Death-Bed Tax Planning: What to Include in Your Last Will and Testament (and More)

April 24, 2023
We discuss tax planning for the terminally ill or elderly, covering the basic necessities and more advanced techniques around death-bed tax planning.

Americans are both living longer and dying in higher numbers than ever before. Striving for old age is not always good, as many individuals move into a protracted incapacity. Due to advances in medicine and technology, people are managing terminal illnesses for longer periods. For example, the number of Americans living with Alzheimer’s is expected to more than double between 2020 and 2050, from over 6 million to nearly 13 million.1

Despite these sobering numbers, most individuals in the U.S. do not have a last will and testament or living trust, nor have they planned for their potential incapacity. Too many people wait until it is too late. Those who do so not only miss out on many of the tax and creditor protection benefits of sophisticated planning, but also leave their families with the difficult, time-consuming burden of estate administration without any direction.

Bar Chart of Americans Over Age 65. In year 2000, 35 million Americans were over the age of 65. In year 2030, the number of Americans that will be over the age of 65 is estimated to be greater than 73 million. In year 2050, the number of Americans that will be over the age of 65 is estimated to be greater than 85 million. Bar Chart of Projected Deaths By Year. In year 2000, the number of deaths was 1.7 million. It is estimated to be 3.1 million in year 2030, and 3.9 million in year 2050. The source is the United States Census Bureau.

Consider, for example, someone who dies intestate (that is, without a will) and without having discussed with family a plan for her real and personal property after death. Planning in advance can help alleviate a lengthy probate court process in which an unfamiliar judge appoints an executor of the decedent’s estate, the assets of which must be collected and reported due to legal requirements. This is only one of many jobs an executor is tasked with, yet imagine the difficulty in simply finding all the assets.

  • Did the decedent have a safety deposit box that someone knew about?
  • Did she have any outstanding loans payable by or to her?
  • Did she have an online brokerage account where she opted out of paper statements?
  • Were her email address and password readily accessible to determine whether she had such online accounts or other financial obligations?

The list of potential difficulties that may arise in simply finding the decedent’s assets is dauntingly endless.

Perhaps many who die without a plan pass away unexpectedly or too soon. However, an increasing number of individuals will likely at least have some warning, whether it be a significantly advanced age or a terminal illness diagnosis. This creates a planning opportunity, which can relieve some anxiety during a difficult time. Indeed, many calls Brown Brothers Harriman (BBH) receives regarding estate planning begin with some unfortunate and terrible news, followed by a sober, “What now?” While it’s important to address planning gaps if you’ve received a terminal illness diagnosis or are advancing in age, these tips can help anyone, young or old, healthy or ill, with planning before death.

The Basic Necessities

The starting point for creating a plan for the terminally ill or those of advanced age is to put into place some basic estate planning documents. These include the following:

This legal document, which in most states must be signed by the testator (that is, the person making the will) in the presence of at least two disinterested witnesses (consult your attorney), disposes of an individual’s real and personal property (with some exceptions for non-probate property, discussed later); names an executor to manage one’s estate, which includes the filing of a final income tax return and estate tax return; and, importantly for those with young children, nominates guardians of minor children when the testator passes away. Trusts created under a last will and testament are referred to as testamentary trusts and come into existence only at death. 

Also called a revocable trust, a living trust may be established in conjunction with a last will and testament. In most cases, the last will and testament would direct the executor to deliver the decedent’s property to the trustee under the living trust, who would then dispose of the property in accordance with the terms of the living trust. In this respect, a living trust is referred to as a “will substitute” because the terms of the living trust, rather than the will, direct final disposition of the assets. A living trust offers privacy (a will, in contrast, is a public document) and often reduces or eliminates unnecessary costs and administrative burdens. If the creator of the trust transfers his or her assets to the trust before death, those assets will become “non-probate” property and will avoid the probate process entirely.

This document names an agent or agents who can act on an individual’s behalf when making certain delineated financial decisions. Some states allow the agent to act at any time, while others allow the agent to act only when the maker becomes incapacitated. Generally, an agent’s powers should be broad and potentially include the power to conduct additional estate planning in the event of the maker’s incapacity.

This set of documents outlines an individual’s medical wishes in various states of medical incapacity and names an agent to make healthcare decisions on one’s behalf.

In addition to assets held in a living trust, there are a few other types of property that pass outside the probate process and are not governed by a last will and testament. These include assets that pass by beneficiary designation, such as insurance policies and retirement accounts, and property titled jointly with rights of survivorship (usually real property or financial accounts). Beneficiary designation forms and title to real property and financial accounts should be reviewed to ensure they are consistent with the overall estate plan.

Individuals who have any of these documents already in place should consider reviewing them if diagnosed with a terminal illness or as they reach an advanced age to ensure they still align with their wishes. All too often, many documents were put in place some time ago and no longer make sense. For example, it is common that an ex-spouse or deceased sibling is named in a document or beneficiary designation form.

As part of this review, one should also consider creating a list of assets, including financial accounts, where each account is held, and a contact person at each institution. At BBH, we often compile this list into one organized book with our clients’ help. 

Finally, individuals should consider their wishes for funeral arrangements and, if their state allows, execute a disposition of remains document that lists their wishes and names an agent to carry them out. Simply getting these basic documents in place will ensure that one is well ahead of the curve.

Tax Planning for the Terminally Ill

Because the federal gift and estate taxes are a unified system of taxation, most substantial gifts made just before death will have no effect on the federal estate tax owed at death. A gift during life will reduce the lifetime basic exclusion amount – the amount that may pass free of gift and estate tax – available to the estate, resulting in the same net estate tax owed.2 Annual exclusion gifts are a notable exception. A dying individual may make gifts up to the annual exclusion amount ($17,000 in 2023) to as many individuals as she wishes. An individual with three married children and seven grandchildren, for example, could gift up to $221,000 this year to her children, children-in-law, and grandchildren, saving up to $88,400 in federal estate taxes. 

However, if you reside in one of the 17 states or the District of Columbia that imposes a separate state-level estate or inheritance tax, gifts made just before death may be an effective step to reduce state-level estate and inheritance tax liability.3 Most of these states do not impose a gift tax. Therefore, gifts made before death do not reduce the amount that may pass free of state-level estate or inheritance tax. The more gifts, the smaller the estate, and the lower the estate or inheritance tax burden.

There are a couple exceptions. First, Connecticut. Connecticut is the only state that imposes a gift tax. Connecticut’s system works much like the federal system, with both a gift tax and an estate tax. Gifts made during life reduce the amount that may pass free of Connecticut gift and estate tax.4 This means that for residents of Connecticut, most gifts made just before death will have no effect on the Connecticut estate tax owed at death. 

The second exception are states that add the value of certain gifts made during life to the value of the estate for estate tax purposes.5 This is referred to as a “clawback.” In 2023, three states have a clawback: Maine, Minnesota, and New York. The amount that may be clawed back is determined based on the time lapsed from the date of the gift to the date of death. In Minnesota and New York, gifts made within three years of death may be clawed back and added to the value of the estate for state estate tax purposes. In Maine, the timeframe is one year. A clawback can put the donor’s estate in a worse position than if no gift had been made. If a gift is clawed back, the donor’s state estate tax liability may be greater than if the donor simply had not made the gift.

The federal estate tax system also has a clawback, but only for certain types of gifts. Two notable gifts that may be clawed back are life insurance and gift taxes paid. If a donor transfers a life insurance policy as a gift within three years of death, the value of the policy will be included in the donor’s estate for estate tax purposes. This clawback rule is not triggered if the donor instead sells the policy for full and adequate consideration. A donor who may not survive three years should consider selling the life insurance policy (perhaps to a trust) instead of transferring it as a gift. Care should be taken in valuing the policy to determine the purchase price (consult your attorney). 

Another gift subject to clawback under the federal regime is the amount of gift taxes paid within three years of death. If a donor gives gifts during life above the basic exclusion amount, she will owe gift tax. Paying gift tax can be an effective estate planning tool because the money used to pay the tax is not itself subject to tax. In contrast, money used to pay estate tax is itself subject to tax. The Internal Revenue Code (IRC) contains a provision to circumscribe one’s ability to benefit from this discrepancy for gifts made close to death. The IRC directs that the amount of gift tax paid on gifts made within three years of death be added to the value of the estate for estate purposes, eliminating the value of paying gift tax on last-minute gifts.  

After considering the foregoing, it may still make sense to give gifts of assets the donor believes will rapidly appreciate. Any subsequent appreciation after the gift is made will not be subject to gift or estate tax. However, the potential estate tax savings of the gift must be weighed against a potential increased income tax liability in the hands of the recipient. Income tax liability is triggered when property is sold at a price higher than the taxpayer’s tax basis in the property. At death, the tax basis of property owned by the decedent is adjusted to fair market value as of the date of death (or six months after the date of death if the alternate valuation date is used). If the estate immediately sells an asset for fair market value, there would be no recognized gain and no income tax liability because the sale price equals the tax basis. In contrast, however, when property is given as a gift, the recipient takes the donor’s tax basis in the property. If a donor gives low basis property before death, and the recipient later sells the property, the recipient’s income tax liability may be greater than the estate tax savings generated by gifting the property before death. This is especially true if the property does not appreciate significantly before death. It may be preferable from a combined estate and income tax liability standpoint to die owning the property rather than hoping for rapid appreciation close to death.

The IRC also prohibits attempts to “game” the basis adjustment rules at death. The rule disallows inheritors to receive the benefit of an adjusted basis if they gifted the asset to the decedent within the last year. For example, if Jack buys XYZ stock for $10 per share and dies five years later when the stock is valued at $100 per share, the cost basis of $10 per share is adjusted to the fair market value at death of $100 per share, effectively wiping out the stock’s built-in capital gain. This is a boon for inheritors, since the asset’s associated income tax bill is eliminated. However, if Jack’s wife, Diane, gifts the XYZ stock to Jack less than one year before he dies, and Diane inherits the asset back under Jack’s will, no step-up in basis is allowed.  

These rules can create some challenges for those with limited time remaining. However, several potential tax strategies are still available. For example, if there are assets with significant built-in losses, it may make sense to sell the asset to realize the loss rather than wait until death. While the basis adjustment rules often are referred to as the “stepped-up” basis rules (thanks to the indomitable hope for a never-ending bull market), they can in fact work to adjust the basis downward for assets with built-in losses. This means an inheritor does not get the benefit of claiming the loss on her income tax return. Therefore, it may be best to have the donor realize these losses and use them to offset other gains in her portfolio. Alternatively, a gift of the asset could be made to the surviving spouse (as long as the donor spouse does not receive it back within one year), who could then choose to hold or sell the asset and then claim any subsequent gain or loss on her own return.

Retirement Accounts

Finally, there could be potential planning options with retirement accounts for the terminally ill. A traditional IRA or similar retirement account that is taxable when distributions are made can be converted to a Roth account, which is not taxable when distributions are made. The downside is that the conversion from a traditional IRA to a Roth IRA is a taxable event, meaning that the plan owner must pay income taxes on the full value of the plan’s assets.  

However, the potential upside could outweigh the upfront cost for a couple of reasons. First, assets outside the traditional IRA can be used to pay for the conversion, reducing the plan owner’s taxable estate. Second, the conversion allows heirs of the Roth account to continue to receive tax-exempt withdrawals. This may be especially effective if the IRA owner is in a lower tax bracket than the IRA beneficiaries. The overall tax liability should be lower because the conversion is subject to tax at the IRA owner’s lower tax rates, rather than the beneficiaries’ higher rates. In short, a one-time estate-reducing tax payment can effectively eliminate the income taxability of the entire retirement plan for many years to come, creating a boon to both the plan owner and his heirs.

Despite the IRC’s efforts to curtail so-called death-bed planning, many opportunities still abound. Of course, it is highly recommended to do as much planning when of sound mind and in advance as possible, but should you or a loved one require any last-minute planning, please do not hesitate to contact a BBH relationship manager or wealth planner.

Up Next
Up Next

A Letter to My Trustees: Using Values to Influence Discretionary Trust Distributions

Adrienne Penta, executive director of the BBH Center for Women & Wealth, and Nicole Jackson Leslie, senior wealth planner, explore how a donor can guide a trustee, even after a trust has been created, to help ensure the trust is used to support and perpetuate a family’s core values for generations to come.

1 Alzheimer’s Association.

2 In 2023, the federal basic exclusion amount is $12.92 million per individual, reduced by gifts made during life.

In 2023, Connecticut, the District of Columbia, Illinois, Maryland, Massachusetts, Maine, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington impose an estate tax. Delaware, Iowa, Kentucky, Nebraska, New Jersey, and Maryland impose an inheritance tax.

In 2023, the Connecticut gift and estate tax exemption matches the federal basic exclusion amount of $12.92 million. 

Annual exclusion gifts are not subject to this rule.

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