaimed asset. Must pass to a person other than the person making the disclaimer (exception for spouse of decedent). It may seem counterintuitive to disclaim what many would consider a windfall. However, there are several valid reasons to disclaim an inheritance: 1. Correcting a Beneficiary Designation Mistake: Disclaiming may be a useful tool to correct mistakes in a beneficiary designation. A common example is if someone other than the surviving spouse is listed as the primary beneficiary. 2. Estate Tax Considerations: Keeping an asset out of an estate may reduce future estate taxes for the individual disclaiming the asset. 3. Income Tax Considerations: For Income in Respect of Decedent (IRD) assets (such as IRAs and deferred annuities), it may be useful to disclaim assets for income tax reasons. The original recipient may be in a high income tax bracket or wish to keep their income low to preserve certain tax deductions or eligibility for benefits that are based on income. Also, an older beneficiary may wish to disclaim if the contingent beneficiary is younger, which would provide a longer stretch distribution period for IRAs, Roth IRAs and deferred annuities. Restricted Beneficiary Designations A spendthrift beneficiary can undermine an estate plan if left unchecked. For accounts with beneficiary designations, a restricted beneficiary option may be a way to control a spendthrift beneficiary. Restricted beneficiary designations typically allow the account owner to limit or restrict the beneficiary s access to the assets they inherit. For example, a restricted beneficiary designation could prohibit the beneficiary from accessing the inherited assets in a lump sum. If you have clients who are concerned about a spendthrift beneficiary or would like to maintain some degree of control over the assets they designate for their beneficiaries, you may want to check with their custodian, plan sponsor, or insurance company to see if a restricted beneficiary designation is available. Beneficiary Designations The use of a restricted beneficiary designation can be very advantageous for tax deferred accounts. Even though an IRA can be stretched through a trust, the process can be cumbersome. There are several disadvantages to stretching through a trust, such as the possibility of the distributions being taxed at the more compressed trust tax rates, stretching over the eldest trust beneficiary s life expectancy, and having to rely on the trustee for proper administration of the payments. It is also noteworthy to consider that nonqualified deferred annuities cannot be stretched through a trust. There are circumstances when the use of a trust may be necessary, but it is recommended to ascertain the purpose of the trust and determine if it is possible to achieve the same results through a restricted beneficiary designation. 9

10 Common Beneficiary Designation Mistakes Beneficiary designations don t always get the attention they deserve. Mistakes can undermine the best of intentions. The following are some of the most common beneficiary designation mistakes. 1. Not Naming a Beneficiary: One of the advantages of having a beneficiary designation is the account passes to the listed beneficiary directly instead of going through probate. If a beneficiary designation is left blank, at death the account passes to the owner s estate subjecting the asset to probate. 2. Naming an Estate as the Beneficiary: By naming an estate as the beneficiary the account pays to the owner s estate and is subject to probate. 3. Not Naming Contingent Beneficiaries: If the primary beneficiary predeceases the owner of the account and no contingent beneficiary is listed, the account pays out to the estate and ends up in probate. 4. Not Updating Beneficiaries: Failure to keep a beneficiary designation up to date can result in disinheritance. Beneficiary designations should be reviewed anytime a client experiences a life changing event, such as divorce, marriage, disability, birth of a child, a death in the family, or a career change. 5. Overlooking Per Capita or Per Stirpes Distribution: If beneficiary designations are not kept up to date and a beneficiary predeceases the account owner, an understanding of how the account will flow to the remaining beneficiaries can help avoid disinheritance. 6. Not Understanding Disclaiming: Disclaiming can be very useful in repairing beneficiary designation mistakes, maximizing estate tax exclusions and income tax planning. 7. Spendthrift Beneficiaries: Leaving a large inheritance to beneficiaries who cannot handle it can cause irreparable damage to a legacy and potentially to the beneficiaries themselves. Understanding the use of trusts or restricted beneficiary designations can help protect beneficiaries from themselves. Questions to Ask Clients and Prospects Do you know the difference between per capita and per stirpes? Are any of your accounts with beneficiary designations listed as per stirpes? Who are your contingent beneficiaries? How do you want the account to pass if your primary beneficiary predeceases you? Are you concerned that one or more of your beneficiaries may not handle money responsibly? Have you established any restrictions on any of your accounts for your beneficiaries? A beneficiary designation review can be a very useful business building tool. It provides an opportunity to add value, and it can be instrumental in the fact finding process. Asking clients to bring in their accounts with beneficiary designations gives you a better understanding of your client s overall financial plan and perhaps information on accounts that are not currently under your management. 10

11 Beneficiary Designation Action Steps: Beneficiary Designation Review Gather client statements, wills and estate planning documents Diagram the beneficiary designation Take into consideration the impact of trusts and spendthrift beneficiaries Provide the client with an organization tool for them to keep their important financial and estate planning documents in a consolidated place. This step also allows you an opportunity to understand how they wish their estate plan to be arranged so you can properly advise them on their beneficiary designations. By diagramming the beneficiary designation you can identify if the account needs to be listed as per stirpes or per capita, or if other special arrangements need to be made with custodians. Discuss with the client the impact of trusts and the purpose behind having the trust. Ask about the capacity of their beneficiaries to responsibly handle an inheritance. Consider restricted beneficiary designation programs if the client has spendthrift beneficiaries. Beneficiary Designations Identify designations subject to probate Keep an eye out for designations that result in assets passing through probate, such as blank beneficiary designations, the estate listed as the beneficiary, or outdated beneficiary designations where the beneficiary is deceased. Review IRA, Roth IRA, qualified plan and deferred annuity beneficiary designations These accounts have different post death distribution options than other accounts. To ensure stretch options are preserved, beneficiary designations that list entities or trusts should be reviewed. 11

12 Trusts There are a variety of different types of trusts, each designed to accomplish different estate planning objectives. The following section will address the fundamental components of trusts, different types of trusts, and some of the most common trusts used in the estate planning process. Trust Mechanics Trust Planning One of the most frequently employed strategies in estate planning is the use of trusts. Generally speaking, trusts are established for one or more of the following reasons: 1. Probate avoidance 2. Control the distribution of assets 3. Reduce income and transfer taxes 4. Benefit heirs or fulfill a charitable intent 5. Protect assets What is a Trust? A trust is a legal agreement where property is managed by a trustee for the benefit of trust beneficiaries. Under this type of legal arrangement, the grantor transfers ownership of certain assets to the trustee who manages the assets for the benefit of the trust beneficiary(ies). Grantor (creates trust) Transfers Assets Trust (separate entity nominal owner of assets) Trustee (administers trust) Income Beneficiary (receives income for trust term) Beneficial Owners (entitled to trust assets) Remainder Beneficiaries (receives remainder of trust assets upon the occurrence of a specified event) Responsibilities of the Parties to a Trust Grantor (trustor) Trustee Beneficial Owner(s) (beneficiary(ies) The grantor of the trust is the person who creates the trust and establishes the terms of the trust. If the grantor retains an interest, partial interest, or an incident of ownership in assets that are transferred to the trust, the trust is called a grantor trust. In some cases, the intent of the grantor is to cede all interest and ownership of transferred assets to the trust to prevent the trust from being a grantor trust. The trustee is the fiduciary responsible for executing the directives of the trust and managing trust assets. Managing a trust is a significant responsibility as the trustee is responsible for filing trust tax returns, ensuring compliance with the terms of the trust, responding to requests from trust beneficiaries, ensuring the trust conforms to applicable laws, and ensuring that trust assets are invested in a prudent manner consistent with the trust s objectives. Every trust should also have a successor trustee named. The successor trustee is the individual(s) or entity who assumes the trustee duties if the trustee is unable or unwilling to perform as trustee. Party(ies) entitled to trust assets, whether in the form of income or remainder assets. Trusts generally have an income and remainder beneficiary(ies). The income and remainder beneficiary(ies) can be the same person, but likely will be two separate individuals or parties. Other than receiving distributions from the trust as specified in the trust document, the beneficial owners generally have no administrative powers over trust assets. The beneficial owners may be able to persuade the trustee to invest or distribute assets according to their wishes, but the trustee is under no obligation to acquiesce to their demands if they conflict with the directives of the trust. 12

13 Revocable and Irrevocable Trusts Trusts fall into two broad categories, revocable and irrevocable. If the trust is set up primarily for probate avoidance, with the grantor retaining full interest or ownership in trust assets, the trust is likely revocable. Conversely, if the trust is created to distance the grantor of the trust from the trust assets with respect to their interest and ownership, the trust is likely an irrevocable trust. Trusts Revocable Trust A revocable trust may also be called an inter vivos trust or living trust. The trust is disregarded for the purposes of taxation during the grantor s lifetime, so that the grantor is treated as the taxable owner of the trust property. There is no separation of trust assets from the grantor since the trust can be revoked or altered at any time by the grantor. Even though the trustee may be a different person than the grantor, the grantor retains all powers under the trust and enjoyment of trust assets. Since the grantor is treated as the taxable owner of the trust assets, the trust is generally established for reasons not connected with taxation such as: 1. Probate avoidance: Revocable trusts may be established solely for avoidance of probate. Assets owned by a revocable trust avoid probate as the trust document itself directs disposition of assets after death. 2. Estate planning: At the death of the trust grantor, every revocable trust becomes irrevocable. Revocable trusts may be established to segment the grantor s assets and pre-fund trusts that become effective after death. 3. Disability: Handling finances in the face of incapacity can be a challenge. Assets may be held in a revocable trust to provide trustee control over these assets if the grantor becomes unable to handle the grantor s affairs. Irrevocable Trust In estate planning, separating the grantor from property can serve many objectives, such as shifting the property out of the grantor s estate, shifting the future income tax liability associated with the property away from the grantor, and removing the future appreciation out of the grantor s estate. Gifting is one way a person can transfer property. However, it may not be feasible or reasonable for the grantor to completely relinquish unfettered control of the property for a number of reasons. An irrevocable trust is a way for an individual to transfer their interest in property and still maintain some degree of control of the asset through the directives of the trust document. Property transferred to an irrevocable trust is completely separated from the grantor and may be subject to a transfer tax upon transfer to the trust gift tax during life, estate tax after death, or Generation Skipping Transfer Tax (GSTT) if the transfer to the trust benefits a skip generation (no transfer tax may be due if the transfer amount is under the applicable exclusion amount). After the transfer is completed, the trust property is typically removed entirely for income tax, estate tax, gift tax, and GSTT purposes from the grantor. Examples of Irrevocable Trusts Credit Shelter Trust (Bypass Trust, B-Trust, CST) Special Needs Trust (SNT) Irrevocable Family Trust Generation Skipping Trust (GST) Charitable Remainder Trust (CRT) Charitable Lead Trust (CLT) Qualified Terminable Interest Property Trust (QTIP) Intentionally Defective Grantor Trust (IDGT) Spousal Lifetime Access Trusts (SLAT) Grantor Retained Annuity Trusts (GRAT) Irrevocable Life Insurance Trust (ILIT) Spendthrift Trust An irrevocable trust is a separate taxpaying entity and operates under a different set of income tax rules. To dissuade the use of irrevocable trusts as tax shelters there is a separate, more compressed, income tax rate schedule for irrevocable trusts. The compressed tax rates serve to increase the amount of income tax paid on income retained in the trust. Many Credit Shelter Trusts, Spendthrift Trusts, or Special Needs Trusts are first established as revocable trusts. During the life of the grantor, the trust is revocable. At the death of the grantor the trust becomes irrevocable and the provisions regarding the distribution of assets post death become effective. 13

14 Taxation of Trusts It should be noted that this section is intended as a general overview of trust taxation. You should consult a knowledgeable tax advisor for specific guidance. Trust Income Defined The legal definition of what constitutes trust income is governed by state law and the definition of income found in the trust document. Many states have adopted the Uniform Principal and Income Act which is a model act that provides definitions of what constitutes trust income and principal. To understand how trusts distribute income, it is necessary to establish how trusts define income. For tax purposes, income is not necessarily the amount of money that is paid out to trust beneficiaries, but rather Distributable Net Income (DNI). Distributable Net Income is the taxable income earned by a trust that is eligible for distribution to an income beneficiary. DNI takes on the income tax characteristics of the asset which generated the income. If the income is a capital gains asset it will be taxable at capital gains rates, if it is ordinary income it will be taxed at ordinary income tax rates. Any amounts distributed over DNI are a return of trust corpus and not taxable. DNI is always distributed before corpus; subsequently the trustee does not have the discretion to report payments of trust corpus before DNI. Even though income may be earned by the trust it may not be taxable to the trust if it is paid out to an income beneficiary in the year it is received by the trust. To avoid trust tax rates, a trustee may pay out all DNI earned by the trust in any given year. Some trusts (sometimes referred to as simple trusts) require all DNI to be paid out to trust income beneficiaries in the year it is earned. Other trusts (sometimes called complex trusts) are able to retain income. By paying the income out of the trust in the year it is recognized to the trust, the income recipient becomes responsible for the income tax at their individual tax rate. The trustee will report income distributed to the income recipient on an IRS Form K-1. For tax purposes, when assets pass out of an irrevocable trust, they pass in kind. It is significant to note that capital gains assets that pass out of an irrevocable trust generally do not receive a step-up in cost basis when distributed from the trust. In order to receive a step-up in cost basis, the capital gains asset must pass through an estate or the trustee must elect to recognize a capital gain on the distribution. The Net Investment Income Tax and Trusts The Net Investment Income Tax (NIIT), also known as the Unearned Income Medicare Contribution Tax, assess an additional 3.8% tax on the lesser of net investment income or excess Modified Adjusted Gross Income (MAGI) above certain thresholds for high income individuals. Trusts and estates are assessed the tax on the lesser of undistributed net investment income or excess Adjusted Gross Income (AGI) over the applicable threshold. Threshold Amounts by Filing Status NIIT Married Filing Jointly $250,000 Single $200,000 Trusts and Estates $12,150 Tax on Long-Term Capital Gain and Qualified Dividends Rate of 20% for: Joint filers with income over $457,600 Single filers with income over $406,750 Trusts with income over $12,150 Be aware that Section 663(b) of the Internal Revenue Code allows a 65 day grace period for paying income out of certain complex trusts. This means that income paid throughout the grace period may be reported as prior tax year income. Be sure to consult with the trust s tax professional before making any distributions. Some irrevocable trusts are drafted to purposely be attributed to the grantor for income tax purposes yet still be separate for transfer tax purposes. These trusts are referred to as Intentionally Defective Grantor Trusts. Some transfers to an irrevocable trust may be subject to a look back period. Look back periods exist to discourage last minute transfers that are intended to reduce assets held by the grantor. Even though the asset has physically transferred to the trust, during the look back period the transfer is considered incomplete and the asset is still attributed to the grantor. Understanding the look back period applicable to a specific transfer is important when developing certain planning strategies. 14

15 2014 Income Tax Rate Schedules Trusts Married Filing Jointly Single Earned Income Bracket Earned Income Bracket $0-$18,150 10% $18,150 - $73,800 15% $73,800 - $148,850 25% $148,850 - $226,850 28% $226,850 - $405,100 33% $405,100 - $457,600 35% $457, % $0-$9,075 10% $9,075 - $36,900 15% $36,900 - $89,350 25% $89,350 - $186,350 28% $186,350 - $405,100 33% $405,100 - $406,750 35% $406, % Estates & Trusts Earned Income Bracket $0-$2,500 15% $2,500 - $5,800 25% $5,800 - $8,900 28% $8,900 - $12,150 33% $12, % The trust income tax rates are set up to dissuade accumulation of trust assets. Trust beneficiaries may not desire income and instead wish to accumulate assets in the trust. To reduce income tax paid at the trust income tax rate and mitigate ongoing distributions of trust income to income beneficiaries that do not want income, the trustee may place trust assets into investments that: Produce little or no current income: Capital gains assets that do not generate dividends or short-term capital gains enable the trustee the ability to choose when to recognize taxation by selling the asset as a long-term capital gain. Mutual funds, ETFs (Exchange Traded Funds), SMAs (Separately Managed Accounts), and stocks are all investments that may provide the opportunity for long-term capital gains. Are tax deferred: Tax-deferred assets provide the trustee with the maximum amount of tax control because the trustee selects when to recognize taxation through a withdrawal. Tax-deferred assets include life insurance cash values and deferred annuities. Additionally, assets that are tax deferred do not run the risk of inadvertently generating a dividend or a short term capital gain. Are tax free: By investing in assets that produce tax-free income, the trustee can eliminate the issue of trust taxation altogether. Municipal bond income and life insurance death benefits may provide tax-free income. Before purchasing life insurance, it is necessary to determine if the trust document allows for the purchase of life insurance. The trust may also need to have an insurable interest in the insured. 15

16 Income Taxes and Estate Taxes In this section we ll review the two primary areas of taxation that impact the estate planning process, income taxes and estate taxes. Income Tax and Estate Planning Income Tax When assets pass from one individual to another, either by death or by gift, the individual receiving the asset receives not only the assets but also the potential tax liability associated with that asset. For that reason, a careful review of the income tax implications of transferring assets is an important part of the estate planning process. Cost Basis Cost basis is the starting point for calculating gain or loss realized on the sale of an asset. A simple formula for calculating gain or loss can be expressed as follows: Amount realized on the sale of an asset Cost basis = Realized gain or loss Assets owned by a decedent receive a new federal income tax cost basis or adjusted cost basis upon death which is typically equal to the current fair market value of the assets. When the fair market value of the asset is higher than the original cost basis of the asset, the cost basis is adjusted or stepped up to the current fair market value. Likewise, if the current fair market value of an asset is less than the original cost basis, the new cost basis is adjusted down to the current fair market value. The step up or step down of cost basis is an important tax planning consideration that relates to the sale of assets after death as well as assets that may be held until death. When considering assets that will pass to beneficiaries, the step up in cost basis is frequently stated as a tax advantage, which it may be if the assets appreciate in value. However, the potential for a step down in basis should not be overlooked. A careful analysis of passing assets at death versus gifting assets during life can reveal some important tax planning considerations. Income in Respect of a Decedent One exception to the adjustment of cost basis upon death applies to assets that are considered Income in Respect of a Decedent (IRD). IRD is essentially defined as income that the decedent would have included in gross income if they had lived. IRD includes tax deferred gain in an annuity contract, pre-tax contributions and earnings in IRAs and other qualified retirement plans, income owed to the decedent or installment payments received after the owner s death. IRD assets do not escape taxation; rather the estate or beneficiary who receives the IRD will be taxed in the same manner that it would have been taxed to the decedent. IRD assets do not receive a step up or step down in basis upon the death of the decedent. The IRD Deduction When reviewing the tax implications of inherited assets with your client it is important to understand both the tax treatment of IRD assets as well as the income tax deduction that the client may be able to claim to offset any income tax liability they incur upon receipt of the asset. The estate or beneficiary that includes an item of IRD on their income tax return is entitled to an income tax deduction on the same return for the amount of additional federal estate tax that is attributable to the inclusion of that item in the decedent s federal estate tax return. For example, assume that your client inherited an IRA worth $100,000 that consisted entirely of pre-tax contributions and earnings. If they liquidated the IRA and received the proceeds in cash, the $100,000 would be considered ordinary income in the year received, subject to ordinary income tax. If we further assume that the decedent s estate exceeded the applicable estate tax exclusion amount resulting in estate taxes being paid and $40,000 in estate taxes attributable to the $100,000 IRA, the client would be able to claim an income tax deduction (the IRD deduction) of $40,000 as an offset to the $100,000 of ordinary income. When a substantial portion of a client s assets are held in retirement plans and IRAs, income tax planning for the estate and beneficiaries is critically important. Make sure beneficiaries and trustees understand the taxation of IRD assets and do not overlook the IRD deduction when applicable. 16

17 The Federal Estate Tax Transfers of property after death are subject to an estate tax. The estate tax is paid by the estate of the deceased and is assessed against all property interests, tangible and intangible, owned by the deceased at the time of their death. A distinction must be made between the estate tax and inheritance taxes. An inheritance tax is assessed against the beneficiary s right to receive property, whereas an estate tax is imposed on the transferor s estate for the privilege to transfer property. Individual states may have an inheritance tax or an estate tax on top of the federal estate tax. This section will focus only on the federal estate tax. Estate Tax Exclusion Amount that an individual can pass to a non-spouse beneficiary at death free of estate tax. Terminology Note The term estate tax exclusion and estate tax credit are used interchangeably in estate planning. The difference between the two is that the estate tax credit offsets the estate tax due dollar for dollar, whereas the exclusion amount represents the amount of property the credit shelters from the estate tax. The estate and gift tax (discussed later) credit combined is referred to as the unified credit. An individual also has a generation skipping transfer tax exemption amount which is currently equal to the estate and gift tax exclusion amount. Exclusion Portability Amounts added to a surviving spouse s estate tax exclusion amount for the unused portion of their deceased spouse s exclusion amount. The portability of the unused estate tax exclusion to the surviving spouse was not available for deaths occurring prior to January 1, Unlimited Marital Deduction U.S. citizen spouses can transfer an unlimited amount of assets to each other free of estate or gift tax. Charitable Estate Tax Deduction Unlimited deduction for amounts passed to charities at death. Form 706 The estate and generation skipping transfer tax return. Form 709 The gift tax return. Income in Respect of a Decedent (IRD) Income owed to the deceased at the time of death yet taxable to the beneficiary. Distributions from IRAs and deferred annuity contracts to a non-spouse beneficiary are IRD assets. Income Taxes and Estate Taxes A thorough estate plan must take into consideration the impact of state inheritance tax and state estate tax. The rules for these state taxes may vary drastically from the federal transfer tax regime. Many states choose to mirror the rules for the federal transfer tax system for simplicity. However, since the passage of EGTRRA (Economic Growth and Tax Relief Reconciliation Act of 2001) and a progressive increasing of the federal exclusion amount, many states have decoupled from the federal rules. The uncertainty in the transfer tax system presents an opportunity to meet with existing clients to keep their estate plan up to date and possibly bring additional assets under management. With the changes to the transfer tax system many individuals need to revisit their existing plans to ensure they fit with ongoing legislative changes. The changes in estate planning laws also present an opportunity to prospect for new clients and gain professional referrals. Prior to portability of the estate tax exclusion, many estate planning attorneys would avoid joint ownership and split property between spouses to maximize the use of each spouse s estate tax exclusion amount. With the introduction of exclusion portability, it may be advisable to reevaluate account ownership structures to see if the clients could benefit from a jointly owned account. 17

18 Estate Tax Strategies According to the IRS, the laws surrounding estate and gift tax are some of the most complex found in the Internal Revenue Code. It is essential that the execution of an estate, gift, or generation skipping transfer tax strategy be accompanied by consultation with an attorney or certified public accountant (CPA) well versed in the subject. The advent of recent estate tax law changes, including the portability of exclusion amounts between spouses, has reduce the need for estate tax planning strategies for some individuals. Once a couple, or individual, has more assets than their estate tax exclusion will cover, other strategies can be employed to mitigate the impact of the estate tax. The main objectives of planning for the estate tax is to: 1) Provide liquidity to cover the estate tax liability, and 2) Reduce the size of the taxable estate to reduce the estate tax owed. Life Insurance Life insurance is fundamental in generating the necessary liquidity to pay any estate tax due. Fund an Irrevocable Life Insurance Trust (ILIT) If life insurance is owned by the deceased, it is an asset included in their estate for estate tax purposes. The inclusion of the life insurance policy has the effect of increasing the value of the estate, which results in more estate tax due. To avoid inclusion of the life insurance policy in their estate, the owner may wish to hold the life insurance policy in an ILIT. Policies owned in an ILIT are not part of the estate and do not increase the value of the estate for estate tax purposes. ILITs are discussed in greater detail in the Gift Tax Strategies section. Trust Planning Some family situations may be complex and require the use of a trust to ensure multiple interests, sometimes conflicting, are satisfied while maximizing estate tax exclusions and separation of the grantor from trust assets. The Credit Shelter Trust (CST) has traditionally been the standard trust used to maximize the estate tax exclusion for spouses without disinheriting a spouse from enjoyment of income from the trust and in some circumstances principal from the trust. Trusts can also be used to freeze growth out of an estate through gifts during life. Charitable Planning Charitable gifting can be a dynamic planning tool if used properly in an estate plan. Any gifts made to charity at death are deducted from the gross estate. Likewise, any charitable gifts made during life are excluded from the estate and are free of gift tax. Gifting Gifts made during life can reduce the size of an estate. One major benefit of gifting is the exclusion of future growth generated by the gifted asset from the estate. One major problem for estates that owe estate tax is generating enough cash to pay the estate tax. Clients that have illiquid assets in their estates (such as farms, businesses, and real estate) may be asset wealthy, but cash poor. During life, it may be advisable for these clients to purchase life insurance to cover future estate settlement costs. The proceeds from the life insurance may save the heirs from being forced to sell assets, which often occurs at a discount due to the hurried nature of the sale. Please note that the life insurance proceeds could be included in the estate of the insured if the ownership of the policy is not structured correctly. Premium payments made to an ILIT are considered a gift (gifts are discussed in detail later). For annual gift maximization purposes, the more beneficiaries that are included in the ILIT the more premium can be gifted, which in turn increases the amount of life insurance coverage. Even though an ILIT s main purposes is to provide liquidity to an estate to pay any estate taxes owed, it can also be useful in covering miscellaneous estate settlement costs, replacement of gifted assets (in this context the ILIT is called a wealth replacement trust), or increasing the size of the overall inheritance. There are additional benefits to charitable planning beyond reducing the estate tax, such as an income tax deduction, avoidance of capital gains tax for appreciated capital gains assets, an income stream (under some charitable planning strategies), and fulfillment of philanthropic desires. Charitable bequests at death of IRD assets (IRAs, Qualified Plans, and Deferred Annuities) can also be a useful way to escape the income tax burden for these assets. 18