Transfer-on-death accounts can help you avoid having your assets go into probate. They aren't, however, sheltered from taxes. You pay income and capital gains taxes on them when you're alive and, when they transfer to your heirs, they're subject to the same estate tax rules as any other account.
When you set up a transfer-on-death account, you give your account administrator the name of the person that should receive the account after your death. When you die, it automatically passes to that party. You can also set up joint accounts with rights of survivorship or "tenants by entirety" accounts that automatically pass to the second account owner if the first one dies as well. It's even possible to combine both so that when you die, the account goes to the joint owner and when she dies, it goes to the beneficiary.
Because the account administrator handles the transfer directly on your behalf, it avoids probate. The money simply gets transferred as an administrative matter. However, if your beneficiary already has died, and you hadn't specified a backup beneficiary, the account could still end up going through probate. In addition, TOD accounts are like other estate planning tools that avoid probate, but don't avoid estate tax. Because the money is yours until you die, it's considered a part of your taxable estate. Bear in mind, though, that as of 2013, your first $5.25 million of estate value passes to heirs tax-free.
One way to get the core benefit of a TOD account and shelter at least a portion of your estate from tax is to transfer assets before you die. The IRS allows you to gift a certain amount of money every year on a completely tax-free basis. For 2013, you can give $14,000 to someone without incurring any gift tax liability or even having to file a return. Your spouse can do it too, letting you gift $28,000. This protects your money from tax and also ensures that it doesn't go through probate because the recipient gets it before you die. You also get to see the recipient enjoy the money.
If you want to wait until you die to transfer money, want to have your wishes respected, and don't want it to be subject to estate tax, you can set up an irrevocable trust. Once money goes into an irrevocable trust, it stays there, but it won't be subject to estate taxes. In addition, the trustee will have to follow your wishes as you define them in the trust document. Bear in mind, though, that transfers to an irrevocable trust are taxable if you go above your lifetime gift limit, which is $5.25 million in 2013. (ref 3)
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