Hang around estate planners long enough, and sooner or later the topic will turn to estate tax, and the hottest trends in avoiding it. First, a little background: the American Taxpayer Relief Act of 2012 set a permanent (or as permanent as you get in Washington anyway) exemption amount and tax rate for large estates. The “exemption amount” is set to adjust for inflation, and for 2014 is $5.34 million. This means any estate under that amount is exempt from the estate tax. Estates larger than that amount have to pay the estate tax, raised from 35 percent to 40 percent.
For larger estates, there are a number of tools to reduce the size of your estate, and preserve your assets for your children and grandchildren. This post is a quick introduction to five of the most common tools.
1. The AB Trust
For a married couple, the AB trust has been the simplest way to avoid estate tax, by giving the surviving spouse a shelter for assets over the exemption amount. The AB trust splits the estate after the death of the first spouse into two, or possibly three separate trusts, the “A” Trust and the “B” trust. The advantage of this type of a trust is that it is revocable while both spouses are alive, and only puts limitations on separate “B” trust necessary to pass assets to the children estate-tax free.
2. Family Limited Partnership
Often the “wealth” that is being transferred is an ongoing business. In this situation, the expectation is that the business will continue to grow, and gain value. By transferring a minority, non-controlling shares of the business to the heirs now, you get a discount by transferring a minority share now, and that portion transferred is out of your estate. If your ultimate plan is to bring the children into the business, this has the advantage of giving them ownership and a vested interest in the success of your endeavors.
3. Irrevocable Life Insurance Trust
Unlike probate, federal tax law considers life insurance proceeds part of your estate. To keep those proceeds out your estate, your can create a trust to hold the insurance policy. Typically these policies are funded through “defective” gifts to the children. Managing these funds and gifts to meet all the legal requirements is exacting, and you should expect to need ongoing maintenance for these types of trusts.
4. Grantor Retained Annuity Trust
The Grantor Retained Annuity Trust, similar to the Charitable Lead Annuity Trust relies on the IRS’s historic low return estimate (based on Treasury bond yields). The grantor retains the return as estimated by the IRS, and the ‘excess’ income is passed to the heirs. Typically these are short term trusts.
5. Charitable Lead Annuity Trust
Supporting charitable causes is an important part of this type of trust. By combining some advanced planning, your charity can receive a steady income for a set period of time, and the balance at the end will go to your heirs. Because of the historic low IRS return estimate, a significant amount of wealth can be transferred to your heirs, tax free through this method.
A word of caution: it’s easy to get the impression that estate planning is for “rich people” based on the focus that sometimes is put on avoiding estate taxes. In reality, avoiding estate tax is only part of what an estate planner does. Protecting yourself in case you or your spouse is incapacitated, putting the right people in charge, and avoiding probate are all very important for those of us who haven’t yet reached the $5+ million mark.
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