Laura Lallos is a senior analyst covering equity strategies on Morningstar’s manager research team and managing editor of Morningstar® FundInvestorSM, a monthly newsletter.
Attorney Colby Green considers that amount "absurdly low for any family who has some money in a 401(k) and a house--whatever that's worth anymore. The killer is the life insurance. It is easy when you are young to buy a lot of life insurance for little money."
Granted, you can pass an unlimited amount of assets to a spouse without incurring an estate tax. But if you do, you waste the exemption of the first spouse who dies. Say a married couple has $2 million in assets and the husband dies. The wife gets $2 million tax-free, but her estate will later owe taxes on $1 million. On the other hand, the husband could put $1 million in a trust that would not be part of her estate. Each would take full advantage of the exemption, and no estate taxes would be owed when the wife died.
"It takes a little planning," Green says, "but nothing too clever. Set up a bypass trust, and once the first spouse dies, use the estate-tax exemption to fund the trust--if you don't use it, you lose it." The key is to make sure each spouse has assets in separate names, which can be used to fund a trust. "Wealthy couples likely have that covered, but middle-class couples may not."
Irrevocable life-insurance trusts shelter the proceeds from estate taxes, but they involve considerable expense and administration (see the related article "Prepare for the Worst
"). Such a trust is probably overkill for ordinary couples.
Attorney Thomas Clark suggests an alternative that makes use of a simple bypass trust. "People who are taking out life insurance simply to support the surviving spouse, which is most people, should name the spouse as the first beneficiary, then the policyholder's trust as the second. Depending on the size of the estate and the tax laws when the policyholder dies, the spouse may choose to decline the life insurance and have it go to the trust. The same strategy can be used with retirement accounts. The key is not to make a claim until you talk to an attorney and decide what needs to go into the trust."
Families with second marriages and step-children are the biggest bugbear for estate attorneys this year. At attorney Matthew Bresette's practice, trusts for such clients' children are almost always funded in an amount corresponding to the estate-tax exemption. The rest is then put in a trust for the surviving spouse. To accommodate changing tax laws, a specific dollar amount is not usually mentioned. "You might create a basic trust and allocate the 'federal exemption amount' to the children of the donor," Bresette says. "But this year, that basically disinherits the children."
Attorney Thomas Abendroth agrees that the absence of an estate tax may distort the estate plans of many blended families. That's because earmarking assets exempt from the tax for children of the first marriage is a convenient way to "keep the interests of the second spouse completely separate from the interests of the children," which is often a goal. "We spent a lot of time this year going back over such plans and asking, 'Does it still work?'"
Because of the inherent conflict in blended families, attorneys may need to be counselors in every sense of the word. Clark encourages clients to disclose their plans to their children. "A husband or wife often plans to take care of a spouse first [in a trust] and then pass the money to children. I'm not sure the kids are expecting that. I offer to be a mediating source beforehand, to avoid an uncomfortable situation after someone dies."
Unmarried couples miss out on the biggest estate tax break there is: the unlimited spousal exemption. "A single-sex couple might start with an assumption that each will leave each other everything," Abendroth says. "If it is a wealthier pair, however, the first to die will pay an estate tax, and then the second person will pay it again on the same assets. So, each should leave property in trust for the other."
Green also recommends bypass trusts. "The surviving 'spouse'--and I use that term because that is how it should be--will have income and the ability to draw principal, but you can keep the money from being taxed again when the survivor dies."
Given legislative and judicial trends, "spouse" is increasingly becoming a legal term for same-sex partners. "It may well be that in five years the couple will in fact be legally married," Green says, "so you might go ahead and have the marital exemption built into the estate planning."
Until that happens, same-sex couples also need to beware of the consequences of unintended gifting during life. "Rules about transferring property freely between husband and wife aren't available," Abendroth says. Adding a partner's name to a savings account or a property deed might end up creating a taxable gift.