What you need to know about portability
One of the great challenges in financial planning is figuring out how to transfer wealth from one generation to the next in the most tax efficient manner possible. Tax efficiency, in this context, means moving the most assets while paying the least amount of estate tax. In the past, tax efficient transfers usually entailed complicated trust structures. However, things became much simpler in 2010 when the idea of making the federal lifetime estate tax exemption “portable” between married individuals was first introduced into the federal tax law.
The federal lifetime estate tax exemption determines how much wealth an individual can leave to heirs without being subject to estate tax. Under current tax law, the lifetime estate tax exemption is $11.4 million (up from $11.18 mission in 2018). This means that an individual can leave up to $11.4 million to her heirs before being subject to the 40% estate tax on whatever remains.
With individual tax payers, this is all quite simple. However, when tax payers are married, things become more complicated. Two contrasting examples—one with portability and one without—will illustrate how portability simplifies the estate transfer process. For both examples, we will assume a married couple with an estate worth $18 million. We assume the man dies first without using any of his estate tax exemption. The wife dies two months later, leaving the entire estate to their children.
Let’s first consider a world without portability. A world without portability is a “use it or lose it” world when it comes to the estate tax exemption. When the husband dies, the entire estate passes to his wife (assuming she is a U.S. citizen) without any estate tax implications. This is called the unlimited marital deduction rule. When the wife dies two months later, the estate will owe estate tax of $2.64 million, or the value of the estate above the wife’s $11.4 million exemption times the 40% estate tax rate.
This is why trusts were so important in pre-portability estate planning. Before portability, any unused estate tax exemption went to fund a bypass trust. The bypass trust was usually set up to provide for the health, education, maintenance and support of the surviving spouse. The remaining assets went to the surviving spouse in a marital trust. The trust structure helped make sure the estate tax exemption of the first-to-die spouse was used to its fullest, but it also increased the administrative hassles associated with estate transfers.
With portability, the situation is much simpler. Now, the unused estate tax exemption transfers to the surviving spouse. In our example, the wife’s lifetime estate tax exemption after her husband’s death would be $22.8 million (her $11.4 million plus his unused $11.4 million.) When she dies two months later, the estate value of $18 million is below the combined lifetime exemption and no estate tax is owed.
Portability is valuable, but it is not automatic. In order for a surviving spouse to claim the deceased spouse’s unused estate tax exemption, the decedent’s executor must file IRS form 706, the United States Estate (and Generation-Skipping Transfer) Tax Return with the IRS in a timely manner. The IRS defines “timely” as “within 9 months of the decedent’s date of death.” If you need more time, you can apply for an automatic 6 month extension.
Please note: Even if your estate is below the exemption threshold, you may want to file form 706 and elect portability because the value of the estate may grow beyond the threshold before the surviving spouse dies.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.