By Deborah L. Jacobs
The sweeping tax overhaul that President Obama signed Dec. 17, raising the exemption from federal estate tax to $5 million a person, includes a wonderful new break for widows and widowers. Starting in 2011, they can add the unused estate tax exemption of the spouse who died most recently to their own. This dramatic change enables spouses together to transfer up to $10 million tax-free. It also eliminates the need in many cases for the tax-planning gyrations that lawyers routinely recommended to preserve each spouse’s estate tax exemption amounts.
Portability, as tax geeks call it (though that term does not actually appear in the new law), was a surprise goodie. Various estate tax bills proposed in Congress over the years would have permitted it. Many people favored it. But it seemed to be off the table until it resurfaced in the bill Senate Majority Leader Harry Reid, D-Nev., introduced following the Obama-Republican compromise.
The law doesn’t change the fact that you can give an unlimited amount to your spouse, during life or through your estate plan (provided she or he is a U.S. citizen) with no tax applied. But until now, without proper planning, when the second spouse died anything above the exempt amount not going to charity would be taxed. In other words, the first spouse’s exemption would be lost. Bypass trusts (also called family trusts) addressed that problem.
Here’s how these trusts work: When the first spouse dies, the trust is funded with up to the tax-free exemption amount. The trust distributes income and principal to the survivor or other family members (usually the couple’s children) while the surviving spouse is alive, then passes on whatever is left to family. Funds in the bypass trust are covered by the exemption amount and are not taxed when the first spouse dies. Nor are they considered part of the survivor’s estate, so they are not subject to tax when she dies.
All this is still true, but portability makes it unnecessary for spouses to use bypass trusts solely to preserve the federal exemption amount. However, 15 states and the District of Columbia still have their own estate taxes, and most have exemptions of $1 million or less. None, as of now, have any portability provisions. That means residents of those states may still want to use bypass trusts to preserve their state estate tax exemptions. (For a map showing the state estate taxes for 2011, click here.)
As with any new process there will be a shakeout period. Portability takes us into uncharted waters, raising financial planning opportunities and potential pitfalls that are new to us all. Here are answers to what are likely to be some frequently asked questions:
Does this provision help me if my spouse died years ago? No. It applies only to deaths after Dec. 31, 2010.
Does portability apply to lifetime gifts as well as assets that pass through an estate plan? Yes. Under the new law, starting in 2011, the lifetime exemption and the estate tax exemption are expressed as a total amount, and it is possible to use this “unified credit” to transfer assets at either stage or a combination of the two. (From 2004 to 2010, the two amounts were different; the gift tax exemption remained at $1 million, while the estate tax exemption went up.)
The estate tax exemption amount is reduced for lifetime taxable gifts. So if, for example, you have used $1 million of the exemption to make taxable lifetime gifts, the unused exemption when you die will be $4 million, rather than $5 million.
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