Imagine you are on a plane, and you start talking to the person sitting next to you. They tell you that they are an estate planning attorney, and they are open to answering any question you have about the subject. If you had this opportunity, you would certainly come away with some useful information. Today, we will share an example of how this conversation may play out at an altitude of 35,000 feet.

Will my heirs pay taxes on their inheritances?

The response to that question can be complex because there are so many moving parts when it comes to taxes. The simple response is yes, there is a federal estate tax, sometimes referred to as a death tax, in the United States. This tax is based on the net value of your assets. Today, most people do not have to pay estate taxes because there is a robust exclusion, or exemption amount. This is a set dollar amount that you can transfer tax-free before any tax would be due against your estate. As of 2021, the exemption was $11.7 million, and the top tax bracket was 40 percent. The important thing for you to know is that this exemption amount will expire at the end of 2025. On January 1, 2026, the exemption is scheduled to go back down to $5.49 million, adjusted for inflation.

In addition to the federal estate tax, there are 12 states that have state-level estate taxes. Oklahoma does not have a state estate tax .

What about income taxes?

The IRS does not generally looked at inheritances as taxable income. There are, however, proposals in Congress that could change this rule. Regardless, distributions of income generated by assets that are held in trust may be considered taxable income. Recipients of such income may be required to pay income tax on that amount.

How can I prevent my heirs from spending their inheritances too quickly?

One option is to use a revocable living trust to provide safeguards. You would create the trust and name yourself as the trustee while you are living. That way you would maintain complete management control of the assets every step of the way. When preparing your trust, you would name an individual or entity to act as successor trustee after your passing or if you become incapacitated.

Your successor trustee should be a person that you know and trust, such as a child who has financial experience. You can also designated a professional fiduciary such as a trust company or the trust department of a bank to act as the successor trustee. Similar to a last will and testament, your trust becomes irrevocable upon your death.

You can include a spendthrift clause in your trust so that your beneficiaries are not be able to directly access the principal assets of the trust. This would also apply to their creditors, so this clause would also offer your heirs asset protection.

You can also hold the assets “in trust” until your heir reaches 35 years of age. During that period, your trustee can pay them income and principal for things such as health, education, maintenance, and support. You could couple those discretionary distributions with mandatory distributions. For example, you might require your trustee to make a mandatory distribution of one-third of the trust principal at age 25, another at age 30 and the final at age 35.

With the provision for limited incremental distributions, the beneficiaries would not have too much money in their hands any one time. This will give your heirs some money, allow them to develop financial maturity, and prevent reckless spending. There is another advantage, creditors cannot reach assets that are in the spendthrift trust. They can only go after resources that have been distributed to your heirs.

What’s the most important thing that people tend to overlook?

The one thing that everyone should understand is that Medicare will not pay for long-term care. Most seniors will need some type of paid living assistance. More to the point, over one-third of elders will eventually require nursing home care. These costs can consume a significant portion of your legacy if you have to pay out of pocket, and for some, the expenses can consume everything you’ve worked so hard to accumulate.

Medicaid will cover long-term custodial care; however, you cannot qualify if you have more than $2,000 in eligible or countable assets in your name. Your home is not a countable asset for Medicaid eligibility purposes. To be eligible, you would need to plan ahead by conveying assets into an irrevocable, income-only Medicaid trust long before you actually need long-term care.

In this situation, you will receive the income that is generated by your trust but the assets would actually be owned by your trust. This is necessary because there is a look-back period of five years. This means that the assets have to be owned by your trust for five years before they are no longer counted as your assets for purposes of qualifying for Medicaid.

We hope you learned something useful during our flight time together.

Schedule a Consultation Today!

Once you are safely on the ground, if you are ready to have your own real-life conversation with an Oklahoma City estate planning attorney, we are here to help. We can gain an understanding of your situation and help you develop a custom-crafted plan that is ideal for you and your family. You can send us a message to request a consultation appointment, and we can be reached by phone at 405-843-6100.