The waning days of 2010 brought some significant changes to the tax code, including the estate tax laws. To get some perspective on what these changes are, as well as the implications for individuals' estate plans, I recently interviewed attorney and estate-planning expert Deborah L. Jacobs. Jacobs is author of the bookEstate Planning Smarts, a compendium of practical advice about estate-planning that covers everything from wills and trusts to charitable giving and reducing the drag of taxes on your investment assets. The following is a transcript of our conversation.
Christine Benz: Given that flurry of activity that went on toward the end of 2010, where are we now in terms of the estate tax rules, and what do folks need to know about them?
Deborah Jacobs: Well, the most important thing is that for 2011 and 2012, every estate gets an exemption amount of $5 million. Maybe even more important than that is the fact that we have a totally new concept in the tax law right now, portability. That term doesn't actually appear in the law, but it's the term that tax geeks are using to describe the fact that a surviving spouse can now carry over any portion of the $5 million exemption amount that isn't used when the first spouse dies. It used to be that couples had to go through the most incredible gyrations to preserve each of their estate tax exemption amounts, and on the federal level, those gyrations are no longer necessary. Portability only applies for the next two years, but I think that regardless of what happens with the tax rates going forward, I think that portability will be extended.
Benz: Can you provide a specific example of how portability works?
Jacobs: Most spouses in a stable first marriage would prefer to have what's called an "I Love You will." So say a man dies with $2 million in assets in his name, and he leaves everything to his wife. Then assume they have joint assets of $1 million in a joint bank account, so that goes to her automatically, too. And then maybe she has her own retirement plan worth $1 million. Then maybe they have a house worth $1.5 million.
Benz: So, now we're up $5.5 million.
Jacobs: Right. So, the husband has $2 million worth of assets, but he is leaving everything to his wife. There's no tax on assets left to a spouse who is a U.S. citizen. So in this example, the husband has an unused exemption amount of $5 million. Assuming the wife is the executor and files an estate tax return electing to carry over the $5 million exemption that he did not use, there is no estate tax due on his death.
Say she lives for another X number of years, and her portfolio does well. And by the time she dies, maybe she's worth $8 million. When she dies, assuming the estate tax exemption amounts have remained the same, she then has available to her $10 million to apply to her estate, at least in terms of the federal taxes. (The state tax systems are another story.) So under that scenario, if she's worth $10 million or less when she dies, she has her own $5 million exemption amount, and she has the $5 million dollar exemption amount that she carried over from her husband. Her estate would not owe any federal estate tax.
However, one of the things that's necessary in order to take advantage of portability is that when the first spouse dies, the executor for the estate has to file an estate tax return whether or not any taxes are due, electing to carry over any unused exemption amount. If you don't file the estate tax return electing portability within nine months of a spouse's death, you lose that right. So, it's as if, you didn't have it at all.
Benz: You noted that portability negates the necessity for some of those machinations that people went through--bypass or credit-shelter trusts designed to preserve each spouse's estate tax exemption. Such trusts may have made sense when estates of more than $3.5 million were taxable, and we didn't have portability. But are such trusts no longer necessary in many situations, except for people who are very wealthy?
Jacobs: In many situations, they're no longer necessary, though many lawyers are giving a really hard sell for them.
In the past, there were two ways to fully use your own exemption amount. You could leave assets directly to someone not your spouse, for example to the kids, or you could use the credit shelter, or bypass, trust. With portability, we now have a third. So, most people would rather not set up a bypass trust.
Now, there are some reasons why you might still want a bypass trust. One is if you're concerned about asset protection, and in this sense, we're talking about protecting assets from the creditors of your heirs. For example, say, you're leaving money to your daughter, and you're afraid she and her husband might get divorced. You don't want her spouse to get the assets. Well, if you leave the money to your daughter in this family trust, that wouldn't be available in the case of divorce.
Another reason is if you think the assets are going to appreciate hugely in value, so much that your surviving spouse won't have enough exemption--even combining the two exemptions through portability--to cover the whole thing.
A third reason is if you want to set up a trust to benefit grandchildren, you can allocate your generation-skipping transfer tax exemption to it at the time that you die. But there is also a $5 million generation-skipping transfer exemption, so this doesn't affect the whole lot of people. (The GST exemption is not portable, so you must use it or lose it.)
So, therefore, I think a lot of people are going to do without the bypass or the credit-shelter trust.
Benz: If I already have a bypass trust, what should I do? Am I fine or do I need to undo it?
Jacobs: If you have an estate plan that has what is called the formula clause, written many years ago, that says an amount up to the full exemption amount goes into the bypass trust, you need to redo your plan. That's because you may be creating a situation where you're leaving no assets to your spouse at all, and instead, everything is going into the family trust.
Benz: The elephant in the room is these laws that change periodically. I think what most people would hope for is to be able to arrive at some plan that is flexible and can withstand these various changes from year to year, particularly folks, who are younger and don't anticipate having to deal with any of these issues until many years to come. So how do you create such a plan?
Jacobs: Well, I'll tell you the arrangement that I have, and I'm not doing anything to rework it. My husband and I have wills that leave everything to each other, but we have the right to turn down all or part of what we inherit from each other--that's called a disclaimer--and have it go into a bypass trust. That leaves you flexibility. But if you put that kind of a plan in place, you have to understand the whole system, which is kind of complicated, and then you have to make a decision within nine months of the spouse's death about what to do. The surviving spouse or someone you delegate this position to has to decide to turn down a portion of this inheritance and have to go into the bypass trust.
Benz: Is there anything else new in the estate tax laws?
Jacobs: The other thing that financial advisors are making a lot of noise about right now is that at least for the next two years, the $5 million exemption can be used either during life or at death so that you can now make lifetime gifts of up to $5 million, as well. If you use up that amount during your life, you can't use it when you die.
For the super wealthy, this is a very exciting development, but in real life, very few people dipped into that exemption amount even when it was $1 million. And who can afford to give away $5 million? So, there is a lot of talk about it in the financial community because there are ways to leverage that amount for the super wealthy with transactions that carry very high fees for financial advisors. Advisors are making a lot of noise about what a great opportunity this is, and I'm saying, "Get real," because this affects very few people.
Benz: I also wanted to discuss beneficiary designations because increasingly more assets are passing through beneficiary designations. There is so much confusion about how to make sure these designations sync up with any estate-planning documents that you have created.
So, first could you explain the difference between probate and nonprobate assets just to give people a sense of how they are different?
Jacobs: Probate assets are assets that pass under a will, and they're subject to the court's supervision. Probate is the process through which a court determines that a will is a legally valid document.
Nonprobate assets are assets that pass by contract or by operation of law, with what are, in effect, will substitutes. A living trust is a will substitute, but even more important are beneficiary-designation forms for retirement accounts and life insurance, as well as jointly titled assets, which people find really confusing.
You're 100% right that more and more of people's assets are nonprobate assets. One thing that's driving this is the financial-services industry because firms now offer clients, say for a brokerage account especially, the chance to fill out paperwork that makes the account transferable on death. That means that on death, all the person named on that form has to do is take a copy of the death certificate to the financial institution, and he can get everything the next day. He can go right from the funeral to the bank.
Benz: And that's not always good because it can conflict with the estate plan?
Jacobs: Yes. I'll share a story to illustrate. For my mother-in-law, my husband had the durable power of attorney, and I was the back fielder. Then when she died, he was the executor, and I was the back fielder. So, as back fielder, I got a call from her broker one day, who said, "Why don't you just fill out a transfer-on-death form, and then you don't have to worry about the assets passing under the will."
And I said, "No, because my husband has a sister, and they take in equal shares under her will."
A less honest person might have said, "Okay, fine," and that would have been the end of it for his sister. So, this is extremely troublesome to me.
Another mistake people make, especially as they get older, is to say, "I want my son to be able to have access to my bank account and help me pay my bills. I'm just going to put his name on my account." So say mama makes the son what's called a joint tenant with right of survivorship. When she dies, it all goes to the son.
Benz: Which maybe isn't what she wanted?
Jacobs: Maybe that's not what she wanted. So, the way to handle that instead would be to use the durable power of attorney. Or, if you just want your son to be able to write the checks and pay the bills, some banks will just let you put his name on his signature card. So he could sign for you, but you're not making him an owner of the account.
The irony of the nonprobate assets is people think that they're making their lives easy, and they don't coordinate this with the rest of their estate plan. Maybe they don't even necessarily tell the lawyer about the nonprobate assets. Yet, if you have a lot of your net worth tied up in nonprobate assets, this is something that you have to constantly keep watching.
Benz: Can you share any concrete tips for managing beneficiary designations?
Jacobs: You know how some people change the smoke alarm every six months when the clocks change? Well, every year, on your birthday or the day after New Year's check that, one, the financial institution has a beneficiary-designation form for you, and two, who is it for?
I also like to see people get help from their financial advisors to have them look over the forms and make sure that they've been filled out correctly. I think it's really important to tell people that this is a very serious part of estate planning, even though it looks easy. Be careful about taking any advice from the person who offers you the form because this person might be in a fairly low-level administrative position.
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