Forces That Affect Your Estate Plan

Everything you own is considered part of your estate when you die. To grasp the importance of planning for the distribution of your worldly goods, consider all the things that influence what happens to them.

1. The role of probate

This is the procedure by which state courts validate a will's authenticity, thereby clearing the way for the executor to collect and pay debts, pay taxes, sell property, distribute funds and carry out other necessary tasks involved with settling an estate. The process can be slow and expensive, and probate fees can absorb 3% to 7% of the estate's assets. And if there is a "will contest," costs will skyrocket.

Mindful of criticism and the spread of devices designed expressly to keep assets out of the grip of probate courts, most states have adopted a streamlined procedure for small estates, with informal procedures requiring little court supervision. Sometimes all that's necessary is for the appropriate person to file an affidavit with the court and have relevant records, such as title to property, changed. Formal probate, in which major steps along the way are supervised by the court, is commonly reserved for large estates.

Not all of your estate has to go through probate. Among the items exempted from probate -- but not necessarily from taxes -- are life insurance payable to a named beneficiary, property left in certain kinds of trusts and assets such as homes and bank accounts held in joint tenancy with right of survivorship.

2. Joint ownership

Property jointly owned with a right of survivorship -- the form that is commonly used by married couples but can be employed by any two people -- automatically passes to the other owner when one owner dies. Tenancy by the entirety, another form of joint ownership, can apply only to married couples and isn't recognized in all states. The pluses and minuses of joint ownership are discussed in detail later. For now, suffice it to say that it is an important estate-planning tool.

3. Federal estate and gift taxes

After years of squabbling over eliminating what many call the "death tax," Congress passed rules that greatly increase the threshold that must be reached before there is any federal estate tax and scheduled the tax's demise in 2010 (unless there's new legislation to extend its provisions). An estate has to amount to more than $2 million before it incurs any federal tax at all. In 2009, the threshold rises again to $3.5 million. Then it disappears in 2010. Married couples who leave personal property to their spouses can avoid tax on the entire estate of the first spouse to die, no matter how much it's worth. This is called the "marital deduction."

If your estate crosses the increased threshold, the pain can still be intense for your heirs. Federal estate-tax brackets can be as high as 45%. Americans who have accumulated substantial assets during their lifetimes need to be careful that they don't hand most of it over to Uncle Sam when they die.

Before you die, you can give away up to $12,000 a year to as many recipients as you want without incurring what's called a gift tax. For married couples the limit is $24,000. The gift tax is designed to prevent people from giving away much of their wealth to prospective heirs and thus escaping the estate tax entirely. The current rules set a lifetime gift-tax exclusion of $1 million. The top rate on taxable gifts drops in tandem with the estate-tax rates until 2010. That's when the estate tax "disappears" and the top gift-tax rate settles in at 35% -- the same as the highest income-tax rate. Lawmakers kept this tax to stymie lifetime transfers of income-producing property to heirs who are in a lower income-tax bracket to reduce income taxes.

There is no limit on gifts between spouses and no limit on the marital deduction described above. This means that, with proper estate planning, the marital deduction and the estate-tax exclusion can be used to pass estates of any size from one spouse to the other without incurring any federal estate tax. To make sure that you take full advantage of this opportunity and to minimize estate taxes upon the death of the second spouse, consult with an experienced estate lawyer familiar with the laws of your state.

4. State inheritance taxes

Most state governments levy some form of death taxes that cut into much smaller estates than the federal tax does. Most states levy an inheritance tax. An inheritance tax is paid by each heir out of his or her inheritance unless the will directs that the estate cover it. (This makes an inheritance tax different from an estate tax, which must be paid by the estate before its proceeds can be divided up among the heirs.)

All states and the District of Columbia also had a so-called pickup tax, which applied only to estates owing a federal tax. While the pickup tax didn't actually increase your tax, it claimed for the state an amount that would otherwise be claimed by the feds. As of 2005, the federal credit and all pickup tax revenue it painlessly channeled to the states disappeared because when Congress voted to eliminate the estate tax by 2010, it also phased out the state estate-tax credit-and with it the pickup tax-on an even faster schedule.

So far, about 20 states and the District of Columbia have changed their laws to keep the cash coming in by "decoupling" from the federal law. They continue to demand the same amount of death tax they were entitled to under the old rules. But because the feds won't give back as much via the credit, if you live in a decoupled state, your estate will wind up paying more death tax than if you died in a state whose lawmakers are going along with the program.

Adapted fromKiplinger's Practical Guide to Your Money,by the editors ofKiplinger's Personal Finance magazine(Kaplan Publishing. Copyright 2005 The Kiplinger Washington Editors, Inc.) Available wherever books are sold or direct at kiplinger.com/store/books.