Common Estate Planning Misconceptions
The internet is great for cat videos and memes, but not always for legal advice.
1. Assets in a revocable living trust are protected from creditors.
If you can amend or revoke your trust, which is typical, then the assets in your trust are not protected from your creditors. It is possible to establish and fund an irrevocable trust, which can allow the trust assets to be protected from your creditors, but that trust will come with some added complications and costs that might not justify the expense of setting it up and administering it.
2. If an asset avoids probate, it is not subject to estate tax.
Assets that are in a revocable trust or that pass to a beneficiary through a "transfer on death" or "payable on death" designation are still subject to estate tax. If you've met with me, you might have seen me use the example of having a pot of money in the middle of the table, and then having various government agencies sitting around the table. It's possible, and quite common, for an asset to be sitting in that pot and for the probate court to look at it and say, "since that asset is payable on death, we don't care about it," while meantime, the IRS's estate tax division will look at it and say, "we don't care that it's payable on death, it's still subject to estate tax." The IRS will rightfully point out that, if I owned that asset when I passed, whether it be in my name or in a trust I control, that asset is still mine and needs to be included in my estate.
It is generally a terrific idea to have assets titled in such a way as to reduce, if not eliminate, the need for probate. But avoiding probate does not mean avoiding estate tax.
3. When I die, the government is going to take everything (or a big chunk of everything).
There are a few simple estate tax rules everybody should know. For purposes of these rules, we'll assume you and your spouse are U.S. citizens.
First, everything you leave your spouse receives a marital deduction. If I leave my wife $5 billion, she will not pay any federal estate tax.
Second, everything you leave to charity receives a charitable deduction. If I leave my church or favorite nonprofit $5 billion, there’s no federal estate tax owed when I pass.
Third, the first $11.58 million (as of 2020) you leave to someone other than a spouse or charity will not be subjec to federal estate tax. So if I pass and leave my children $11.58 million, they will not pay any federal estate tax.
Fourth, if you make a gift (or combined gifts) of over $15,000 to someone other than your spouse in one year, you're supposed to file a gift tax return. That doesn't mean that tax will be owed. Typically, all you're doing is using part of your exemption against the gift and estate tax. But you still need to file a gift tax return to report the gift.
Fifth, IRAs are funky. Even if they’re not subject to estate tax on account of a decedent being below the $11.58 million exemption, non-Roth IRAs are still subject to income tax as distributions are made from the IRAs. The SECURE Act, which passed into law at the end of 2019, and which now seems like old news in light of how insane the start of 2020 has been, provides (with a few narrow exceptions) that inherited IRAs need to be distributed out to beneficiaries within 10 years. So depending on the size of an IRA and a beneficiary’s tax bracket, there could still be a hefty amount of income tax paid even when there is no estate tax paid.