Monday, June 13, 2011

Q&A Series: Estate Planning under the Tax Relief Act of 2010

Marge and George are trying to get their estate documents in order, and they have some questions about how to title their assets to be of the greatest benefit to their estates.

Q: I’m proud to say that we’ve been financially diligent over the years, accumulating a moderate amount of assets. We’re now in the process of updating our estate documents. Do you have any suggestions for how we should title our assets? Our old documents are very complicated, with each of us having trusts. Is this still necessary?

Good for you for being such industrious savers, Marge and George! It looks like all your hard work has paid off. I’m glad to see that you’re being just as conscientious about making sure your estate is in order. I can’t tell you how many times I’ve seen negative estate tax implications and probate issues arise because proper estate planning was not accomplished.

Since the Tax Relief Act of 2010 was enacted, we’ve been reaching out to clients with enough assets to worry about the estate tax about the importance of reviewing and updating their estate documents (or creating them if none are currently in place). Based upon the tax simplification this legislation provides, most of our clients have found that it’s time for an estate planning tune-up.

The Basics

The amount a taxpayer can leave to heirs free of federal estate and gift tax is known as the applicable exclusion amount. Over the years, the exclusion amount has increased from $600,000 in the 1980s to $5 million in 2011 and 2012, with married couples being allowed to leave $10 million estate tax free since each spouse is granted a separate exclusion. In the case of a decedent’s death on or after January 1, 2012, the basic exclusion amount will be indexed for inflation.

In prior years, it was important for the assets of a married couple to be titled in each spouse’s individual name and not in the joint names of the married couple. While this may seem counterintuitive, it was the only way to ensure that each estate could benefit from using both exemptions since an exemption could not be shared. In other words, regardless of which spouse died first, you wanted to make sure there were enough assets in that spouse’s estate to fully utilize the exemption.

Under the old law, it was also important for married couples with significant assets to establish marital trusts under their Last Wills & Testaments as a way to ensure that the estate or gift tax exclusion amount for the first spouse of a couple to die could be preserved and passed along to the surviving spouse. I am one of the many people who complained that these requirements were overly complicated. Simply put, the tax code needed to be simplified to allow a married couple to share their exemptions – regardless of which spouse died first and how the assets were titled. This concept is commonly referred to as portability.

And so, with the passage of the Tax Relief Act of 2010, portability was finally enacted for the 2011 and 2012 tax years. This means that for the estate of a spouse who dies at any time during those two years, the remaining exclusion amount in his or her estate will directly pass to the estate of the surviving spouse for both estate and gift tax purposes.

The law doesn’t change the fact that you are allowed to make unlimited gifts to your spouse, in life or through your estate plan if he or she is a U.S. citizen, with no tax applied. But until the legislation was passed, if proper documentation was not in order, anything above the exempt amount that was not going to charity would be taxed upon the death of the second spouse.

How Portability Works

Let’s say a married couple’s assets are titled jointly, and that they have a total net worth of $8 million. Under this scenario, if the husband dies in 2011 (and he hasn’t made any taxable gifts in prior years) he won’t need to use any of his $5 million estate tax exemption since all the assets are titled jointly and the unlimited marital deduction allows him to transfer his share of the joint assets to the wife without incurring any federal estate taxes.

Then, if the wife dies in 2012 and her estate is still worth $8 million, the husband’s unused $5 million estate tax exemption will be added to the wife’s $5 million exemption. The result is that the wife’s estate will receive the full $10 million exemption, and her $8 million estate won’t owe any federal estate taxes at all.

Prior to the enactment of the Tax Relief Act of 2010, the husband’s unused applicable exclusion would have been lost if the assets were titled jointly and no marital trusts were in place. Without the portability provision, at the time of the wife’s later death, she would only be able to pass on $5 million of her total $8 million estate free of federal income taxes. And with today’s estate tax rate of 35%, the wife’s estate would owe $1,050,000 upon her death.

One important caveat is that portability is not automatic. To get the husband’s unused exemption, the husband’s executor would have to file a federal estate tax return on which the unused portion is calculated and allocated to the wife. Without this filing, the wife’s estate would be unable to take advantage of the portability provision.

Besides the obvious tax advantages, another major advantage of the portability provision is that, for the most part, it makes marital trusts unnecessary for preserving the federal exemption amount. Accordingly, it would be unnecessary to go through the hassle of probating a marital trust, which is often a complicated ordeal.

The Controversies

While many estate planners argue that portability isn’t a good enough reason to revise estate plans that are already in place, I tend to disagree unless a couple has a combined estate greater than $10 million. I’ve heard several comments from legal professionals that dealing with marital trusts is not a problem. My feeling is that it’s often difficult for a grieving spouse without any financial training to deal with probate issues concerning trusts, the passing of assets and other issues that must be addressed through probate.

Furthermore, the portability provision was designed to simplify small estates and excludes the vast majority of estates from having to go through probate and file estate tax returns. By allowing married couples to combine their exclusions up to $10 million via portability, a high percentage of all U.S. estates will be excluded from being required to file an estate tax return.

It’s true that the portability provisions may not be continued after 2012 and that the law will revert back to pre-Bush era provisions if not extended. But my opinion is that there’s a very slim chance portability will be done away with entirely. You may recall that Congress couldn’t agree on any tax changes before the Bush-era tax cuts were set to expire at the end of 2010. Because of rushed negotiations and some horse trading in Congress, the new estate tax laws were based on the existing $5 million exclusion and 35% tax rate. At the time, President Obama was pushing for a $3.5 million exclusion with a 40% beginning incremental tax rate. But instead, President Obama comprised and agreed to a two-year extension of the Bush-era tax cuts.

Since the subject of estate taxes is so important to wealthy donors, my personal opinion is that there is little chance that the estate tax provisions will not be extended in some form similar to the current legislation. With the Republican-controlled House, and with the potential for Republicans also gaining control of the Senate in the next election, I think it’s possible for portability to become permanent. It would not surprise me to see the exclusion decrease to $3.5 million and the tax rates increase, but even so, I believe the portability provision will remain in effect.

Nevertheless, several states have their own estate taxes without portability clauses, most with exemptions capped at $1 million or less. For residents of those states, utilizing marital trusts to preserve their state estate tax exemption is a wise choice. You can check with your tax professional or Rollins Financial to find out if your state has its own estate tax and whether or not it contains a portability provision.

Thanks so much for your questions, Marge and George. As I’ve stated before, it’s important to fully evaluate your particular situation when making estate planning decisions. There are other issues regarding portability that complicate matters, like what happens if the surviving spouse remarries. It would be impractical to cover all of the “what if…” implications in this post, but I am always happy to discuss case-by-case scenarios with readers or clients personally. As I’ve said in the past, it’s important to consult with a financial adviser when developing your estate plan, and in that regard, Rollins Financial is here for you.

We encourage our clients and readers to send us questions for our Q&A series at And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Joe Rollins

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