Portability Provision Simplifies Couples' Estate Planning

Note to readers: This video originally posted on Jan. 24, 2013. We are refeaturing it as part of Morningstar.com's Tax-Relief Week 2013.

Christine Benz: Hi. I am Christine Benz for Morningstar.com. The recently enacted tax package has implications for spouses inheriting assets from one another. Joining me to discuss this topic is estate-planning expert, Deborah Jacobs.

Deborah, thank you so much for being here.

Deborah Jacobs: Thank you for having me.

Benz: Spouses inheriting assets from one another have long been able to take advantage of the marital deduction. Let's talk about what that is, Deborah, and also talk about whether this new tax package that passed through Congress will maintain that marital deduction?

Jacobs: The unlimited marital deduction allows spouses to pass an unlimited amount to each other tax-free, provided that the spouse inheriting is a U.S. citizen. And what happens then is that there is no tax on assets going to that spouse, whether they pass outright or in a special kind of trust, but there is tax on those assets when the second of them dies.

The new tax law did nothing that changes that, it just makes things a little bit better by extending a provision that became part of the tax law for the first time two years ago, and that was set to expire along with everything else at the end of 2012. This provision is called portability; that's not a term that appears in the tax code.

Here is what it means. Portability means that the surviving spouse can add to their own $5 million a tax-free amount whatever portion of the spouse who just died, whatever portion of their tax-free amount was not used during lifetime gifts. So, what this means is that couples together can transfer during life or when they die a total of $10 million-plus. And the reason I keep saying "plus" is the tax law says $5 million, but it's adjustable for inflation. So, in 2012 it was adjusted to $5.12 million apiece for a total of $10.24 million together. We are expecting another inflation adjustment in 2013 though the Internal Revenue Service has not yet announced it.

Benz: This is obviously good news for very affluent couples, maybe not such a big deal for people who aren't so affluent, but you note that even for people who want to take advantage of this portability provision, you still need to take some steps to make it work for you. Let's talk about how that would work if, in fact, you want to take advantage of this portability.

Jacobs: Yes, portability is not automatic. In order to get portability, the surviving spouse must file an estate tax return even if no tax is due. And what this means is that a lot of people who don't think they have to worry about estate taxes are going to have to be aware that they must file this return anyway. I am hoping that the IRS is going to develop a short form for this so that people could even fill it out themselves the way some people do their own income tax returns and perhaps create consumer-oriented software for this as well down the line.

But the important thing to keep in mind right now, and I'm kind of on a public-service campaign about this--I have been for the last two years because I expected this provision to be extended--was you have to know there is this thing called portability and that's not likely to cross your radar screen on an annual basis the way income taxes and other sorts of taxes do. It's a sort of for most people a once-in-a-lifetime kind of a thing or maybe twice-in-a-lifetime, but it's not the sort of thing we think about all the time. You need to know there is such a thing as portability and you need to be aware that you must file an estate tax return in order to carry over this unused amount.

I would encourage everyone to file the estate tax return, electing--that's the word--electing portability even if they don't think they are ever going to have a use for it because what if you win the lottery or what if you sell your business and have a sudden windfall or what if you become rich through investments, you just never know. So, why not be optimistic about it?

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Benz: Deborah, one thing that a lot of couples had drafted in a pre-portability era was that they drafted these bypass trusts or B trusts or family trust they're sometimes called, and the idea is to take advantage of both partners' exclusion amounts. Let's talk about what these trusts are? And if you are someone who has such a trust, which has been very much sort of common estate planning prior to portability, do you still need it? Should you dismantle it? Let's talk about some guidance for people in this particular situation.

Jacobs: So, just to sort of put this all in context, there have always been two ways for couples to each use their full federal estate tax exclusion amount. Portability adds a third very simple way. The other two ways that have existed for long time; one is to leave assets outright other than to a spouse, for example to children. The other more popular strategy is to do what was called AB planning. It's to use what's called the bypass trust or a credit shelter trust. And the way this works is that you put into the trust an amount up to the exemption amount. So, you can put in anything up to $5.12 million right now into this trust, and it can even pay income to the surviving spouse during life if you want, but the point is that ultimately, the assets in the trust are going not to the spouse. And so, you're using your estate tax exemption amount, and when your spouse dies, there is no tax on those assets. You have essentially applied your exemption amount to the trust. This is sometimes called the family trust because this trust typically is set up to take care of the whole family or part of the family.

And then anything not going into the bypass trust would go to the spouse either outright or into another special kind of trust for the spouse, which typically pays income during the spouse's life and then goes to other beneficiaries. At that point in time, when the second spouse dies, the assets in that other trust, typically called the A trust or the marital share, are subject to tax. So, the bypass trust is appropriately named because it bypasses the estate tax.

Now, portability is much simpler than setting up a bypass trust. So, there is widespread debate right now, and there has been actually for the last two years about whether people actually needed a bypass trust. For the last two years, lawyers have argued among other things, you still need a bypass trust because you never know what Congress is going to do. Well, now we know what Congress did, so that argument gets taken off the table.

Why you might still want a bypass trust is for all the reasons that people set up trusts anyway, which is to protect assets from creditors, and I don't mean that you're necessarily going to default on financial obligations, but when we say creditors, we also don't want a lawsuit against you. So, they protect assets from creditors, they protect assets from divorcing spouses. And if you want to pass assets to grandchildren, you can use a bypass trust for this purpose, as well.

The drawback is the same drawback that applies to all trusts, which is that, trusts are much more complicated to maintain than most lawyers let on. It's not that they are necessarily trying to deceive you. They think of trusts as quite simple because they deal with them every day, but anyone who has ever been a trust beneficiary or the trustee of the family trust will tell you that it can really be a pain in the neck.

Benz: How about people who already have these trusts set up? It sounds like it's sort of a judgment call for people who are still in that mode, where they're doing there estate planning. What if you and your spouse have already setup this AB trust system? Should you dismantle it, or should you just hang on?

Jacobs: I don't see any harm in having it, but you do need to go back and look at your estate-planning documents to see how much money is destined for that trust because people who did their estate plans long ago and have not recently looked at them, might find that more money is--if the document says I want to fund the bypass trust up to the exemption amount, it's now $5 million plus, but in 2001, it was $675,000.

So, if you haven't done your documents in a long time, they may no longer reflect your intent. And especially for people who want to make sure that their spouse is adequately provided for, that $5 million might be all you've got. You might not want to be putting it into the bypass trust. The setup that I like the best for people who are just thinking of doing this or perhaps for people who are making slight amendments in their estate-planning documents--they want to leave the bypass trust, but they want to have maximum flexibility--the setup that I like is to give the surviving spouse the right to turn down--the legal terminology is "disclaim"--what they've inherited and have it go into the bypass trust.

Now, there is a joke: "A surviving spouse never disclaims." But I see no harm in setting up things this way. I think unless you have really compelling reasons for wanting a trust and your spouse is going to be comfortable living within the structure of this trust, which is another thing to think about I think it's much better to rely on portability, and I think most clients will want to go that route, even though most lawyers will probably tell them they're making a big mistake.

Benz: Deborah, thank you so much for being here to provide some color and discuss this complicated issue of portability. We really appreciate you being here.

Jacobs: Thank you for having me.

Benz: Thanks for watching, I am Christine Benz for Morningstar.com.