Approaches You Can Use to Reduce the Bite of Estate Taxes

If you died tomorrow, what would happen to your mutual fund investments?

That’s not a pleasant question to ponder, but it’s an important one, assuming that you want to leave as much wealth as possible to your spouse or heirs.

“Demographic trends suggest that there will be a tremendous amount of money passed between generations over the next 15 to 20 years, not just in financial assets like mutual funds but also in closely held businesses and real estate,” says Stephen P. Barnes, a certified financial planner in Phoenix, Ariz.

Investors who make the right preparations will be able to minimize federal and state death taxes. Uncle Sam’s bite alone can range as high as 55% on multimillion-dollar estates. Many will also succeed in keeping their assets out of probate, the often slow and costly process of transferring a deceased person’s estate through the court system.

As you delve into estate planning, you might even discover that some of your mutual fund investments are inappropriate. For example, if you want to provide for a grandchild’s college costs, you may want to replace a conservative bond fund with a more aggressive stock portfolio.

One way to transfer mutual funds or other assets is simply to give them away while you’re alive. You can leave as a gift up to $10,000 a year--either in cash or shares--to as many recipients as you want, tax-free. Your spouse may also transfer up to $10,000 annually to any number of individuals.

“Over the years, you can really donate a lot of money in this manner,” says Victoria Felton-Collins, a principal at Keller Coad & Collins Investment Counsel in Irvine.

A nice aspect of gifting is that you will be around to enjoy your heirs’ gratitude. In addition, you can reduce the size of your estate--and any resulting estate taxes and probate fees--by giving assets away while you’re alive.

One obvious disadvantage is that you lose control of the money. Another drawback of gifts is that there’s no “step up” of the shares’ cost “basis.” This is a fancy way of saying that the recipient might owe taxes on any capital gains you have accrued but haven’t paid taxes on. By contrast, when you die and bequeath appreciated assets to heirs, those assets will generally get an automatic step-up in basis, which wipes out any previous capital-gains tax liability. (Estate taxes may still apply, however.)

On the other hand, there’s usually not a huge unpaid tax liability with mutual funds, Barnes says. Certain types of funds, such as bond and money market portfolios, might not have any accrued gains.

Even with stock funds, there usually aren’t huge tax liabilities because the Internal Revenue Service requires investors to pay taxes on at least some of a fund’s gains each year rather than defer them, as could be done with individual stocks.

There’s generally little extra paperwork involved for anyone wanting to present a mutual fund as a gift, says Howard Schneider, a vice president with the AARP Investment Program at Scudder, a Boston-based fund group that caters to members of the American Assn. of Retired Persons.

Someone wanting to transfer shares to adult children would merely register the fund in the recipient’s name, he says. With minor children, a custodian must be named. It shouldn’t be the donor because those assets could be included in the person’s estate if he or she died before the child became an adult, warns Felton-Collins.

People wanting to bequeath mutual fund assets have several options. One is simply to hold fund shares within an individual retirement account. Anything in an IRA will pass to the beneficiaries you name, avoiding the time and cost of probate.

But with an IRA, as with a gift, the step-up of basis doesn’t apply--which could create an estate-tax liability, Felton-Collins says. The lone exception is with money passing from one spouse to another. This involves no estate taxes (although ordinary income taxes will apply on withdrawals).

Another possibility is to include your mutual funds and other assets in a living trust. There are several advantages to trusts, including the fact that assets pass to heirs without going through probate.

Another selling point is flexibility--as long as you’re alive, you can change key provisions, such as whom to bequeath assets to, and in what amount. A living trust per se doesn’t avoid estate taxes, but it can be used in conjunction with various tax-reducing techniques to minimize Uncle Sam’s bite.

The key disadvantage of trusts is the cost to set them up, which generally ranges from several hundred dollars to a few thousand. They become more appropriate as the size and complexity of an estate increases, although it’s difficult to say at exactly what level a trust becomes cost-effective. Barnes recommends against the do-it-yourself approach. “It’s worth the extra dollars to have a law firm draw up a living trust.”

Anyone with existing mutual fund holdings who decides to establish a trust must re-register his or her shares to ensure that they will be included, Schneider says.

Of course, mutual fund assets can also be passed to heirs with the help of a simple will, rather than a trust. However, the transfer won’t avoid probate, unless the assets are held in joint tenancy--a form of ownership that passes the entire amount to the survivor.

Joint tenancy is common among married couples, but it’s also available for people with other relationships, such as a grandparent and grandchild. Just be aware that when you add someone other than a spouse as joint tenant, that could be considered a gift, with possible estate-tax complications.

Estate-Planning Essentials

Estate planning is one of those things for which there’s no second chance. If you die with an inferior plan or none at all, you could saddle your heirs with unnecessary probate fees or taxes. Here are some of the basic factors that shape estate-planning decisions:

* Spouses can leave an unlimited amount of property to each other without triggering federal estate taxes.

* Each person can pass up to $600,000 in mutual funds and other property to heirs free of federal estate taxes.

* The value of an estate includes real estate, cash, mutual funds, other financial and tangible property, life insurance (possibly) and personal belongings, as well as a share of jointly owned assets.

* Probate costs--the legal and administrative expenses of passing a deceased person’s wealth through the court system--are distinct from estate taxes. That is, heirs might incur one, both or neither, depending on how the estate plan is set up.