If you expect your estate to have a significant estate tax liability at your death, be sure to include a well-thought-out tax apportionment clause in your will or revocable trust. An apportionment clause specifies how the estate tax burden will be allocated among your beneficiaries. Omission of this clause, or failure to word it carefully, may result in unintended consequences.
There are many ways to apportion estate taxes. One option is to have all of the taxes paid out of assets passing through your will. Beneficiaries receiving assets outside your will — such as IRAs, retirement plans or life insurance proceeds — won’t bear any of the tax burden.
Another option is to allocate taxes among all beneficiaries, including those who receive assets outside your will. Yet another is to provide for the tax to be paid from your residuary estate — that is, the portion of your estate that remains after all specific gifts or bequests have been made and all expenses and liabilities have been paid.
There’s no one right way to apportion estate taxes. But it’s important to understand how an apportionment clause operates to ensure that your clause is worded in a way that your wealth will be distributed in the manner you intend.
Suppose, for example, that your will leaves real estate valued at $5 million to your son, with your residuary estate — consisting of $5 million in stock and other liquid assets — passing to your daughter. Your intent is to treat your children equally, but your will’s apportionment clause provides for estate taxes to be paid out of the residuary estate. Thus, the entire estate tax burden — including taxes attributable to the real estate — will be borne by your daughter.
One way to avoid this result is to apportion the taxes to both your son and your daughter. But that approach could cause problems for your son, who may lack the funds to pay the tax without selling the property. To avoid this situation while treating your children equally, you might apportion the taxes to your residuary estate but provide life insurance to cover your daughter’s tax liability.
Omission of apportionment clause
What if your will doesn’t have an apportionment clause? In that case, apportionment will be governed by applicable state law (although federal law covers certain situations).
Most states have some form of an “equitable apportionment” scheme. Essentially, this approach requires each beneficiary to pay the estate tax generated by the assets he or she receives. Some states provide for equitable apportionment among all beneficiaries while others limit apportionment to assets that pass through the will or to the residuary estate.
Often, state apportionment laws produce satisfactory results, but in some cases they may be inconsistent with your wishes.
If you ignore tax apportionment when planning your estate, your wealth may not be distributed in the manner you intend. We can answer your questions about taxes and estate planning.
The stretch IRA: A simple yet powerful estate planning toolThe IRA’s value as a retirement planning tool is well known: IRA assets compound on a tax-deferred (or, in the case of a Roth IRA, tax-free) basis, which can help build a more substantial nest egg. But if you don’t need an IRA to fund your retirement, you can use it as an estate planning tool to benefit your children or other beneficiaries on a tax-advantaged basis by turning it into a “stretch” IRA.
Stretching the benefits
Turning an IRA into a stretch IRA is simply a matter of designating a beneficiary who’s significantly younger than you. This could be, for example, your spouse (if there’s a substantial age difference between the two of you), a child or a grandchild.
If you name your spouse as beneficiary, he or she can elect to roll the funds over into his or her own IRA after you die, enabling the funds to continue growing tax-deferred or tax-free until your spouse chooses to begin withdrawing the funds in retirement or must take required minimum distributions (RMDs) starting after age 70½. (Note that RMDs don’t apply to Roth IRAs while the participant is alive.)
If you name someone other than your spouse as beneficiary, he or she generally will have several options:
Usually the inherited IRA is the best choice because it maximizes the benefits of tax-deferred or tax-free growth.
Naming a trust as beneficiary
A disadvantage of naming your child or grandchild as beneficiary of your IRA is that there’s nothing to prevent him or her from taking a lump-sum distribution, erasing any potential stretch IRA benefits.
To ensure that this doesn’t happen, you can name a trust as beneficiary. In order for a trust to qualify for stretch treatment, it will need to meet certain requirements, such as distributing RMDs received from the IRA to the trust beneficiaries.
Contact us for additional details.