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Death and Taxes: Five Things You Need to Know

Scott Rothbort

Benjamin Franklin was quoted as saying, "In this world nothing is certain but death and taxes." Unfortunately, society places upon us many legal and financial responsibilities associated with death. However, with proper planning, you can make the outcome of death -- from a legal and financial perspective -- more tolerable. I will now share with you some actionable ideas that will help you prepare for the certainty of death and taxes for a loved one or yourself.

Before I begin, please be aware that none of the following should be deemed to be direct legal or tax advice. For this, consult with qualified legal and tax professionals.

1. Start Funding Your Retirement Now

I have a saying about Social Security. It is that the contributions by individuals to the program are non-tax deductible charitable contributions. In other words, we cannot rely on Social Security to finance our retirement. Four reasons why: our population continues to outlive the Social Security Administration's earlier actuarial (statically probable) assumptions, thus pushing out the age of eligibility; the returns on Social Security consistently underperform alternative investments and will continue to do so unless participants (you and I) can elect to invest in a broader class of assets , such as index funds ; and Social Security is double taxed -- first when we earn the money and second when we receive payments in retirement.

That said, you need to prepare for retirement on your own and as early as possible. How: you want to do so in tax-efficient plans that the Internal Revenue Service (IRS) has made available to all of us. These plans are far superior to the antiquated and unreliable Social Security system. They include Individual Retirement Accounts (like traditional IRAs, Roth IRAs and SEP-IRAs, which vary as to current tax deductibility and future tax nature of withdrawals) and employer sponsored plans, such as 401(k) (for-profit employer sponsored plan) and 403(b) (not-for-profit employer sponsored plan).

Not only do such plans have the ability to defer income, they can also act as a form of life insurance. For example, my mother was able to build her IRA over time, withdraw from the account to provide income and after her passing it will now be left to her beneficiaries, which were designated to be her surviving children.

As a designated beneficiary, I can elect to take my portion in cash and pay taxes now or roll-over the account into a beneficiary IRA A beneficiary IRA allows me to continue to invest the proceeds of the original IRA, thus generating long term growth and income with the provision that every year I must take out a "minimum required distribution."

To learn more about IRAs, check out the IRAs section on TheStreet.com.

2. Purchase Contingent Put Bonds

Years ago investors purchased estate anticipation bonds -- more commonly known as "flower bonds" -- to help pay for federal estate taxes (which I explain in greater detail below). These bonds were purchased at discount (less than 100 cents on the dollar) to par value (full maturity value or 100 cents on the dollar) and would mature at par value upon the death of the holder. However, the last flower bond matured in 1998. In its place, an investor may purchase contingent put bonds through their registered broker . I suggest using a broker that has a large inventory of such bonds.

These bonds may be put to the issuer in the event of the death of the holder of the securities . A put is an option (see put option ) granting the holder the right to sell. However, there is no free lunch. A contingent put bond may be subject to the following conditions:

The yield on these bonds may be less than that of bonds without the put feature.

The face value (maturity value) of the bonds may be considered the value at death, boosting up the value of the estate for tax purposes. If this is the case, then the good news is that there is no capital gain when putting the bonds. As always, this is subject to interpretation by one's legal and tax advisors.

3. Have Life Insurance

My father passed away when I was 16-years-old. While he worked in the life insurance industry he had no life insurance, other than that provided by his employer.

Life insurance is a contract between the insurance policy owner and an insurer. Under the terms of the policy, the insurer agrees to pay a sum of money to the policy owner's beneficiary (or beneficiaries) of the policy upon the death of the insured.

The two most popular forms of life insurance are "whole life" and "term life." Whole life is permanent in nature, if paid fully over a period of time. Whole life is very expensive but accumulates a cash value. On the other hand, term life provides coverage for only a specified period of time and it is comparatively inexpensive, but no cash value accrues to the benefit of the policy owner.

My father died three months after purchasing his first home with my mother. However, because of his pre-existing medical condition he was not eligible for private mortgage insurance , commonly referred to as PMI. PMI is a form of term life insurance, which a mortgage lender will require a borrower to contract for to insure payment of the mortgage in the event of the death of the borrower. Needless to say, I learned the importance of life insurance after my father left my mother and her three children in a new home with a mortgage and no life insurance.

I started to purchase life insurance for both my wife and myself once we had our first child. Every few years I would buy another incremental policy for one of us as we could afford to do so. Here we are now nearly 18 years after our first policy, we now have five children and a great deal of our life insurance is permanent in nature and fully paid for.

The lesson here is to buy as much life insurance as you can at an early age when it is cheaper and you are still insurable. (Life insurance requires an underwriting process that includes a physical or other medical tests and examinations.).

To learn more about life insurance, check out the Insurers Screener on TheStreet.com.

4. Be Tax Savvy

The tax laws surrounding death are very complex. While a qualified estate attorney and tax professional can help to structure one's estate, there are some very simple steps that you can take in advance of one's death:

According to tax regulations, the original cost amount (purchase cost value)of securities when passed to an estate's beneficiary is stepped up to the market value on the time of death of the decedent. This is referred to as a step-up in cost basis. Thus, if a loved one is close to death, it pays to sell any securities that have an unrealized loss prior to their death in order to deduct those losses on their last tax return.

On the other hand, if the loved one had unrealized gains, it pays to hold those securities, because the cost basis of those holdings will receive a step-up in basis. This is only important if the assets pass through the estate. If the securities are held jointly such as a Joint Tenants with Right of Survivorship (JTWROS), then this is not an issue until the survivor dies.

Both the federal government and many states have estate taxes. The federal estate tax is commonly referred to as the "death tax" and it is the subject of great political debate. While an estate might not be subject to federal estate taxes, it may be liable for state estate taxes. Using one's legal and tax professional may help to minimize estate tax liability through a properly structured will and trust .

5. Have a Properly Executed Will

Dying without a will is referred to as "dying intestate." When an individual dies intestate then the estate (an entity set up to hold the decedent's property) must go through the process of probate (the legal process of settlement of the estate within the courts). This process will not only be lengthy and costly but could result in individuals receiving all or a portion of the estate whom the decedent may not have wanted to designate as a beneficiary.

Furthermore, estates which are intestate are likely to see the state take a larger portion of the estate than had the decedent died with a valid will The lesson here is to make sure that you prepare for death early, by executing a valid will.

Please note that as laws may vary from state to state and with the complexity of estate law, I strongly urge you to closely review your estate and have your will prepared by an estate attorney.

These outlined five steps are good starting points, but there is a multitude of actions that you can take in advance of the death of a loved one or in preparation of your own death. Being proactive will maximize the amount of money passed to your heirs and minimize the legal issues and taxes that may occur after death. And in order to help you navigate the maze of estate-related laws and regulations, be sure to utilize legal and tax professionals, where necessary.

Finally, don't delay. Time really is of the essence -- whether in purchasing life insurance or taking actions close to death. Learn to separate the emotional aspects of dealing with the illness or pending death of a loved one from the financial responsibilities and opportunities which are thrust upon you.