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Understanding estate and gift tax rules

How to make the most of higher exclusions, and a popular portability provision.

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I’ll do it tomorrow. How common is that reaction to the mere mention of estate planning? But, there are good reasons to get down to it, even if your wealth currently falls below the federal estate and gift tax exclusion amounts.

The lifetime gift and estate tax exclusion, which allows you to pass money to heirs, other than your spouse, free of federal estate or gift taxes, is $5.45 million in 2016. There is also an unlimited marital deduction, which allows you to leave an unlimited amount to your spouse’s estate, tax free.1 So, when you leave money to your spouse, you are not using up any of your exclusion amount.

What’s more, the maximum federal estate and gift tax rate remains at 40% and the applicable exclusion amounts will continue to be indexed for inflation annually. In addition, with the popular portability provision, couples can take full advantage of each other’s unused federal estate and gift tax exclusion amounts, without the need to create complicated trusts or wills.

“Of course, a future Congress could pass new estate and gift tax laws, which could change the exclusion amounts, tax rates, or both,” says Mark Albertson, estate planning specialist with Fidelity Investments. “But that would require a proactive move on the part of Congress.”

Putting portability into action

Let’s look at a hypothetical couple—Peggy and Bill Melman. The Melmans had $6 million in total assets, and their individual wills transferred all assets to the surviving spouse. Because of the unlimited marital deduction, when Bill died in 2008, Peggy inherited all his assets without incurring any federal estate taxes. However, because the assets were all transferred to Peggy using the unlimited marital deduction, Bill’s federal estate tax exclusion, which was $3.5 million in 2008, was not used and, therefore, was lost. As a result, when Peggy died in 2009 with $6 million in assets, her estate was able to take advantage of only her personal federal estate tax exclusion of $3.5 million. The remaining $2.5 million of Peggy’s estate was subject to a 45% federal estate tax, which could have been avoided by properly taking advantage of Bill’s exclusion.

Now let’s look at how the example would change utilizing portability—the transfer of any unused federal estate tax exclusion to a surviving spouse. If Bill had died in 2012, the executor of his estate could have used the unlimited marital deduction to transfer all his assets to Peggy and could then have made an election to use the Deceased Spousal Unused Exclusion (“DSUE”) amount. In this example, if Peggy were to die in 2016 with the $6 million in assets, her estate would have a total of $10.57 million in federal estate tax exclusions. As a result, none of the $6 million estate would be subject to federal estate tax.

Considerations for married couples

There are many considerations and limitations associated with planning for portability that could impact your overall estate plan. Here are some of the details you should consider when you consult a tax or estate planning professional:

Portability applies only to a surviving spouse. Unused federal estate tax exclusions cannot be transferred to anyone but a surviving spouse.

Portability generally does not apply to state estate taxes. Approximately 19 states, plus the District of Columbia, impose an estate and/or inheritance tax.2 These state estate taxes are separate from the federal estate tax. Most of these states do not currently allow portability to be used to transfer a state estate tax exclusion to a surviving spouse. You may want to ask your adviser about traditional estate planning options that can potentially help reduce the impact of state estate and/or inheritance taxes.

Portability does not help control bequests. Portability can ensure that a married couple is able to take advantage of leaving almost $11 million to their heirs without incurring any federal estate taxes, but it doesn’t control how those assets will be distributed. “As estate tax exclusions remain high, federal taxes can be less of a concern, while control becomes a more important estate planning objective,” explains Albertson. “Clients may still look to traditional estate planning strategies, such as revocable trusts that contain family trust language, to direct when and how their heirs receive assets from the trust.”

Portability does not address asset appreciation. With traditional estate planning, at the death of the first spouse, an amount up to the federal estate tax exclusion limit would be put into a trust for the benefit of the surviving spouse. Because the money goes into a trust rather than directly to the surviving spouse, it is considered to be part of the deceased spouse’s exclusion. When the surviving spouse dies, the assets in this trust, including any growth on the assets, are excluded from the surviving spouse’s estate for estate tax purposes. So, in our previous example, if Bill’s $3.5 million exclusion amount had been put into a trust at his death, and the value had grown to $5 million by the time Peggy died, the full $5 million would pass outside Peggy’s estate, free of estate taxes.

With portability, however, when one spouse dies and transfers assets and any unused portion of the federal estate tax exclusion to the surviving spouse, that exclusion amount does not change; therefore, any appreciation on the deceased spouse’s assets will be included in the estate of the surviving spouse. So, again using our example of the Melmans, if Peggy had relied on portability rather than a trust to take advantage of Bill’s $3.5 million exclusion, the amount of that exclusion would have remained at $3.5 million. If those assets grew to a value of $5 million by the time Peggy died, her estate would still be allowed to protect only $3.5 million from federal taxes using Bill’s exclusion.

If you believe your total marital assets are above, or have the potential of appreciating above, the federal estate tax applicable exclusion amount, you may want to consider working with an estate planning professional to create a traditional estate plan. By doing so, you can help ensure that any potential appreciation of the first-to-die spouse’s assets accumulates outside the surviving spouse’s estate.

Portability does not apply to the generation-skipping transfer (GST) tax exemption. In 2016, individuals can exclude up to $5.45 million in transfers from the GST tax. Unlike the federal estate tax exclusion, however, the GST tax exemption is not portable, so any unused portion does not transfer to a surviving spouse. You should consult your estate planning attorney to determine whether you should make a GST in the future. Be sure to ask how to effectively use all available GST tax exemptions.

Portability can be affected if the surviving spouse remarries. When calculating the DSUE amount, the IRS looks at any unused exclusion from the “last deceased spouse.” As a result, if the surviving spouse remarries and outlives his or her second spouse, it can have an effect on the amount of exclusion that is available when the surviving spouse passes.

Putting an estate plan in place

You may want to revisit your estate plan with an adviser. Here are some potential next steps to consider:

  1. Update your existing estate plan. If you have an existing estate plan in place, you may want to revisit your plan with your adviser in light of the current law, including its portability provisions. This task could involve drafting new wills and amending existing living trusts. If this is not done prior to your death, your surviving spouse might be limited by elements of your existing estate plan that fund certain trusts or distribute estate assets to other heirs.
  2. Establish a plan if you don’t have one. To take advantage of current tax laws, including the potential use of portability provisions, consider putting a properly written plan in place. For example, your desire to transfer all your assets to your surviving spouse, and take advantage of laws that currently allow portability, may be frustrated if you don’t title your assets properly and don’t have a will in place to appropriately transfer your assets. Without a will, your state’s intestacy laws may control the distribution of your estate and, as a result, your assets might not all transfer to your surviving spouse.
  3. Update your beneficiaries and joint ownerships. As always, be sure to update the beneficiary designations on any retirement accounts, transfer on death (TOD) accounts, annuities, life insurance policies, and any other financial instruments that have named beneficiaries, in order to ensure that the transfer of these accounts at your death coordinates with your overall estate plan.

Gifting strategies to consider every year

For investors with an eye toward reducing taxes, there are certain gifting vehicles that make it possible to pass assets to the next generation, or to the charities of their choice, tax free. “For many, the act of gifting, whether to children or grandchildren, or to a favorite charity, is a great estate planning strategy,” observes Albertson. These strategies include:

Annual exclusion gifting. The annual exclusion remains $14,000 in 2016. This means that you can gift $14,000 per individual, or $28,000 for a married couple, to as many individuals as you would like, without reducing your lifetime exemption.

Front-loading 529 college savings plan accounts. These accounts can be especially useful because you can front load them with five years’ worth of annual exclusion gifts at one time, potentially not making a taxable gift, or reducing your lifetime exemption. You effectively remove these assets from your estate, the earnings in the college savings accounts grow tax deferred, and, as long as distributions are used for qualified higher education expenses, distributions are federal income tax free.

Note that if the donor of the front-loaded five-year gift dies within the five-year period, the prorated portion of the transferred amount for the years after death will be included in the donor’s estate for estate tax purposes.

Making tax-smart charitable contributions. Donating long-term appreciated securities during your lifetime may be a particularly taxsavvy strategy. As a general rule, donations of long-term appreciated securities (either stocks or mutual funds) directly to a qualified charity are deductible at their fair market value on the date of contribution. You don’t pay capital gains taxes on the appreciation. In addition, you may avoid the 3.8% Medicare tax on net investment income for single filers with modified adjusted gross income (MAGI) above $200,000 and joint filers with MAGI above $250,000.

Direct payments of educational or medical costs. Payments made directly to a loved one’s school for tuition are not treated as taxable gifts and, therefore, do not reduce your annual exclusion or lifetime gift tax exemption. Similarly, direct payments to a loved one’s medical care provider are not treated as taxable gifts.

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The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
1. Special rules apply with respect to the exclusion and with respect to portability when one or more spouse is not a U.S. citizen.
2. Source: Ashlea Ebeling, “Where Not To Die In 2014: The Changing Wealth Tax Landscape” Forbes.com, September 11, 2014
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