Best Investments for Estate Planning

In an economic system undergirded by the principle of private property, the primary purpose of investment is to benefit the investor. One option available to the owner of property, however, is to pass it along to survivors via bequest. Since a bequest is intended to benefit people other than the investor, it may conflict with the structure and purposes of conventional investments. Another complication relating to bequests is the applicable rules of taxation. These factors have fostered the creation of a specialized form of financial planning called estate planning.

In law, an estate is the algebraic sum of a decedent’s assets, both tangible and intangible. Thus, it includes all physical possessions such as land, personal property, physical assets, as well as legal rights and entitlements, minus the value of all liabilities or claims on those assets. (An economist would refer to an estate as net worth.) Estate planning aims at maximizing the value of the estate to the decedent’s heirs. This includes not only the explicit monetary value of the assets but also their net present value, which considers the time taken to distribute them via the probate process.

Probate is the legal regime by which the wishes of the decedent regarding division of the estate are carried out. Those wishes are expressed legally in a document called a will (or final testament). A living will or medical directive sets out the measures a person approves for the purpose of prolonging or sustaining his or her life. A person who dies before executing a will is said to die intestate. The person responsible for carrying out the terms of the will is the executor; this person is normally nominated by the decedent in the will. An administrator handles the affairs of those who die intestate. A durable power of attorney is held by a person or persons empowered to act for people unable to act on their own behalf for medical or other reasons.

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The “Death Tax” Misnomer

Although the estate tax is frequently dubbed the “death tax,” the transfer of property after death is what is really being taxed. There is a corresponding “gift tax” on transfers of property during the decedent’s lifetime. Moreover, assets transferred to a spouse or charity are normally exempt from the tax.

The Estate Planning Process

The legal and fiscal ramifications of death are sufficiently complicated that advance planning is required to maximize the value of the estate to heirs. One illustrative ramification is the probate process. It is a tremendous irony that probate, which was designed in law precisely to implement the wishes of the decedent, acts in practice to frustrate the most likely wish – that the decedent’s assets be passed along to heirs as quickly as possible. (In economic terms, the longer it takes to transfer assets, the less valuable the assets are at death.) A delay of a year in retitling assets and verifying net worth is not at all unusual, and longer delays sometimes occur. Consequently, one key purpose of estate planning is avoiding probate to the maximum degree possible.

Certain asset classes are well-suited for avoiding probate. These are assets whose ownership transfers automatically upon death through the operation of law. Life insurance is the classic instrument of probate avoidance. Life insurance assets can normally pass directly to beneficiaries upon submission of a death certificate, without having to pass through probate. This is very convenient, since it allows death benefits to pay all or most of the decedent’s final expenses. (Rather than wait one year or longer for payment, funeral homes would probably factor the receivable, which in turn would reduce its value to the business and necessitate higher prices for funeral-home services.) Thus, life insurance is an ideal form of estate-planning investment, since it maximizes the value of the bequest to the heir(s).

Annuities provide life-insurance benefits to named beneficiaries and are issued by insurance companies. Thus, they share the pass-through status of life insurance vis-à-vis the probate process. Moreover, life annuities can be structured in “joint-life” or “joint-and-survivors” form to provide for cessation of payments to a couple after the first of two deaths or only after both deaths. Judged strictly according to ease of transfer, then, annuities are also an excellent estate-planning tool.

Individual stocks, bonds, and mutual-fund shares are a mixed bag from the standpoint of probate. On the one hand, they require retitling of ownership, ordinarily done through the probate process. On the other hand, many states allow these assets to be titled in a form that provides automatic transfer of ownership. This designation is variously called “transfer-on-death (TOD)” and “payable-on-death (POD).” POD applies to bank assets (such as checking and saving accounts) rather than security assets. Registration of securities in TOD form will pass their ownership directly to the named beneficiary without sending them through probate.

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Avoiding the Estate Tax

In principle, the estate tax included a flat tax on each of numerous brackets, plus a graduated tax upon the remainder of the estate in excess of the bracketed amount. In practice, as of 2009, it was equivalent to a flat tax of about 45% on the amount exceeding the unified tax credit of about $3.5 million. The estate tax was repealed effective 2010, but scheduled to resume in 2011 with a lower unified credit of $1 million and a higher effective tax rate of 55%.

The husband and wife in a household each had an estate-tax exemption amount, and one avoidance strategy was to combine these exemptions in a will or living trust so as to double the amount of income shielded.

Another commonly-used strategy to counter the estate tax was to offset it through estate-planning investment. The death benefit from a life-insurance policy performed this function. (Because the decedent’s death date is uncertain, a “permanent” whole-life policy was preferred to term insurance for this purpose.) Sometimes the insurance premiums were paid by the decedent as a gift to his or her children, who may own the policy since they have an insurable interest in their parent. The policy might reside inside a life-insurance trust so as not to form part of the estate. Alternatively, the surviving parent donated an asset to a charity inside a trust established for the heirs’ benefit. (This provided a tax deduction for the donor.) The income from the asset paid the insurance premiums, the charity received the appreciated asset upon the parent’s death, and the policy death benefit paid the estate taxes. The trust was called a “charitable remainder trust.”

Avoiding Other Taxes Levied On Heirs

Estate taxes are not the only taxes facing heirs. Physical or financial assets may be subject to capital-gains tax upon sale. The tax is calculated by subtracting the original purchase price from the final sale price; any positive difference constitutes a capital gain. Currently in the U.S., short-term capital gains apply to an asset held for less than one year; long-term capital gains apply to assets held for longer than one year. Short-term capital gains are taxed as ordinary income, up to a maximum rate of 28%. Long-term capital gains are taxed up to a maximum of 15%.

The original sale price is called the cost basis; it may be adjusted upward to reflect taxes paid prior to final sale. Upon death, heirs benefit from a step-up in cost basis to the valuation as of the decedent’s death. This stepped-up basis can significantly reduce the heirs’ eventual tax bill. Securities benefit from this step-up in cost basis, while annuities do not. This confers an advantage to securities in estate-planning investment. (Securities must be sold in order for full value to be received, while annuities repay part of the principal in each distribution payment, along with the interest that has accrued during the accumulation period. Thus, there is no final selling price for an annuity and no capital gain.)

Annuities are geared toward benefitting the annuitant, and the guarantee of lifetime income is a substantial benefit indeed. Beneficiaries are afterthoughts in the annuity structure; the death benefit was added when people began to complain about the surrender of value to insurance companies upon the death of the annuitant. Corporations are designed as perpetuities, intended to survive long after the deaths of their founders and shareholders. Consequently, they are inherently better situated to preserve value for heirs.


Estate planning is the process of maximizing estate value to heirs. One way to accomplish this is to avoid probate. Assets that pass automatically to heirs through operation of law are exempt from probate. These include life insurance and annuities. Securities can also qualify in states that accept the “transfer on death” (TOD) designation for securities registration, which designates a beneficiary whose name automatically replaces the decedent’s on the registration.

Estate taxation was repealed for tax-year 2010, but was scheduled to resume under more onerous terms in 2011. Formerly structured as a combination lump-sum tax on bracketed amounts plus graduated tax on the remainder, the estate tax was effectively a flat tax on the value of the estate that exceeded the amount of a unified tax credit/exemption. Techniques for avoiding the estate tax involved increasing the exempted amount or using life-insurance proceeds to pay the tax.

Heirs may also face capital-gains tax, a somewhat-progressive tax on nominal gains up to a maximum of 15%. Recipients of securities benefit from a step-up in cost basis to the date-of-death valuation, which reduces the capital gain and amount of tax owed. In contrast, annuity principal is returned to the annuityholder gradually in each distribution payment. Consequently, there is no capital gain and investment income is taxed as ordinary income instead. Since ordinary income-tax rates are currently well above long-term capital-gain rates, a substantial tax advantage accrues to inheritors of securities compared to inheritors of insurance assets.

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