With the cloud of uncertainty over estate and gift taxes cleared, individuals and couples can get down to some serious planning.
The good news: Lifetime gift and estate tax exclusions have risen slightly, to $5,340,000 in 2014, while the maximum estate and gift tax rate remains 40%. What’s more, the applicable exclusion amounts will continue to be indexed for inflation annually, and the popular portability provision that allows couples to take full advantage of each other’s unused federal estate and gift tax exclusion amounts, without having to create complicated trusts or wills, remains effective.
“Of course, a future Congress could pass new estate and gift tax laws, which could change the exclusion amounts, tax rates, or both,” says Dan Murphy, director of estate planning with Fidelity Investments. “But that would require a proactive move on the part of Congress, in contrast to the fiscal cliff, which would have triggered changes automatically.”
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. When Bill died in 2008, Peggy inherited all his assets without incurring any federal estate taxes, because of the federal unlimited marital deduction. Bill’s federal estate tax exclusion, however, was wasted. So, when Peggy died in 2009 with $6 million in assets, her estate was able to take advantage of her personal federal estate tax exclusion only, not Bill’s. In 2009, the federal exclusion was $3.5 million. As a result, $2.5 million of Peggy’s estate was subject to federal estate tax, at a 45% tax rate.
Now let’s look at how the example would change under current law, which permits 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 elected to use the unlimited marital deduction to transfer Bill’s unused $5,125,000 federal estate tax exclusion to Peggy. If she were to die in 2014 with the $6 million in assets, her estate would have a total of $10,465,000 in federal estate tax exclusions: the $5,125,000 transferred from Bill and her own $5,340,000 exclusion amount. 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. States have their own estate taxes. Approximately 19 states, plus the District of Columbia, impose an estate and/or inheritance tax.1 These state estate taxes are separate from the federal estate tax. You may want to ask your adviser about traditional estate planning options that may help minimize the potential 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 more than $10,680,000 to their heirs without incurring any federal estate taxes. “As estate tax exemptions remain high, federal taxes can be less of a concern, while control becomes a more important estate planning objective,” explains Murphy. “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, the amount exempted from federal estate taxes for the first-to-die spouse is put into a trust for the benefit of the surviving spouse. The assets in this trust, no matter their amount, are outside the surviving spouse’s estate for estate tax purposes. This means that this trust can appreciate in value to any size, and will not be subject to federal estate taxes when the surviving spouse dies.
With portability, however, when one spouse dies and transfers assets and any unused portion of the federal estate tax exclusion to the surviving spouse, any appreciation on the deceased spouse’s assets will be included in the estate of the surviving spouse. If the surviving spouse’s estate (including the deceased spouse’s assets and appreciation on those assets) is larger than the surviving spouse’s available federal estate tax exclusions (including any unused federal estate tax exclusion transferred from the deceased spouse), federal estate tax will be owed on the difference.
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 2014, individuals can exclude up to $5,340,000 worth of transfers from the GST tax. Unlike the federal estate tax exclusion, however, the GST tax exemption is not portable, as 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 utilize all available GST tax exemptions.
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:
- 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 may involve drafting new wills and amending existing living trusts. If this is not done prior to your death, your surviving spouse may be limited by elements of your existing estate plan that fund certain trusts or distribute estate assets to other heirs, including portability.
- Establish a plan if you don’t have one. To take advantage of current tax law, 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, at least for 2014, to take advantage of portability may be frustrated if you don’t hold all your assets jointly with your spouse and you don’t have a will in place to transfer your assets to your surviving spouse. If this is the case, your state’s intestacy laws may control the distribution of your estate and, as a result, all your assets might not transfer to your surviving spouse.
- 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, to ensure that these accounts are included in your estate plan. Naming your spouse as joint owner or beneficiary of your accounts can potentially provide a simple way to avoid state intestacy laws and take advantage of portability.
Gifting strategies to consider every year
For investors with an eye to reducing taxes, there are certain gifting vehicles that make it possible to pass assets to the next generation or to 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 Murphy. These strategies include:
Annual exclusion gifting. The annual exclusion remains $14,000 in 2014. 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 eating into 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, without incurring any taxable gift. You effectively remove these funds from your estate, the earnings in the 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 may be a particularly tax-savvy 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, and you don’t pay capital gains taxes on them (you also 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 modified AGI above $250,000).
Direct payments of educational or medical costs. Direct tuition payments to a loved one’s school are not treated as taxable gifts and, therefore, do not count against your annual or lifetime gift tax exemption. Similarly, direct payments to a loved one’s medical care provider are not treated as taxable gifts. "In 2013, we finally received some stability to the estate tax laws,” says Murphy. “Now, planning based on the current tax code is much less problematic than it was before.”
- For more guidance on estate planning, visit Fidelity's Trust and Estate page