Planning your estate? Look beyond your will.

Planning your estate? Look beyond your will

Did you know that as much as 80 percent to 90 percent of your property and assets may not be covered by your will? And, in fact, that making out a will is only a small part of estate planning?

If you are like most people, you and your spouse share joint ownership of most of your assets, which means that at the death of either one of you, these assets pass outside the will. And you have other large assets - life insurance, for example, or retirement benefits - that are controlled by the designation of a beneficiary and also pass outside the will. Because a will controls the distribution of only a small portion of your estate, the estate plan incorporated in the will may not be entirely effective. The result could be that you end up placing a substantial tax burden on your heirs.

The estate plan - what

to consider

You should begin your estate planning by exploring ways to minimize gift or estate taxes, which typically range from 37 percent to 55 percent. While there are no federal gift or estate taxes on transfers between spouses, transfers to non-spouses are taxable.

There are two provisions in the law that can help minimize federal gift and estate taxes. The first is the ability each individual has to give up to $10,000 to anyone each year free of gift taxes. A husband and wife, for example, can give $20,000 to each of their children each year free of gift taxes.

The second is the ability of each individual to transfer $600,000 of property during his or her lifetime or at death free of taxes. Any cumulative transfer over this amount would be subject to federal tax rates starting at 37 percent. Transfers, either during one's lifetime or at death, can be outright or in trust. So a married couple can pass $1,200,000 of property to their heirs free of federal gift or estate tax - if they have a proper estate plan.

Most individuals wish to pass all of their assets to their surviving spouse. By doing so, however, they lose the ability to pass $600,000 of assets tax-free to their heirs. An individual can retain this tax benefit by establishing a trust under the will to hold $600,000 for the benefit of the surviving spouse. Upon the surviving spouse's death, the assets of the trust pass to the trust beneficiaries free of estate tax.

In order to determine whether you have $600,000 available to be given outright or allocated to a trust under your will, you must inventory your estate assets. You must determine which assets pass under your will (for example, property in your name only) and which do not (for example, jointly held property and life insurance payable to a spouse). You need to look at the deeds to your primary residence and vacation homes, and at the beneficiary designations for life insurance, retirement plans, and trust agreements, all of which can pass to a beneficiary outside the will.

Other types of property held jointly with right of survivorship also bypass the will. For example, savings bonds, securities, or any other assets placed in joint ownership with a spouse, a child, or a grandchild pass outside the will.

How ownership of appreciated assets is held can also have a dramatic effect on the income tax position of the surviving spouse. The law provides that inherited property takes as its income tax basis the fair market value on the day the owner dies. It is this "step-up" in the income tax basis that creates a significant tax savings opportunity - or tax pitfall, if it is not planned for properly.

The simple recording of the title to a vacation home, for example, can have dramatic tax effects. To get the value of the step-up in basis, ownership must be recorded in a certain way, and title to the property will determine the income tax consequences of its sale. Let's take, for example, a couple who purchases a vacation home for $100,000 that is worth $200,000 at the time of the husband's death. Following her husband's death, the widow sells the property for $220,000.

If the property is held in her name only, the tax basis of the property is the original cost - $100,000. If the property is held jointly, the tax basis will be $150,000 - the original cost plus one half of the total appreciation in value attributable to the husband's half ownership of the property. But if the property is held in the husband's name only, the property tax basis would be $200,000, the full step-up in the value of the property at the time of his death.

So, if the property is held in the wife's name, she will realize capital gain of $120,000 ($220,000 minus $100,000) when she sells it for $220,000, and she will be subject to a capital gains tax of $33,600 (assuming a 28-percent tax rate). If the property is held jointly, she'll be taxed $19,600 on capital gains of $70,000 ($220,000 minus $150,000). But if the property is held in the husband's name, the widow is taxed only $5,600 on capital gains of $20,000 ($220,000 minus $200,000). So check the titles for each of your assets and make the appropriate changes as part of your overall estate plan. You could save a bundle.

One caveat here: the title is of concern to couples who live in common law states. If a couple lives in a community property state and holds the vacation home as community property, there generally will be a full step-up in basis upon the death of either spouse.

Don't make the all-too-common mistake of overlooking retirement benefits and insurance policies. A substantial portion of your net worth consists of interest in your company's retirement, profit-sharing, or employee stock option plan, nonqualified personal retirement plan, deferred compensation, or stock acquired under an employee purchase plan. And there are also individual retirement accounts (IRAs) or Keogh accounts. For example, plans that designate the surviving spouse as the beneficiary have certain income tax advantages over plans that designate the estate as beneficiary. Depending upon the size of the estate, composition of the assets, and the survivors' need for cash, you may find that life insurance proceeds are more appropriately directed to your estate or to a tax-saving trust separate from the will. With all of these, the most important thing to do is designate a beneficiary. And, remember, when a beneficiary designation conflicts with the will, the beneficiary designation rules.

So how should these arrangements be set up? A proper estate plan takes into account the coordination of all property transfer methods (as shown in the diagrams). While you can direct all property transfers by your will, doing so can sometimes have adverse tax consequences.

The bottom line is that these arrangements should not be made without careful consideration.

Don't forget other

estate ideas

In developing an estate plan, other planning ideas may be appropriate. You may wish to consider, for example, the creation of a revocable living trust or an irrevocable life insurance trust. Another consideration would be to find the most effective way to minimize the excise tax on "excess" retirement benefits or the generation-skipping transfer tax.

* Revocable living trusts. If you own property in several states, a revocable trust arrangement can avoid multiple probate proceedings involving considerable expense and inconvenience. And a revocable living trust can provide an easy and convenient way for property to be managed if you should become incapacitated by illness or advancing age. But, if you put property in a revocable trust while retaining the right to take the property back and make other decisions about it, you will be taxed on the property and the income it earns, and it will continue to be a part of your taxable estate. * Irrevocable life insurance trust. Transferring life insurance policies to an irrevocable trust is a very popular estate planning technique. If the insured person is careful to transfer to the trust all the rights and incidents of ownership of the policy, including the right to change the beneficiary, the life insurance proceeds will not be subject to estate tax. The technique fails, however, if death occurs less than three years after the transfer. * Excise tax on excess retirements benefits. A relatively new 15-percent excise tax or 15-percent estate tax is now imposed on retirement benefits that exceed certain limits. The computations are complex and generally involve plan balances in excess of $750,000. You should be aware that various steps can be taken to reduce or delay this tax. Because this is so complex an issue, however, it warrants an article on its own, and is beyond the reach of this article. * Generation-skipping tax. This tax applies where assets of more than $1 million are transferred by will, trust, or any other arrangement to grandchildren or great-grandchildren. The tax, a flat 55 percent, is in addition to the gift or estate tax also imposed on the transfer. * Citizenship. There's no estate tax on any assets left to a spouse who is a U.S. citizen. But a change in the law provides that, if the surviving spouse is not a U.S. citizen, estate tax may be due soon after the death of the first spouse. Depending upon the non-citizen spouse's visa status, up to $600,000 of assets may be exempt from taxation. In any event, you might want to explore the new "qualified domestic trust," which may defer the payment of the tax.

The moral: careful

planning is a must

Estate planning involves much more than simply preparing a will. You need to consider carefully all your property, and who holds title to it or is a beneficiary of it. A well-designated estate plan integrates all the transfer of your property with your will.

PHOTO : The unplanned estate

PHOTO : The planned estate

Mr. Vacarro is a partner with Coopers and Lybrand.