Estate planning in the world of portability

The federal estate tax was once a major concern for many individuals. That is no longer true on account of a dramatic increase in the federal estate tax exemption and a relatively new feature in the law called “portability.” These changes have been made “permanent,” meaning they will remain in force unless and until legislation changes them.

While the changes eliminate the estate tax bite for most, the need for careful planning remains. In fact, in many cases it is more important than ever to have a coordinated and thoughtful estate plan.

Key features of the new rules

Here’s what you need to know about the current estate tax rules.

Federal applicable exclusion amount. Each person can transfer $5.43 million during his life or at death without paying a federal gift or estate tax. This amount is inflation indexed and can be expected to rise to $6 million by 2020.
Federal tax rate. The rate on amounts transferred in excess of the allowed amount is 40%.
Federal portability. If someone dies without having made full use of his or her allowed amount, then the unused amount may be “ported” (i.e., transferred) to the surviving spouse.
State transfer taxes. State transfer taxes vary and remain relevant. While Missouri is not one, several states impose gift, estate, or inheritance taxes in addition to the federal tax. These state taxes are important to consider if you reside or own property in other states.
Income tax planning is at a premium. The federal estate tax exemption is high and rates are low. The highest marginal income tax rate for many has swelled to nearly 50 percent.
Trusts remain relevant. You will find that portability is a favorable provision but has limitations. Trusts are still a valuable tool to accomplish many tax and non-tax objectives, such as to preserve wealth for grandchildren and more remote descendants, to protect assets against creditors or divorce, and to protect wealth that—through appreciation greater than inflation—may become estate taxable.

Benefit of portability

As a result of portability, a married couple can transfer $10.86 million of wealth tax-free, irrespective of which spouse owned the assets and without the use of trusts. Also, because portability-driven estate plans will make use of transfers directly to surviving spouses, the income tax basis will be adjusted to fair market value twice: once when the first spouse dies and again when the surviving spouse dies.

What’s the catch?

Portability suffers a number of limitations:

Administrative costs. A federal estate tax return is required to take advantage of portability. Preparation of the return can be time-consuming and expensive. This cost must be weighed against the potential costs of failing to port the exemption.
Effective for estate tax only. For families wishing to shield assets from transfer taxes for multiple generations, portability is not very useful. Portability offers no protection from a separate “generation skipping transfer” tax imposed when wealth “skips” multiple generations.
Amount shielded is not inflation indexed. At the death of the first-to-die spouse, the portability benefit becomes fixed. If the wealth doubles in value the portability benefit may not be sufficient to shield the assets from estate tax. By contrast, trusts can be used instead to shield the assets from estate tax even if values multiply.
Portability benefit can be lost. Re-marriages can disrupt the benefits.

Lifetime estate planning considerations

All estate plans need to evaluate whether to rely on the portability provisions and use transfers taking effect automatically at death to transfer assets to the surviving spouse. Consideration must be given to the following:

non-tax benefits of a trust (e.g., creditor protection, division of beneficial ownership from management, providing for minors , instructions can be provided by the donor);
the couple’s potential to generate wealth (including age);
ease or difficulties in coordinating beneficiary designations to achieve the desired disposition;
exposure to various state transfer taxes;
expectations what tax laws may be in the future; and
the likely income tax consequences of the plan.

Considerations after a spouse has died

Whenever a married individual dies with assets less than the annual exclusion amount, it is important for the family to evaluate (and document) whether an estate tax return should be filed to elect portability. A return must generally be filed within nine months of death to take advantage of this favorable provision. If more time has elapsed, you should still seek advice about your options; relief might be available.

What factors guide the decision?

There are a number of considerations, which affect whether an estate tax return should be filed. Simply stated, the estate must balance (1) the risk the surviving spouse’s estate must pay estate tax on account of a decision not to file a federal estate tax return at the first spouse’s death against (2) the current cost of filing the return.

It is important to consider whether any state estate tax filings may be required. For some state filings, completion of Form 706 is required to produce the state return. In these situations, the cost to file the federal return, in addition to the state return, is low.

The filing can operate as a form of insurance against accumulating too much wealth and can help to simplify tax planning by mitigating the role of estate considerations in the planning process.

Conclusion

The estate tax rules have changed, and we enjoy stability in the law. Now is the time to evaluate whether your estate plan achieves your goals in the most practical manner. As more and more estate plans rely on automatic transfers at death, it becomes increasingly important to frequently review beneficiary designations and titling to ensure all are consistent with the plan. For individuals who recently lost a spouse, now is also the time to evaluate whether an estate tax return should be filed to “lock in” portability’s potential benefits.

WK is equipped to help our existing and new clients to navigate these complex topics during both the planning and estate administration phases. We are ready to help the families we serve to address the portability rules following the death of a loved one.

Contact your WK advisor at (573) 442-6171 or (573) 635-6196 to learn how we can help.

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Estate planning in the world of portability