An estate-planning expert shares insights on who needs to take action--and who doesn't.
By Christine Benz | 03-18-11 | 06:00 AM | Email Article

The waning days of 2010 brought some significant changes to the tax code, including the estate tax laws. To get some perspective on what these changes are, as well as the implications for individuals' estate plans, I recently interviewed attorney and estate-planning expert Deborah L. Jacobs. Jacobs is author of the bookEstate Planning Smarts, a compendium of practical advice about estate-planning that covers everything from wills and trusts to charitable giving and reducing the drag of taxes on your investment assets. The following is a transcript of our conversation.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Christine Benz: Given that flurry of activity that went on toward the end of 2010, where are we now in terms of the estate tax rules, and what do folks need to know about them?

Deborah Jacobs: Well, the most important thing is that for 2011 and 2012, every estate gets an exemption amount of $5 million. Maybe even more important than that is the fact that we have a totally new concept in the tax law right now, portability. That term doesn't actually appear in the law, but it's the term that tax geeks are using to describe the fact that a surviving spouse can now carry over any portion of the $5 million exemption amount that isn't used when the first spouse dies. It used to be that couples had to go through the most incredible gyrations to preserve each of their estate tax exemption amounts, and on the federal level, those gyrations are no longer necessary. Portability only applies for the next two years, but I think that regardless of what happens with the tax rates going forward, I think that portability will be extended.

Benz: Can you provide a specific example of how portability works?

Jacobs: Most spouses in a stable first marriage would prefer to have what's called an "I Love You will." So say a man dies with $2 million in assets in his name, and he leaves everything to his wife. Then assume they have joint assets of $1 million in a joint bank account, so that goes to her automatically, too. And then maybe she has her own retirement plan worth $1 million. Then maybe they have a house worth $1.5 million.

Benz: So, now we're up $5.5 million.

Jacobs: Right. So, the husband has $2 million worth of assets, but he is leaving everything to his wife. There's no tax on assets left to a spouse who is a U.S. citizen. So in this example, the husband has an unused exemption amount of $5 million. Assuming the wife is the executor and files an estate tax return electing to carry over the $5 million exemption that he did not use, there is no estate tax due on his death.

Say she lives for another X number of years, and her portfolio does well. And by the time she dies, maybe she's worth $8 million. When she dies, assuming the estate tax exemption amounts have remained the same, she then has available to her $10 million to apply to her estate, at least in terms of the federal taxes. (The state tax systems are another story.) So under that scenario, if she's worth $10 million or less when she dies, she has her own $5 million exemption amount, and she has the $5 million dollar exemption amount that she carried over from her husband. Her estate would not owe any federal estate tax.

However, one of the things that's necessary in order to take advantage of portability is that when the first spouse dies, the executor for the estate has to file an estate tax return whether or not any taxes are due, electing to carry over any unused exemption amount. If you don't file the estate tax return electing portability within nine months of a spouse's death, you lose that right. So, it's as if, you didn't have it at all.

Benz: You noted that portability negates the necessity for some of those machinations that people went through--bypass or credit-shelter trusts designed to preserve each spouse's estate tax exemption. Such trusts may have made sense when estates of more than $3.5 million were taxable, and we didn't have portability. But are such trusts no longer necessary in many situations, except for people who are very wealthy?

Jacobs: In many situations, they're no longer necessary, though many lawyers are giving a really hard sell for them.

In the past, there were two ways to fully use your own exemption amount. You could leave assets directly to someone not your spouse, for example to the kids, or you could use the credit shelter, or bypass, trust. With portability, we now have a third. So, most people would rather not set up a bypass trust.

Now, there are some reasons why you might still want a bypass trust. One is if you're concerned about asset protection, and in this sense, we're talking about protecting assets from the creditors of your heirs. For example, say, you're leaving money to your daughter, and you're afraid she and her husband might get divorced. You don't want her spouse to get the assets. Well, if you leave the money to your daughter in this family trust, that wouldn't be available in the case of divorce.

Another reason is if you think the assets are going to appreciate hugely in value, so much that your surviving spouse won't have enough exemption--even combining the two exemptions through portability--to cover the whole thing.

A third reason is if you want to set up a trust to benefit grandchildren, you can allocate your generation-skipping transfer tax exemption to it at the time that you die. But there is also a $5 million generation-skipping transfer exemption, so this doesn't affect the whole lot of people. (The GST exemption is not portable, so you must use it or lose it.)

So, therefore, I think a lot of people are going to do without the bypass or the credit-shelter trust.

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