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Spousal Estate Tax Planning Using Portability Rules

Spousal portability rules can help couples achieve an optimal estate tax reduction even post-mortem, but they don't eliminate the need for planning.

Helen Modly, CFP, ChFC, 11/14/2013

Prior to 2011, couples had to plan ahead to be sure they could fully use both of their individual estate tax exclusion amounts. One strategy was, and still is, to divide the assets by registration and titling while both spouses are alive. The more common strategy is to create an estate plan with a by-pass or credit shelter trust that is funded with assets equal to the applicable exclusion amount at the first death, with the remainder of the assets transferring outright or in a marital trust to the surviving spouse. This structure is also known as an A/B trust arrangement. Other trusts could be added depending upon the level of control desired by the grantor.

Planning Before Portability
What happens to those couples who have never done this level of planning? Most advisors can share stories of multi-millionaire couples with "I love you" simple wills and everything is owned jointly between them. Before 2011, all the assets would pass directly to the surviving spouse at the first death. Assuming both were U.S. citizens, there would be no estate tax due at the first death. However, the estate tax exclusion amount (currently $5,250,000) would be unused and wasted. When the second spouse dies, only the amount of his or her individual exclusion would be available to offset the estate tax liability. Essentially, this couple would be able to use only one exclusion worth $5,250,000 vs. both exclusions worth $10,500,000. With a top estate tax rate of 40%, that translates into a loss of up to $2,100,000 for their heirs--a heavy price to pay for poor or no planning.

How Portability Works
The portability rules were designed to provide a remedy for poor planning. Along with the increase in the exclusion amount up to $5,250,000, the law appears to have been designed to allow most couples to avoid the hassle and the costs of advanced estate planning. Note that portability does not eliminate the need for any estate planning. Other, even more valid reasons for planning may still remain.

Using the scenario above with all assets being held jointly and no advanced planning, all the assets would transfer to the surviving spouse at the first death bypassing taxation and thus not utilizing the available exclusion. In this case, the executor of the estate can elect to transfer the unused exclusion amount to the surviving spouse to be applied against gift taxes during their lifetime or against any estate tax liability at his or her death.

Game over, right? Who needs a fancy estate lawyer anymore?

Not so fast. First of all, notice that this doesn't happen automatically; the executor of the estate has to elect to do it. Couples with little to no planning often name a family member as executor, so unless that person seeks professional advice, they may miss the opportunity to make the election.

Another requirement is that an estate tax return (form 706) must be filed regardless if it is required for current estate tax purposes.

Potential Pitfalls of Relying on Portability
Know that there are many potential adverse consequences with relying on the portability rules to utilize both exclusion amounts. The most obvious in our political climate is that the tax law changes in the future and this benefit is no longer available.

Helen Modly, CFP, ChFC, is executive vice president and director of investment services for Focus Wealth Management, a fee-only registered investment advisor in Middleburg, Va. Modly has more than 20 years of experience providing wealth-management services. She is a member of NAPFA and FPA. She can be reached at info@focus-wealth.com. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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