What Is Estate Planning?

What Is Estate Planning? article image.

Estate planning is the process of organizing your assets in preparation for passing them down to your heirs. The process addresses life's two big certainties—death and taxes—and can make at least one aspect of your passing easier on your loved ones.

How Does Estate Planning Work?

The goal of estate planning is to ensure that your assets are distributed in the manner you desire, typically while minimizing the impact of taxes that can reduce the value of those assets before or after you bequeath them.

For purposes of estate planning, assets may include cash savings, real estate, stocks and bonds, retirement funds and life insurance benefits, as well as any other items of significant value (artworks, rare collectibles and the like). They may be passed on to your heirs or possibly other beneficiaries, such as charities you support.

The taxes that come into play are estate taxes and inheritance taxes:

  • Estate taxes are collected upon your death if your estate's total value exceeds certain exemption limits: As of 2020, the federal government can collect taxes on estates with values that exceed $11.58 million. Assets that exceed this dollar amount are taxed from 18% to 40%, but estates can bring down the actual rate they end up paying with tax credits and other methods. Twelve states—Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont and Washington—and the District of Columbia collect estate taxes. Their rates are lower than the feds', ranging from 0.8% to 16%, but their exemptions are also much lower, from $5.7 million in D.C. and Hawaii to $1 million in Massachusetts and Oregon.
  • Inheritance taxes apply to heirs based on the value of certain items they inherit. Inheritance isn't considered income for purposes of the federal income tax (but inherited securities and real estate can be subject to capital gains tax when an heir sells them). Six states tax inheritance: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. Strategic estate planning may be able to reduce heirs' exposure to these taxes.

How Does a Will Help You Plan Your Estate?

The foundation of any estate plan is a will. In fact, you may not need much of a plan beyond that if you don't expect your estate to be taxed. A will, in simple terms, is a legal document that spells out who you want to receive your money and property when you die.

Having a will, especially if you have a spouse, ex-spouses or children, could help your family avoid the lengthy probate processes required when a will is absent. All estates are subject to probate—review by a special court established to oversee distribution of dead persons' assets—but in cases where the deceased leaves a will, probate calls for the court to ensure it is genuine, to provide oversight of the executor named in the will and to oversee collection of applicable taxes.

When a person dies intestate—with no will, or with a will the court deems invalid—the court reviews the deceased party's assets, liabilities and family relationships and decides how money and property are to be distributed. If there are no direct heirs (living spouses or children), the estate is typically taken by the state. Probate is a public process that can delay the release of assets at a time when grieving families need them.

Filling out a basic will and ensuring it is acceptable to the probate court (by having your signature witnessed and notarized, for example) is not especially complicated. Basic will-making templates or kits that meet different states' needs can be found online for a few dollars or even free. Because a will is a legal document, it's advisable to have an attorney with experience in estate matters review it once you've prepared it, or anytime you choose to revise it. Doing so can avoid legal snags down the road.

To create a simple will, the legal fee is typically a few hundred dollars; more complicated wills (involving extensive assets or with complicated distribution instructions) tend to take more time and will likely cost closer to $1,000. If you want to set up a trust (see below), lawyer's fees could run from $2,000 to $3,000. Once you've set up a will, expect your lawyer to charge an hourly fee to update or modify it in the future.

If you have more extensive assets or otherwise feel a need for more sophisticated estate planning, it becomes even more important to get sound legal advice. Depending on your assets and goals, it also may be prudent to consult a financial advisor with estate planning experience. You'll have to pay for those professionals' advice, but it will be worth it to avoid potential problems.

More Estate-Planning Tools You Might Explore

Estate planning professionals employ a variety of legal strategies and tactics to secure your assets for you and your heirs, and to shield them as much as possible from taxation. Not all will apply in every case. When deciding which apply to your situation, and when setting them up or making changes in them, it's wise to get professional guidance.

Payable-on-Death (POD) Accounts

You can convert cash savings accounts and certificates to POD accounts by designating one or more beneficiaries who'll take over the accounts when you die. Doing so automatically transfers ownership, bypassing the probate process. Setting up POD beneficiaries is free, and it can be a very clean way to transfer assets. There are some caveats to be aware of when considering POD accounts, however:

  • If there's a discrepancy between your will and POD instructions, the POD order will take precedence.
  • If an account is owned jointly, the POD order won't be executed until all account holders die.
  • If you die with outstanding debts or tax obligations, holdings in POD accounts may be used to settle them.

Living Trusts

A living trust is a legal entity that can hold assets on behalf of its creator and distribute them when they die. A trust can contain investments, cash funds and real estate, and distribute them (or income they generate) to heirs according to your instructions. A trust has financial standing independent of its creators and trustees; it can be the beneficiary of a life insurance policy or annuity, and an annual federal tax return must be filed for it.

A trust set up by an individual or a couple could, for example:

  • Issue payments to heirs on a monthly or annual basis.
  • Hold a home for shared use by the heirs, and dedicate funds to pay for maintenance of the property.
  • Distribute income for life to a surviving spouse and, upon their death, shift assets to children or grandchildren.

Living trusts are categorized as revocable and irrevocable. A revocable trust is one in which a person names themselves or somebody else as trustee—empowered to add and remove assets, add or change beneficiaries and even dissolve the trust altogether. When the owner of a revocable trust dies, assets in the trust are considered part of their estate and potentially taxable.

Irrevocable trusts, on the other hand, can't be altered once they're created. Once the creator sets up the trust, it's turned over to one or more independent trustees to oversee on their behalf. The trustee may be a financial advisor or investment manager, but sometimes a family member who isn't a beneficiary of the trust. Assets included in irrevocable trusts are generally not part of estate tax calculations and can't be pursued by creditors. The trustee manages the trust's assets according to the owner's initial guidelines and then distributes the contents once its creator dies.

Trustees are also responsible for filing the trust's tax returns. Trustees are entitled to "reasonable compensation" for their stewardship, and often take payment in the form of 1% to 2% of the trust's total assets each year, with the percentage typically being lower on trusts with greater holdings. (With smaller trusts, flat-fee annual payments may be negotiated.)

Charitable Bequests

Many individuals include charitable gifts in their wills, and estate planners sometimes use them—and their tax advantages—to help skirt estate taxes. Some charitable gifts can be deducted from the estate's total value for purposes of calculating estate taxes, for example, so it may be possible in some cases to use gifts to bring an estate's total value below the federal or state exemption limit, preventing taxation of the assets that remain.

Prepaid Funeral Arrangements

While not strictly a matter of settling your estate, planning and paying for your funeral arrangements today can help your heirs avoid having to use a chunk of their inheritance (or their own funds) to cover your final arrangements. Working with a funeral director allows you to select and pay today for a burial plot or cremation services, a casket, tombstone and all related services (even flowers) for your own final services. Prepayment can help you avoid cost increases that may occur over the remainder of your lifetime. When planning your final arrangements, the U.S. Federal Trade Commission advises asking about contingencies such as what happens if the funeral home or crematory goes out of business before you die, and what provisions are made for transportation in case you die away from home.

Living Will

A living will is a written set of instructions for your own medical care, to be followed in case of terminal illness or injury that leaves you incapacitated or otherwise incapable of expressing your wishes. A living will can include "do not resuscitate" (DNR) orders, indicating circumstances under which you prefer not to be receive CPR, heart defibrillation or other measures if your heart stops or you stop breathing; instructions on whether to use extraordinary measures to prolong your life in case of terminal conditions; and whether you wish to be an organ donor. A living will can help your loved ones and medical staff make difficult decisions according to your wishes.

Benefits of Having an Estate Plan

The main advantage of estate planning is knowing your assets will be distributed the way you want them to be upon your death. Good estate planning can also ensure, to the greatest degree possible, that your money and property will go to your loved ones, the charities you support, and anyone else you care to designate, and not to state and federal tax collectors.

Estate Planning Tips

Estate planning isn't a job anyone relishes, and once you've made your mind up to tackle it, it can be tempting to set up your estate and then move on to other, more appealing projects. But it's best to think of estate planning as an ongoing process. It doesn't require constant attention, but it's something you should revisit regularly, particularly as your finances evolve and/or your family grows. Here are some tips for making the process go smoothly:

  • Work with professionals. These can include attorneys, tax professionals and investment advisors with estate planning experience.
  • Review your beneficiaries. Families change and grow over time, and keeping current with the beneficiaries of your will, POD accounts and revocable trusts can save your heirs time and trouble. Eliminate any beneficiaries who have died, and make sure you've considered grandchildren or even great-grandchildren who may have come along since you first compiled a will.
  • Account for financial changes. If you acquire a second home or other real estate, set up new individual retirement accounts, discover a nonprofit you feel passionate about supporting, or otherwise have big changes in your financial picture, your estate planning may need to be adjusted accordingly.

It isn't a task anyone likes to dwell on, but there's a kind of comfort that comes with arranging for the assets you've worked to accumulate to be passed on as you see fit. Careful estate planning is a final gift your heirs will appreciate at a time when they're missing you most.