The purpose of estate planning is often to pass assets to survivors and heirs with as little tax as possible. Planning can be challenging as estate tax laws are complicated and continually subject to change. When you add to the mix evolving family circumstances, estate planning can become a puzzle which needs to be solved more than once during a lifetime.
A common challenge which must be addressed by couples is the likelihood one spouse may outlive the other. In such scenarios, provisions must be made for assets to transfer first between spouses before eventually passing to the next generation. A spouse can currently leave an unlimited amount of assets—free from estate tax–to their survivor, but thought needs to be given to the ultimate transfer to the next generation.
Thanks to a provision called “portability,” a surviving spouse may inherit the deceased spouse’s individual federal estate tax exemption, currently $5.43 million. Combined with their own exemption, the surviving spouse can therefore pass $10.86 million to the kids with no federal estate tax. This current exemption amount is scheduled to increase annually with inflation.
Rather than using portability to pass assets to a surviving spouse directly, another common practice is to use the deceased spouse’s exemption to fund a bypass trust (also referred to as a credit shelter trust). Doing so removes these assets from the surviving spouse’s estate, while allowing the survivor access to the funds in the event they are needed. At the surviving spouse’s death, assets in the bypass trust pass to heirs free from federal estate tax, no matter how large the trust’s assets have grown.
A deciding factor in choosing between portability and a bypass trust is the capital gains tax. While assets passed directly to a surviving spouse using portability are entitled to a step-up in cost basis before being transferred to heirs, assets passed via a bypass trust retain the trust’s cost basis. This could result in a large capital gains tax if trust assets have appreciated significantly. Ultimately, the choice between portability and a bypass trust hinges on the expected wealth passing to beneficiaries after factoring in capital gain tax rates (currently 15% to 23.8%) and estate tax rates (currently 18% to 40%), whichever the estate faces.
Further complicating matters is the fact many states levy their own inheritance tax, independent of the federal estate tax. The state of Oregon, for example, imposes a tax that ranges from 10% to 16% on estates valued over $1 million. Consider the following scenario: A widow living in Oregon has two children and assets of $1.5 million. Her estate is well below the $5.43 million federal exemption, but is above the $1 million Oregon exemption. If she were to pass away, state estate taxes of $50,000 would be owed ($500,000 x 10%).
Fortunately, Oregon has no gift tax limit. If the widow gifted $300,000 to each of her children immediately prior to her death, her estate would settle with assets of $900,000 and no state estate tax would be owed. While her federal lifetime exemption ($5.43 million) would decrease by roughly the $600,000 she gave her kids, it is still more than sufficient to shelter her estate from federal estate tax.
The bottom line? Coordination between the investor, investment advisor, and an estate attorney can help turn what can be a complicated puzzle into a plan.