Married Couples and the New Estate Tax

Uncertainty about the estate tax is resolved. You don’t have to worry about frequent shifts anymore. Now, it’s time to consider how the new rules affect your estate plan and revise your plan.

You know that the lifetime estate and gift tax exemption is set at $5 million per person, indexed for inflation. For 2013 the inflation-adjusted exemption is $5.25 million. That means for anyone who passes away in 2013, the first $5.25 million of his or her estate avoids estate taxes, if none of the exemption was used by making lifetime gifts. For taxable estates, the maximum tax rate is 40%.

Spouses also can make unlimited tax-free gifts and bequests to each other, as long as the receiving spouse is a U.S. citizen.

Married couples retain the exemption portability that was created in the 2010 tax deal. After one spouse passes away, the surviving spouse can use both his or her own lifetime exemption plus any exemption of the deceased spouse that wasn’t used to shelter assets. Portability gives a married couple a true $10 million joint exemption ($10.5 million in 2013). Unlike under the pre-2010 law, spouses don’t have to worry about making sure each spouse has title to enough property to maximize use of his or her exemption.

Let’s consider how this affects the plan of the stereotypical married couple with children.

Before the 2010 deal, the standard estate plan provided for a spouse’s will to leave to a bypass trust an amount up to the unused lifetime estate and gift tax exemption. This trust (also called a credit shelter trust, A-B trust, or family trust) ensured the spouse’s exemption was maximized. The trust would pay income and principal as needed to the surviving spouse, and after that spouse passed away the children or other objects of affection would receive the trust remainder. The rest of the estate would pass directly to the surviving spouse under the will, except for any special or charitable bequests.

Do you still need a bypass trust under the new law? The main reason to use the trust under the old law was to take full advantage of the lifetime exemption while providing for your surviving spouse. Unless your estate is likely to be more than $10 million, you don’t need a bypass trust for that reason. But there are other reasons a bypass trust still can be an important part of an estate plan.

Creditor protection. Leaving assets in a trust often protects them from the creditors of your loved ones. Creditors can include ex-spouses, winners of lawsuits, and business partners. It also includes lenders and credit card companies of those who have trouble controlling their spending, make bad decisions, or suffered economic misfortune. If one or more of your loved ones has financial problems, a rocky marriage, or is in a line of work that is at risk of lawsuits, consider leaving at least part of your estate in a bypass trust that eventually benefits them.

Preserving your intentions. You want to provide for your spouse for the rest of his or her life, but you also might want to ensure whatever is left of the estate goes to those you want eventually to receive it. Some people are concerned a spouse might remarry and leave the money to the new spouse and perhaps a new family. Others already are in second marriages and aren’t confident the surviving spouse will leave any of the estate to the children of the first marriage. There are other reasons why your spouse might not carry through on your intentions, and those are reasons to consider having a bypass trust.

Preparing for growth. Remember the estate tax is imposed on the value of assets at the time of the owner’s death. Perhaps your joint estate is worth less than $10.5 million today. But what might it be worth after five, 10, or 20 years? Yes, the exempt amount will increase over time, but only at the rate of the Consumer Price Index. Good investments, a small business, or real estate could grow at a higher rate over time. Beware leaving your spouse to deal with that future growth and its tax problems. You can shift future growth out of your spouse’s estate, and still allow him or her to benefit from the assets, by leaving some of it to a bypass trust.

The grandparents’ tax. The law preserved the generation-skipping transfer tax. This tax is imposed when assets skip a generation by a grandparent leaving assets directly to the grandchildren. There’s a $5 million exemption to the GSTT, but there’s no portability to that exemption. If you don’t leave the assets to a bypass trust that eventually benefits your children, your $5 million exemption to the GSTT is lost. Your estate might not be valuable enough for this to be an issue, but for some of you it is something to consider.

State taxes. About half the states have estate or inheritance taxes or both. Most of them have exemptions far lower than the federal exemption, and none has a portability provision. If your state isn’t one that’s abolished death taxes, you might want a bypass trust to reduce state taxes.

The remarriage glitch. When the surviving spouse remarries, the portability of the first spouse’s unused exemption becomes uncertain. When the surviving spouse’s second spouse passes away before the surviving spouse, then the surviving spouse has available only the unused exemption of his or her second spouse. If it is less than the unused exemption of the first spouse, that’s too bad. The first spouse’s unused exemption is lost. But if the first spouse had used a bypass trust, the full exemption would have been used at that time. (If the surviving spouse remarried and died before the new spouse, the surviving spouse’s estate can use the full unused exemption of the first spouse.)

Avoiding administrative errors. Portability of the unused exemption is not automatic. Your executor must follow the IRS regulations. Using a bypass trust ensures the exemption is used and not lost due to errors or oversights.

There’s a potential downside to using a bypass trust. When your spouse inherits assets from you, he or she increases the tax basis to their current fair market value. When he or she passes away, whoever inherits the assets increases the basis again to their current fair market value. But when you leave the assets to a bypass trust, there’s only one increase in the basis. When assets are distributed from the trust to the beneficiaries, they’ll take the same basis the trust had, no matter how much time has passed. This could be a reason to bypass the bypass trust for high growth assets.

There’s another source of some confusion. The lifetime estate and gift tax exemption is indexed for inflation. But once a spouse dies, the amount of the unused exemption transferred to the surviving spouse is fixed. It no longer is indexed for inflation.

Before the 2001 tax law raised the exempt amount, the standard will stated that a portion of the estate equal to the exempt amount would go into the bypass trust. There still are many wills out there with this or similar provisions.

Except for the very wealthy, you don’t want this provision now, because it could mean that all or most of your estate is put into the trust. Your surviving spouse will have few or no assets in his or her own name. Most people want their spouses to own some assets outright without having to go through a trust or worry about other beneficiaries challenging spending and other decisions.

That’s why the standard today is to use a formula to fund the bypass trust. You decide the maximum percentage of your estate or the dollar amount you want to go into the trust, or the minimum you want going to your spouse. Your will should have a formula reflecting that. For example: “The bypass trust shall be funded up to either the maximum federal tax exempt amount or 40% of the gross estate, whichever is less.” Or the limit can be a dollar amount, or the clause can be phrased to ensure your surviving spouse is left with a minimum amount of assets and the bypass gets the remainder up to the exempt amount. Talk with your estate planner to derive the formula that meets your goals.

Another approach is to create a bypass trust but leave the entire estate to your spouse. After you pass, your spouse works with the estate planner to disclaim, or renounce, all or a portion of the estate. The disclaimed amount goes into the bypass trust. This lets your spouse and the estate planner fine tune your plan based on asset values at the time.

This approach is only advisable for a first marriage that is very stable and in which there is agreement over who ultimately should inherit.

Since the estate tax exemption was increased in 2001 I’ve advised readers that the high exemption is no reason to ignore estate planning. Your plan should be about a lot more than taxes. Also, in many cases the high exemption is not a good reason to remove a bypass trust from your plan. There still are benefits to using this old-fashioned tool.