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Schwab MoneyWise®

Basics of Estate Planning

Protect yourself and your family with an estate plan.

Our Two Cents

Estate planning is for those you love. It is essential to create a will as soon as you become a parent—if for no other reason than to specify a guardian for your children.

You’re working hard to build financial security with investments and property, so it makes sense to work just as hard to protect it. At its core, estate planning is about keeping you and your family safe by ensuring that your life’s work winds up in the right hands.

Does estate planning apply to you?

No one can predict the future, but one thing is sure: If you leave unanswered questions about how to settle your affairs, life for those you love could be even more difficult. That’s why answering questions now—and formalizing those answers in an estate plan—is an important step that shouldn’t wait.

Estate planning becomes especially important as soon as you have a child. This section can help you get started on defining who will inherit your assets. We suggest that you work with an experienced estate planning attorney to create a plan.

What an estate plan can do:

  • Specify who will care for your minor children.
  • Spell out the distribution of your assets.
  • Minimize estate taxes and other transfer taxes.
  • Avoid the costs, publicity, and delays of probate.
  • Help ensure that you and your affairs are taken care of in the way you specify.

Some other terms to get familiar with:

Beneficiary designations

Beneficiary refers to the person or people you specify to receive the assets in your retirement account, life insurance policy, or annuity. If there is a discrepancy between your beneficiary designation and your will or trust, your beneficiary designation will take precedence. Therefore, it is extremely important to keep your designations up to date; otherwise, your assets could revert to your estate—or even go to an ex-spouse.

Note that if you designate someone other than your spouse or a charity as your beneficiary, those assets will be included in the value of your estate and can increase your estate-tax liability.

Advance health care directive, or a living will

This essential document states your wishes about receiving life-sustaining medical treatment if you become terminally ill.

Will

Everyone needs a will, especially if you have children. In most states, this is the only way to appoint a legal guardian for your minor children. Also, in the absence of a will, assets are distributed by the state and might not go to the people you prefer.

Wills are usually inexpensive to prepare and provide a straightforward way to state your wishes. However, if you only set up a will and do not set up a trust, your estate will likely have to go through probate. There are many ways to prepare a will, but you should have it prepared by an attorney who specializes in trusts and estates to ensure that it is legally binding.

Probate

Probate is the process of wrapping up a person's financial affairs after he or she dies. It is generally required when assets are registered only in the name of the person who has died and when the only estate-planning document is a will (or when there are no documents at all). During probate, a will is submitted to a court for approval, assets are collected and distributed, and all bills and taxes are paid—all under the supervision of the court.

Although probate can help guarantee that assets wind up in the right hands, the process can be both time-consuming and expensive. Also, probate documents are public records, which can compromise privacy. Whenever possible, it is better to minimize—or avoid—probate. In fact, a good portion of estate planning is about how to do this.

Marital property

Property acquired by either spouse during the course of a marriage is referred to as "marital property."

Most states follow the common-law system, which says that all marital property is owned by the person listed on the deed, title, or other ownership document. If only one name is on the property, that spouse has exclusive ownership. If both names are listed on the title, each spouse owns one-half of the property.

Under common law, a spouse with sole ownership can leave that property to anyone he or she chooses. If spouses share ownership, each spouse’s ability to pass on his or her half interest depends on how they have specified ownership.

Nine states use a different system. Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin (it’s optional in Alaska and Tennessee) follow the community property system, in which all property acquired or earned during a marriage is owned equally by both spouses. Any property that was owned by one spouse prior to marriage (as well as inherited property) remains separate, unless it is combined with other marital assets. In community property states, each spouse is free to leave his or her half to whomever he or she chooses, not just the surviving spouse.

If you are in a committed non-marital relationship, you must have a will or trust if you want to provide for your partner. Not all states recognize common-law marriages. This means that if you die without a will or trust, your estate will be distributed according to your state’s laws, and your partner may get nothing. Similarly, if you want your partner involved in your medical care or financial life if you become incapacitated, you should appoint him or her as your attorney-in-fact.

Power of attorney

Because a will doesn't go into effect until after your death, it makes no provision for what happens if you become ill or incapacitated. That's where a durable power of attorney for finances and a durable power of attorney for health care come in. You can use these documents to name an individual as your attorney-in-fact and give them the authority to conduct broad financial and legal affairs on your behalf.

Unlimited marital deduction

According to estate tax law, all spouses who are U.S. citizens can transfer unlimited assets to their spouses, both during their life and at death, free of estate tax. Note that if your spouse is not a U.S. citizen, you can set up what is known as a qualified domestic trust (QDOT), which postpones payment of estate taxes until after your spouse dies.

Pay-on-death and transfer-on-death accounts

A pay-on-death bank account does exactly what it says; upon your death, it will be used to pay the person, or people, you designate—without going through probate. Similarly, the assets in a transfer-on-death brokerage account will automatically go to whomever you designate.

Trusts

Depending on your circumstances, your attorney may recommend that you set up a trust or combination of trusts to distribute your assets outside of probate.

Simply put, trusts can be set up in your will (a "testamentary trust") or as a separate legal entity while you are alive (a "living trust"). Since a testamentary trust doesn’t go into effect until an individual’s death, it can’t be changed. A living trust, on the other hand, becomes effective the moment you sign the document and fund the trust. It can be changed or canceled while you are alive but becomes irrevocable after your death.

A common planning tool to avoid estate taxation of life insurance is an irrevocable life insurance trust (ILIT). With an ILIT, a trust irrevocably owns the policy, and the proceeds are kept outside the individual’s taxable estate (as long as the trust purchases the policy or the original owner lives at least three years after transferring an existing policy into the trust).

Although a trust requires more time and expense to set up than a will, it can have several advantages. A trust not only avoids probate, but also provides for potential incapacity. In addition, depending on how it is structured, it can reduce estate taxes. However, you should always consult with a professional estate planner on all trust matters.

Pour-over will

This option can be used along with a trust. This type of will "pours" any property that had been left out of the trust and was owned by the deceased into the trust.

Property titling

Like beneficiary designations, property titling takes precedence over a will. While every state allows sole ownership, states differ when it comes to the types of joint or concurrent ownership that are allowed. Here are the most common forms of property ownership:

Property titling
Form of property ownership Pros Cons
Sole Allows owner to have total and sole control during life and following death, via a will or trust Subject to probate
Tenancy in common Allows ownership in unequal proportions

Allows unlimited number of holders
Subject to probate

Harder-to-control disposition during life and death

Community property Prevents spouse from being disinherited

Each spouse owns an equal interest
Subject to probate

Restricted to spouses only

Only valid in nine states

Mandatory equal ownership
Joint tenancy with right of survivorship Avoids probate Mandatory equal ownership
Tenancy by the entirety Avoids probate Restricted to spouses only

Mandatory equal ownership

Stepped-up basis

When you give someone appreciated property during your life, he or she generally assumes your cost basis for income tax purposes. For example, if you give your daughter 100 shares of stock that you purchased for $10/share and that are now worth $20/share, the value of the gift is $2,000. But for tax purposes, she takes on your cost basis of $1,000. This means, for example, that if she later sells the stock for $3,000, she will owe taxes on the $2,000 difference between her cost basis of $1,000 and the sale value of $3,000.

On the other hand, when you pass on appreciated property at your death, the recipient will inherit your cost basis along with the property. In the example above, your daughter would pay taxes only on $1,000, or the difference between $2,000 and the sale value. This is known as a stepped-up basis.

This effect is compounded for spouses in community property states. As an example, let's say that you and your husband purchased a home for $100,000. At his death, 40 years later, the home is valued at $1 million. Had you sold the home prior to his death, you would have had to pay taxes on the $900,000 gain (minus the homeowner's exemption if it is your primary residence). Upon his death, however, the basis is "stepped up" to its current value of $1 million, avoiding all capital gains. On the other hand, if you live in a common law state, the stepped-up basis is applied only to the deceased's interest. In this way, married couples in community property states have a distinct advantage over those in common law states.

Estate tax

This tax applies to those who own an estate worth more than $5.45 million (or $10.9 million for a married couple). The estate includes:

  • The entire investment portfolio
  • All cash
  • The current market value of any property owned
  • The total value of all IRAs, 401(k)s, and pensions
  • The value of any life insurance policy, as long as there is an "incident of ownership," allowing the right to name a beneficiary or borrow against it

Executor

An important part of planning an estate is selecting a trusted person to act as the executor (or personal representative). The executor has several critical jobs, including overseeing the distribution of assets, hiring an attorney to handle legal details, paying the estate taxes and outstanding bills, and closing the house after death. This role involves significant responsibilities, so think carefully about whom to choose.

Gift tax

This tax is designed to prevent people from avoiding estate taxes by giving away their property during their lifetime. However, you can still give away up to $5.45 million during your lifetime without incurring a gift tax.

In addition, you can give up to $14,000 per year to as many individuals as you like (or $28,000 per recipient per year for a married couple) without any tax or reporting requirements. You can also give unlimited gifts to your spouse or charity, or pay tuition or medical expenses directly to an institution, free of gift tax.

Unlimited charitable deduction

This deduction allows you to transfer unlimited assets to qualified charitable organizations, free of estate or gift tax.


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The information on this website is for educational purposes only. It is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner, or investment manager.

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