Introduction: The Importance of Reducing Spouses Estate Tax Burden
When it comes to estate planning, one of the biggest concerns is how to reduce a spouses estate tax burden. While no one wants to think about losing a spouse, it’s essential to plan for the future to ensure your loved ones aren’t left with a hefty tax bill. Many people mistakenly assume that simply naming their spouse as a beneficiary will be enough to cover estate taxes, but the reality is more complicated.
Without proper planning, your spouse could face significant financial challenges, including the potential liquidation of valuable assets to pay the estate tax. In this blog, we’ll walk you through some key strategies, including the use of portability and irrevocable life insurance trusts (ILITs), that can help you minimize the tax burden on your spouse and secure your family’s financial future.
The Role of Portability in Estate Planning
Some newer laws make it easier to take advantage of exemptions when passing on your estate, but this still requires prior planning. To ensure your beneficiaries won’t have to deal with a major tax burden when you pass away, it’s crucial to understand portability and how life insurance can be used to reduce a spouse’s estate tax burden.
Understanding the Unlimited Marital Deduction Privilege, Estate Tax, and Portability
Unlimited Marital Deduction: You can leave your entire estate to your spouse when you die, and your spouse won’t need to pay estate tax until he or she passes away. However, after that, the government could claim a large portion of the assets, with tax rates historically fluctuating from 40% to 50%. This tax must be paid in cash, which sometimes forces heirs to liquidate large, generationally owned assets to cover the bill.
Portability and Its Benefits: The exemption per person is $13.6 million, and a provision known as “portability” allows you to transfer your exemption to your spouse after your death. This effectively doubles the exemption amount since spouses can pass on any unused exemption.
Simplification of Portability: Portability isn’t automatic, but it has been significantly simplified by the American Taxpayer Relief Act of 2012. Previously, transferring your exemption to your spouse required setting up bypass trusts, which involved navigating complex legal loopholes. The new provision allows a spouse to directly elect to take the deceased spouse’s exclusion by filing an estate tax return, even if no estate taxes are owed. Failing to file or filing late results in the loss of portability, limiting the surviving spouse to the individual exemption rate.
The Importance of Filing an Estate Tax Return: Estate tax is tricky because most people think of the cash they have on hand, without considering the true value of their properties and business holdings. In today’s economic environment, $13.6 million might not represent a lifetime of assets. That’s why it’s crucial to always file an estate tax return when your spouse dies to ensure you can claim his or her exemption.
Potential Challenges with Exemptions
Even with the exemption, it might not be enough in certain scenarios. For example, if the first spouse dies and leaves $16 million in assets to the surviving spouse, the surviving spouse might intend to use both exemptions together when he or she passes away. However, if the first spouse has $15 million in appreciating assets, particularly in high-value real estate holdings, these assets could far exceed both exemptions by the time the surviving spouse dies. This situation could force the beneficiaries to liquidate some of these holdings, potentially during a booming market, to pay the estate tax.
Leveraging ILITs to Reduce Spouses Estate Tax Burden
Immediate Liquidity with ILITs: An Irrevocable Life Insurance Trust (ILIT) can be a game-changer for covering estate taxes. By funding an ILIT with life insurance, you create a cash asset that’s available immediately upon your death. This can be used to pay the estate tax bill, preventing your beneficiaries from needing to sell off family assets.
Minimizing Gift Taxes: ILITs also help reduce the impact of gift taxes, which share the same exemption as estate taxes. This strategy allows you to move significant assets out of your taxable estate, protecting your or your spouse’s deduction.
Keeping a Portion of Your Assets Out of Your Estate
To keep assets out of your taxable estate, it’s best to use a trust. Any policies owned outright by you and given to your spouse will be considered part of your taxable estate. Gifting the policy to your spouse directly wouldn’t accomplish your goal of keeping assets out of the estate. Instead, you can:
- Create a Trust and Gift a Policy to It:
- Be aware of the three-year rule, where any gifts made within three years of your death are considered part of your estate.
- Use the Trust to Purchase Policies:
- The trust purchases policies on your life, with your spouse as the beneficiary. Neither you nor your spouse can have any control over these policies.
Conclusion: Proper Planning is Key
Spousal estates are complicated because most finances are so intertwined. While portability makes covering the cost easier, it requires proper prior planning to ensure it is used to its full advantage. This careful planning ensures that beneficiaries won’t have to cover a major estate tax bill.
For more information on planning around estate and gift taxes, contact a Howard Kaye financial advisor or call 800-DIE-RICH today.
