Throughout your working years, you may accrue a few assets—like a home, car, retirement account, and those vinyl records you’ve meticulously salvaged.
At some point, you might want to start thinking about your estate plan, which is a blueprint for how to distribute those assets if you become incapacitated or die.
A lot of us tend to put off this all-important task. In a 2020 study by Caring.com, 60% of surveyed Americans agreed that estate planning is important, but only 32% of respondents said they had documents in place.
You don’t have to be wealthy or nearing retirement to start the process. In fact, planning ahead—even just by drafting a simple will and assigning beneficiaries to your accounts—may help save your family time and money down the road.
First, what is an estate?
Your estate is everything you own, from money in the bank to your investment accounts and even debts you owe. Following your death, your estate may go through a process called probate to prove there are no legal challenges to your last will. The executor—someone you’ve appointed to handle your estate—will use your assets to pay off any debts.
The remaining money is distributed among your heirs. When taxes get involved, there’s less to go around. Some of those taxes include:
Estate taxes: In 2021, the federal estate tax generally applies when a person’s assets exceed $11.7 million at their time of death. Some states have their own estate taxes, too. But this is something most of us won’t have to worry about. According to the Tax Policy Center, only 0.07% of filers paid estate taxes in 2019.
Inheritance taxes: A handful of states have inheritance taxes, which are separate from the federal estate tax. If this tax applies to your heirs, they’ll pay it.
Income taxes: If you’ve set up a trust that generates income, the person who owns the assets may have to pay income tax.
1. Draft a will
A will is a document that designates who gets your assets and names an executor to carry out your instructions. Generally, you should draft a will if you are married, have kids or pets, or own assets. Without a will in place, the court will distribute your assets (or name a legal guardian for your minor children) according to state law, which could dictate different decisions than you would make.
Generally, you should draft a will if you are married, have kids or pets, or own assets.
“This can be messy for your heirs,” says Sean W. Mullaney, a financial planner with Mullaney Financial & Tax, Inc.
Additionally, the probate process can cost 3% to 7% or more of the total estate value, and it could take up to a year or two to complete, delaying the distribution of your assets. Having a will can help cut down on the time and money your family spends in probate. There are other ways to avoid probate, but we’ll get to those soon.
2. Update your beneficiaries
You won’t need to use a will to distribute all of your assets. Some of them, such as retirement plans and life insurance policies, let you name beneficiaries for that particular asset. The beneficiary automatically inherits any money in these accounts without going through probate.
And if a married couple has a joint bank account, the surviving spouse becomes the full owner of the money. There are a few more options for passing your bank account to a beneficiary, such as a payable-on-death account, so talk with your bank about the best solution for you.
If you haven’t assigned one or more beneficiaries to your eligible financial accounts, they could go to a probate court, where a legal process decides who gets the money.
“Beneficiary designation forms and payable-on-death forms should be checked annually and updated for life events.”
“This is huge,” Mullaney says. “Beneficiary designation forms and payable-on-death forms should be checked annually and updated for life events. If you don’t, the money could go to the wrong person and/or create very bad headaches for your heirs.”
Those “life events” typically include marriage, the birth of a child, and divorce. You may also need to update these forms if your relationships change over time or one of your beneficiaries dies.
3. Consider setting up a living trust
When you set up a trust, you ask a third party (the trustee) to hold an asset in a trust fund on behalf of your beneficiary. There are many types of trusts, but a major distinction is whether they’re irrevocable or revocable:
In an irrevocable trust, the assets no longer belong to you—they belong to the trust. As a result, the money isn’t subject to estate taxes and won’t go through the probate process.
A revocable trust allows you to retain control over the assets and even dissolve the trust at any time. These won’t go through probate either, but they’re usually subject to estate taxes.
Bypassing some or all of the probate process can help your assets get to your heirs faster, and irrevocable trusts may even lower your estate taxes. Talk with an estate attorney to figure out if this is the right move for you.
4. Convert traditional retirement accounts to Roth accounts
A traditional retirement account—such as an IRA or 401(k)—allows you to put aside money for retirement, and you won’t pay taxes on the funds until you withdraw from the account later.
But if you pass those traditional accounts to your heirs, they could end up with a large tax bill since they also inherit the tax liability. You can help them avoid this by gradually converting traditional accounts to Roth accounts. With a Roth account, you pay taxes on your savings now (and potentially eliminate the future tax bill).
This process may push you into a higher tax bracket while you’re living, so Mullaney suggests this only “if your financial situation is very solid. Tax planning for one’s heirs should not be done at the expense of your own financial future. … You should only do Roth conversion planning if it directly benefits you.”
5. Gift your money while you’re alive
You may already be familiar with the gift tax. As of 2021, the IRS allows individuals to give up to $15,000 per person per year, tax-free. If you’re worried about estate taxes, inheritance taxes, or a lengthy probate process, this move can help you direct your money where you want it to go.
“This is a later-in-life estate-planning strategy that can be very effective if your finances are very strong and stable,” Mullaney says.
6. Hire a professional
Estate planning can get complicated, so you might benefit from hiring an estate planner or a financial advisor who specializes in estates. They can help you draft a will, set up a trust, and recommend how to transfer your assets.
If you don’t have a complex portfolio, they may provide streamlined advice. For example, they can help you draft a simple will and discuss your beneficiary designations. If you own assets—say, real estate or stocks or bonds outside of your retirement accounts—the attorney or financial planner can help you figure out how to transfer them if you’d like to avoid probate. Because your financial situation and relationships change over time, you may need to update your plan every once in a while.
Whether you want to take care of your family or donate to charity, you don’t want taxes to eat up the money you leave behind. Setting up a plan can ensure more of your estate falls into the right hands.