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Being And Staying Financially Smart With Your Estate Plan

Being and Staying Financially Smart With Your Estate Plan by Morningstar Investment Research

Estate-planning expert Deborah Jacobs outlines how to approach the estate tax exemption and gift tax rules, addresses a popular misconception about estates, and offers key documents that all individuals should have in place.

Christine Benz: Hi. I am Christine Benz for The recently enacted tax package included some provisions affecting the estate tax. Joining me to discuss these provisions is Deborah Jacobs. She is an estate-planning expert. Deborah, thank you so much for being here.

Deborah Jacobs: Thank you for having me.

Benz: We were set to see some really substantive changes in the estate tax laws, but the new tax package really didn't change a lot. Let's talk about what's changing and importantly, what is staying the same in the realm of estate taxes?

Jacobs: Well, I think the headline is almost nothing changes for you. The only thing that really is different from the system that we've had in place for the last two years is that the tax rate for people who are subject to tax has gone up from 35% to 40%, but in point of fact, very few people have to worry about taxes anymore. So, that's a huge relief. The threat was that more people were going to be subject to tax because when the Bush-era tax cuts expired, it meant that we were going to have an automatic tax hike. But in point of fact, the amounts that are tax-free are the same as they have been for the last two years.

Benz: So it was poised to go to $1 million exclusion amount, which would obviously begin to affect a lot more people. Now that exclusion amount will rise to $5 million-plus. Let's discuss, Deborah, what that exclusion amount is specifically, and also how does that relate to lifetime gifts that someone might make? How do those two limits work together?

Jacobs: Well, I think this is the area in which there is the greatest confusion out there and part of it is terminology. When we say the exclusion from estate tax, there are a few different terms that are kicking around. Some people call it the basic exclusion, some people call it the unified credit, some people call it the exemption, which is a more familiar term. It's the tax-free amount. It's the amount that you can pass either during life or when you die without there being any tax to pay.

If you go over that amount during your life, it's called gift tax, and you must pay it. A common source of confusion is the person making the gift pays the tax, not the gift recipient. On the other hand, if you pass it through your estate, your heirs must pay it, and at that point it's called estate tax and it's that tax that's now 40%.

The exclusion or the exemption whether you use it during your life or when you die refers to transfers that would otherwise be subject to tax. So, we called them taxable gifts. There is a whole separate category of ways to give assets away in the form of what are not considered taxable gifts. The way you do this is by using what's called the annual exclusion, and again, the terminology gets a little confusing because we're using the word exclusion in both contexts.

The annual exclusion is the amount that each of us can give away to an unlimited number of people without it being considered a taxable gift, and that amount, which has gone up in 2013, is currently $14,000 a year. So, Christine, I could give $14,000 a year to you, to each of your siblings, to each of your children, to your husband to an unlimited number of people, and if you're married, you can combine your two amounts and give away $28,000 to as many people as you want each year without it being subject to tax.

You can give this amount away by writing a check, you can give away a piece of jewelry, you can give away a piano, you can put money into a trust, you can put money into a 529 education savings account. There are many, many ways to use the annual exclusion, most people just write a check.

Benz: So, you are saying, if I exceed that $14,000 amount to one person, that starts counting toward that $5 million-plus exclusion amount.

Jacobs: Yes, that's exactly right. If you go over that $14,000 amount per person, obviously, you must file a gift tax return, which is due the same day as your income tax return, reporting the gift because the IRS wants to keep track of it while you are alive, so they know how much is left when you die. Anything that counts toward the $5 million-plus exclusion amount, any part of that that you give away while you were alive, gets subtracted from what can pass tax-free when you die.

Benz: One thing we've been hearing about this latest tax package is that it takes a lot of those Bush-era tax cuts, and it makes them permanent. I guess the question is, is anything in the tax code truly permanent? Couldn't Congress revisit these estate tax laws down the line?

Jacobs: Well, you're absolutely right about that, but look how much trouble this was. The estate tax system alone was in limbo for the last two years, and then before that it was in limbo for another bunch of years. Really, it's been in limbo for about a 11 years now, the law that passed just after New Year's, it took just three pages in a law that is a 157 pages long to resolve these issues.

So, look how much time it took Congress just to get those three pages together. I think the likelihood that they will enact a comprehensive estate tax reform package anywhere down the line is extremely unlikely. As for the fact that it made the Bush-era tax cuts permanent, that whole system resulted from a compromise in Congress, which involved what's called the sunset tax provisions that would expire and that was all part of horse-trading long ago and put us into a very, very difficult situation.

Benz: It seems like there might be a strong temptation by leaving the exclusion amount at $5 million-plus. It seems like people might be inclined to say, "Well, I really don't need to worry about estate planning. This tax will never affect me because I don't imagine my estate will ever be worth that amount." What do you say to people who are kind of thinking that at this juncture which maybe a logical thing to think?

Jacobs: Well, you wouldn't believe, it's not just that this juncture, but when I first started writing my book, Estate Planning Smarts, in 2008, and I told people what I was working on they would say, "Oh, I don't have an estate. I don't need to worry about estate planning." And of course, when they said that they were thinking that an estate was a big house, sort of Gatsby-style house, and in fact, everybody has an estate. So, that's a mistake; that's a very popular misconception. You don't have to own a big house to have in an estate. Your estate consists of everything you own when you die. That includes your home, if you own a house. It includes all your personal property and value possessions, your car, investments, bank accounts, retirement plans, any interest in a family business or partnership. So, all of these things are part of your estate.

Now, the one reason that you need an estate plan, even if you don't need to worry about taxes is, that if you if you die without a will or a living trust, it's called intestate in legalese, state law determines how most of your belongings are distributed. And the result may not be what you want because depending where you live, these laws establish a ranking of inheritors. And some of the newer laws say everything will go first to the spouse then to children, parents and siblings, but there are also states where the child is entitled to a certain share, Or say you're involved with somebody romantically, and you're not married and you don't have a will. Under state law, everything might go to your parents when you in fact want to provide for a long-time partner. So, everybody needs a will, letting everybody know how they want their assets distributed when they die rather than leaving it up to state law to dictate all this for you.

Benz: And certainly parents of minor children need to make arrangements in case something should happen to them. There are other documents that would also need to fall in place for most families, not just the higher-net-worth folks?

Jacobs: Yes. In fact, a will is the only document that you can use to appoint a guardian for a minor child if you want to have a say in that yourself. There is no other way to do that, and if you do not provide for that in a will, and your child is orphaned, then a court has to step in and make that decision.

Another thing that people have to address is that many people don't associate with estate planning is making provisions for yourself. In fact, the first chapter in my book, Estate Planning Smarts, deals only with protecting yourself if something happens to you. For example, everybody over the age of 18 should have a durable power of attorney and that's a document that appoints someone to handle your assets if you can't handle them for yourself.

Everyone over the age of 18 should also have what's called a health-care proxy or a health-care power of attorney, appointing somebody to make medical decisions if even temporarily you can't make them for yourself. If you're hit by a bus, for example, in New York now, we have so many people riding bikes around the city and I think to myself, as I see all of these very young people getting around town on a bike, if they were hit on their bike and badly hurt even if they fully recovered, there might period of time during which they couldn't even talk to their doctors and make their wishes known, and once they are over the age of 18, they're not considered a child with respect to their parents anymore.

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