Too many married couples are making a big mistake. They believe current estate tax law exempts them from having to plan or consider estate tax implications in their Estate Planning strategy. That misunderstanding could lead to problems. While the estate tax law enacted in early 2013 has many benefits, you need to know how to maximize them.
Two provisions greatly help married couples easily pass significant wealth to their loved ones. Most families will avoid any federal estate tax because of them.
The first provision is the lifetime estate and gift tax exempt amount. The exempt amount was set at $5 million (indexed for inflation) for each person. The inflation indexing fixes it at $5.43 million in 2015. The exempt amount allows each person to transfer up to $5.43 million to others free of estate and gift taxes. The exemption can be used during your life through gifts, through your will, or through a combination of both.
This exempt amount is in addition to the annual gift tax exclusion that is set at $14,000 for 2015. It also is in addition to the unlimited tax-free gifts for qualified education and medical gifts. So, with proper planning a person can transfer free of estate and gift taxes far more than $5.43 million.
The second provision is known as the portability rule. Under the old law, the lifetime exempt amount was a use-it-or-lose-it asset. When an individual’s estate and gifts weren’t enough to fully use his or her lifetime exemption, the unused amount expired. No one else could use it. It was important for many married couples to ensure each had sole title to enough assets to use all or most of the exemption. That prevented part of one spouse’s exempt amount being unused when the other had assets exceeding the exempt amount.
Equalizing ownership isn’t as important with portability. Now, when one spouse dies without using all of his or her exempt amount, the unused amount can be transferred to the surviving spouse. That gives the surviving spouse his or her own exempt amount plus the unused amount of the other spouse. Under portability, a married couple truly can transfer $10 million ($10.86 million in 2015) free of estate and gift taxes.
Portability makes most couples believe they don’t have to worry about maximizing the use of the marital deduction.
When a person gives or leaves property to his or her spouse, the transfer qualifies for the unlimited marital deduction. It avoids gift and estate tax liability. Since the marital deduction is unlimited, a person can leave the entire estate to the surviving spouse and avoid estate tax issues. In addition, since the first spouse’s full exempt amount is transferred to the surviving spouse, that spouse can pass a full $10.86 million to the next generation tax free.
So, what’s the problem with using the marital deduction?
A potential problem is that portability of an unused exempt amount is not automatic. The executor of the estate of the first spouse to pass away must elect to transfer the unused exempt amount to the survivor. That means filing an estate tax return even when one isn’t required by the tax law. If the executor doesn’t know this or fails to do it, the unused exempt amount is lost.
When someone has more than one deceased spouse over his or her lifetime, only the exempt amount of the last deceased spouse can be used by that person’s estate. That means if your surviving spouse remarries, your unused exempt amount won’t be available if your spouse also survives the subsequent spouse.
Also, a price of portability is the estate of the first spouse to pass away is subject to audit until the audit period for the second spouse to pass away has closed. Plus, the carried over exempt amount from the first spouse to pass away is not indexed for inflation. It’s a fixed dollar amount, regardless of how long the surviving spouse lives. So, it might not be worth as much when the surviving spouse passes.
There are other reasons not to rely solely on the marital deduction and portability.
You won’t have any control or influence over how the property eventually is distributed. Your spouse could re-marry, develop an interest in a new charity, or be unduly influenced by someone in later years. The result is your property could end up with people or organizations you had no knowledge of or interest in.
This is especially important for those with children from a previous marriage. You might intend to provide for your spouse and have some or all of any remaining wealth go to your children from the previous marriage. That might not happen if you use the marital deduction to leave all or most of your estate to your spouse. Or your spouse might have children from a previous marriage. Your spouse could leave more of your wealth to them than you intended.
Leaving property outright through the marital deduction also can put the wealth at risk from potential creditors of your surviving spouse or from a subsequent spouse or others. Your spouse might not be prepared to assume the burden of managing and caring for the property. Also, some spouses aren’t able to say “no” to their children and depend on the other for that. When the tough parent passes away, there’s no one to protect the property.
It’s also possible the assets will appreciate faster than the exempt amount. The exempt amount increases with the Consumer Price Index, which has had low growth in recent years and about 3% for the long term. The value of your assets could increase faster, leaving your spouse with a taxable estate after some years of compounded growth.
Keep in mind that more than 20 states still have estate or inheritance taxes or both, and their exemptions usually are less generous than the federal amount. You might need to do some tax planning if you live in one of these states, even if you’re exempt from federal taxes.
There are remedies for these and other risks. They involve doing more than taking advantage of the marital deduction and exemption portability. Under each of these strategies, your will transfers some or all of your estate to a particular type of trust or trusts. The trusts used depend on your situation and concerns.
Marital trust. The primary beneficiary is your spouse. The trustee will distribute all of the income and principal needed to maintain the surviving spouse’s standard of living.
The trustee will manage the property, which solves a problem when your spouse isn’t prepared for that task. The trust also protects the property from creditors, pleading children, and others. You can either designate who will receive the remaining trust property after your spouse passes away or give the spouse the right to appoint the final beneficiaries.
There are disadvantages. When the children eventually receive property from the trust, the tax basis won’t increase the way it would if your spouse inherited the property and the children inherited from him or her. There also will be costs of creating and maintaining the trust. Also, your spouse might not like asking the trustee for money when needed. The marital trust will be protected by your lifetime exempt amount but won’t qualify for the marital deduction.
Bypass trust. The typical bypass trust pays the surviving spouse its income for his or her life and also allows the trustee to dip into principal when it is in the best interests of the surviving spouse. After the surviving spouse passes away, whatever remains in the trust goes to your children or other beneficiaries you named.
The bypass trust doesn’t qualify for the marital deduction. Instead it is protected by your lifetime exempt amount. As with the marital deduction trust, the basis of assets won’t increase when they are distributed from the trust to the children. They’ll take the same tax basis the trust had in the assets.
QTIP trust. The qualified terminal interest property trust must meet special requirements. The income beneficiary must be your surviving spouse and must receive all income earned by the trust at least annually for the rest of his or her life. You can allow the trustee to dip into principal for spending needs. You also designate who receives the remaining trust property after your spouse passes away.
The unique effect of the QTIP trust is that it qualifies for the marital deduction in your estate. It passes tax-free to your spouse without using any of your lifetime exempt amount. The potential downside is that the trust value eventually is included in your spouse’s estate, which is the same tax result as if you’d left the property directly to your spouse.
Many of you shouldn’t rely too much on the marital deduction and portability of your exempt amount. Sure, that would eliminate federal estate and gift taxes, but it could create other problems as I outlined. Most of you probably want to use a combination of the marital deduction, your exempt amount, portability, and one or more of these trusts. You might use other tools if you own a business or have other special factors in your estate.
Work with your estate planner to decide how much to leave outright to your spouse, in one or more trusts, and outright to your children or charity. You know now that federal estate tax implications are only one consideration. With most people not having to worry about federal taxes, there are other important considerations.
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