How Estate Planning Works

The goal of a good estate plan is threefold: to distribute your assets where you want them after you die, to make sure your heirs don't have to pay exorbitant taxes on their inheritance and to ensure that a person you trust will be able to manage your affairs if you're alive but unable to make decisions.

Wills are a very important part of any estate plan, and it's important to make one no matter how many assets you have. Everyone owns something of value or something of sentimental importance to their heirs, and making a will ensures that these are distributed fairly and without delay. Also, wills are not only a way to distribute possessions. If you have children, your will is the best place to name guardians for them.

If you die intestate -- without a will -- the state court decides which of your surviving relatives gets what, regardless of what you wanted. Even if you made your wishes clear while you were alive, unless you put them down in a legally binding will, it's likely that they will not be observed. This can have very messy consequences with regard to child custody issues, as well as the distribution of assets. You may want your best friend to be the legal guardian of your child and to inherit most of your money, for example. But even if you have discussed this with your family and best friend, if you die intestate, it's more likely that one of your nearest blood relatives will be chosen as guardian, and your money distributed among your family.

Making a decision about power of attorney is at least as important as making a will, because it affects you while you're still alive. The person you choose is called your agent and needs to be someone who you can trust completely, and who understands what your wishes are and agrees to carry them out. You don't have to be incapacitated to give someone power of attorney. For example, many people make a spouse their agent so that this person can manage their finances while they're out of town. If you want someone to be able to make decisions for you when you're incapacitated, you need to give them durable power of attorney. Otherwise, it actually goes out of effect as soon as you are incapacitated.

Medical power of attorney functions just like financial, but involves medical issues. Whoever you choose as your agent for this kind of power of attorney needs to understand your wishes and philosophy about the means taken to prolong your life. For example, if you're in a coma and it's unlikely that you'll come out of it, your agent can decide whether or not to keep you on life support. It's also very important to discuss your views on these kinds of issues with your doctor before you become ill.

Read on to find out about trusts and how to reduce taxes on your estate.

Depending on your financial situation, setting up a trust can be the best way of handing down assets. Trusts are not just for the very wealthy -- they can be advantageous for anyone with an estate worth $100,000 or more. The main reasons people set up trusts are to avoid high tax rates and the cost, delays and publicity associated with probate court, the court that handles wills.

Everyone wants to avoid probate proceedings if possible. Estates worth more than $100,000 are usually subject to probate under state law, and the probate process typically ends up costing 2 to 4 percent of the estate's total value. This money goes to court and legal fees, because the executor of the will has to catalogue the dead person's property, pay any debts and taxes, and then prove the validity and legality of the will in court before he can distribute property to the heirs. Probate is also slow. The courts are always busy, and there can be delays of a year or more before the heirs receive anything.

Trusts avoid probate entirely. Once you set up a trust, all the assets in the trust are considered separate from you and owned by the trust. The trust involves three parties:

The grantor can be either an individual or a couple, and it's even possible for the grantor and the trustee to be the same person. The majority of trusts are living trusts, or trusts that are set up while the grantor is alive. You can put all kinds of assets into a trust, including savings accounts, stocks, bonds, real estate and personal property.

Trusts are most cost-effective with estates worth $1 million or more. The taxes on these estates can be extremely high if they're handled through probate. On estates worth more than $4 million, taxes reach 46 percent [source: Savewealth.com]! This percentage is the gift tax demanded by the government, and it becomes even higher if you will money to your grandchildren instead of your children.

Another good way of minimizing taxes on your estate is by making gifts called inter vivos to your heirs while you're still alive. One person can give up to $12,000 a year to an individual free of tax, and married couples can give $24,000.

It's possible to change a will and update an estate plan whenever you want. For most estate planning, you need the help of a good lawyer, which means there are costs involved. Making a basic will typically costs between $300 and $2,000, and making a basic trust plan generally costs between $1,600 and $2,300 if you are single, and between $1,800 and $3,000 for couples. Trust plans also include the drafting of a will.

There's no avoiding death. But with careful planning, you can keep the financial repercussions of your death from being painful to your loved ones. You can start with the information and resources listed on the next page.