Federal Estate and Gift Taxes - an Introduction

The federal estate and gift taxes--we sometimes call them "wealth transfer taxes"--are the reason for much of what I do for my higher net-worth clients.  These taxes have gotten a lot of attention and debate time among pundits and politicians recently, and we're going to be talking about them a lot on this blog.  This post is the first in a series on how these taxes work, and what you can do to minimize their impact on your family.

The stated policy purpose of the wealth transfer taxes is to prevent the creation of large concentrations of inherited private wealth.  The tax is therefore supposed to be paid only by "the wealthy."  There's a never-ending debate over whether this is a proper thing for the government to be taxing in the first place, and whether it's not so much a tax on dynastic wealth as it is a tax on upward mobility--but all I want to talk about on this blog is how the taxes work, and how good estate planning responds to them.

While the estate tax is imposed on any transfer at death, and the gift tax on any transfer during lifetime, the Internal Revenue Code gives you a "unified credit" which cancels out the tax on a certain amount of wealth being transferred. We usually talk about the "exemption equivalent" amount that is protected from the credit, rather than the amount of the credit, because it's easier for clients to understand.  However you want to think of it, if the wealth that you have to pass on to the next generation is less than the exemption equivalent, the federal wealth transfer taxes aren't an issue you need to worry about.  (The Ohio estate tax might be, but that's another topic for another time only if you die before January 1, 2013.)


Right now, the exemption equivalent is $5 million, but that could change in a very taxpayer-unfavorable way at the end of next year.  We'll go into why that is in a future installment.

There are a couple of other mechanisms that provide relief from the estate and gift taxes.  The policy of the current estate tax is to tax accumulated wealth once per generation, so transfers between spouses are accorded a "marital deduction" and are thereby not taxed.  Also, mostly for administrative convenience, you are allowed a certain amount of gifts each year, the "annual exclusion," which are not counted for tax purposes.  The annual exclusion is $13,000 per recipient per year, and that number is adjusted for inflation from time to time.

In our next installment, we'll talk about what gets included in an estate for estate tax purposes.

(Updated in response to the repeal of the Ohio estate tax effective 1/1/13.)

Retirement Assets Payable to an Estate

Qualified retirement assets, like traditional IRAs and 401(k)s and ESOPs and pension accounts, usually have a death beneficiary designated. This allows them to pass outside of probate. If the beneficiary is a surviving spouse, the spouse can "roll over" the assets into her own IRA and defer taking distributions until her "required beginning date."  Other individuals, or trusts which are designed to qualify as "designated beneficiaries," have to start taking distributions the following year, but they get to stretch the distributions out over their life expectancy.  This deferral is important because distributions out of an IRA or other retirement account are taxed as ordinary income for the year you receive them, and assets that aren't distributed yet continue to grow tax-free.

So what happens if the account owner didn't designate a death beneficiary? This happened in an estate I'm just finishing up. The decedent was a relatively young gentleman who never got around to doing any estate planning--no will, no death beneficiary designations--"no nothin'," as they sometimes say. Because there was no death beneficiary on his pension account, it became payable to his estate by default.

He had two heirs who each got a 50% share of the estate. Due to the peculiarities of how qualified plan distributions work, the pension trustee could not make distribution straight to the heirs.  The estate had to first open an IRA account. The pension plan made a "direct transfer" to the estate IRA.  The heirs each opened an individual IRA, and the estate immediately transferred the assets in equal shares to their accounts. 

Because the pension plan did not have a "designated beneficiary," the heirs are required to take distribution of the IRA within five years.  This isn't as good as taking it out over one's life expectancy, but at least they can get some deferral.

Probate and How to Avoid It

Many clients come to me wanting, among other things, to "avoid probate"--that is, to avoid having assets in their estate administered in the probate court.  There are several reasons why you might want to do this:

• Privacy is the biggest reason: anything that gets filed in probate court, including an inventory or account showing the value of assets, is part of the public record and accessible to everyone.
• In Ohio, where I practice, assets in a probate estate are subject to the claims of creditors of the deceased, while most non-probate assets are not.  This is not true in some other states.
• Probate administration is a slow-moving process, and keeping assets out of probate often permits them to be distributed faster.  This is not necessarily true in large estates, where the preparation, filing, and possible auditing of the federal estate tax return is usually the most important factor determining the speed of distribution.

So how do you tell if something is going to go through probate, or avoid probate?  If an asset is in your name individually and does not pass to someone other than your estate at death by contract or operation of law, it’s a probate asset.  If any asset you don't own directly passes to your estate at death, it’s a probate asset.  Anything else is not a probate asset.  For example:

• Things you've given away before you die are not probate assets because, well duh!, you no longer own them at death.
• Property in a revocable trust is owned by the trustee, and not by you individually.  Even if you are serving as your own trustee, you hold the trust property in a fiduciary, not individual, capacity.  So long as the trust document tells us what to do with the property when you die, the trust will not be a probate asset.
• What you have saved in a retirement plan account or IRA is technically owned by the plan trustee or IRA custodian in trust for your benefit.  Like the revocable trust corpus, it will not be a probate asset so long as you've named a beneficiary.
• If you have insurance on your life, it doesn't matter whether you own the policy or someone else does--so long as you've designated a death beneficiary, the proceeds will not go through probate.
• Real estate held in a joint & survivor or survivorship tenancy, or for which you've designated a transfer-on-death beneficiary, does not go through probate because title passes by operation of law at your death.
• Securities or bank accounts titled “joint & survivor” or which have transfer-on-death beneficiary designations, do not go through probate either, though in this instance it's because title passes by contract (the account agreement with whatever institution you're dealing with) rather than operation of law.
• Property interests which terminate at death do not become part of the probate estate because the property no longer exists.  Examples of this would be an old-style pension that pays you an annuity for life, but has no death benefit.

Intestate Succession

What happens if someone dies "intestate"--that is, without having made a will?  Who gets their property?

The answer is provided by something called the "statute of descent and distribution."  This law tells us what to do with a deceased person's property. It's the legislature's attempt to guess what the deceased would have wanted if he or she had been asked the question or had bothered to tell us, and it's not an unreasonable guess in most instances. The people who take under the statute of descent and distribution are known as "heirs at law" or, in some situations, "next of kin."

We'll take a look at how one such statute works after the jump.