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Using Life Insurance and Portability to Reduce Your Spouse’s Estate Tax Burden When You Die

No one wants to think about losing a spouse or leaving a spouse behind when they die. That’s why a lot of my clients don’t consider how their spouse will handle their estate when they’re gone. They simply list their spouse as a beneficiary to the estate, assuming there will be enough cash on hand to cover the cost of the estate tax. The problem is, the surviving spouse can find themselves in a complicated position because by inheriting your legacy, he or she also becomes responsible for passing it on.  

Some newer laws make it a bit easier to take advantage of exemptions in passing on your estate, but this still requires some prior planning. To make sure your beneficiaries won’t have to deal with a major tax burden when you pass away, you should understand portability and how life insurance can be used to limit your taxable estate.

The Unlimited Marital Deduction Privilege, Estate Tax, and Portability

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 dies. Then, the government is going to take a huge chunk of the assets after the exemption, with tax amounts that historically have fluctuated from 40 to 50%. This amount must be paid in cash, sometimes causing heirs to have to liquidate large, generationally owned assets to pay a big tax bill.

The exemption per person is $11.7 million, and a provision that most refer to as “portability” allows you to transfer your exemption to your spouse after your death. This, in essence, doubles the exemption amount because spouses are permitted to pass on any unused exemption.

Portability isn’t automatic, but it has been simplified significantly by a part of the American Taxpayer Relief Act of 2012. In the past, to transfer your exemption to your spouse, you’d have to set up a series of bypass trusts, fraught with legal loopholes.

This was simplified in the new provision, which allows a spouse to directly elect to take his or her spouse’s exclusion. To do this, you must file an estate tax return when the spouse dies, even if you don’t have to pay any estate taxes. If that return isn’t filed or is filed late, the surviving spouse loses the portability and is capped at the individual rate.

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, $11.7 million might not represent a lifetime of assets. That’s why you should always file an estate tax return when your spouse dies to ensure you’re always able to claim his or her exemption.

But even the exemption might not be enough. Consider a scenario in which the first spouse dies and leaves $13 million in assets to the surviving spouse. The surviving spouse files the estate tax return, with the intention of using both exemptions together when he or she dies. But what if the first spouse has $13 million in appreciating assets and many of those are in high-value real estate holdings?

By the time the surviving spouse dies, it’s probable that these real estate holdings would far exceed even both exemptions and may cause the beneficiaries to have to liquidate some of the holdings. Not only would the beneficiaries lose the property, they’d have to liquidate that property during a booming market. To avoid this situation, the best choice is to set up an irrevocable life insurance trust (ILIT).

How ILITs Can Help Spouses

Funding an ILIT with life insurance helps to create an additional source of funding that’s immediately liquid at the time of your death. This is a cash value that can be used to cover an estate tax bill, so your beneficiaries won’t have to liquidate assets.

Aside from that, you can avoid impacting your eventual estate tax with the gift tax.

Gift taxes and estate taxes are covered under the same exemption. Any amount you gift above the annual exclusion of $15,000 per person will be included as part of your estate. Unfortunately, giving your assets away during your lifetime isn’t a way around the estate tax.

Using life insurance allows you to gift a policy’s cash value at the time of transfer, which means you can fund a much larger amount with a smaller premium and claim the premium as the gift tax excluded amount. That exemption of $15,000 per year is the limit per person, so you can make several gifts of life insurance to different beneficiaries. This moves the money out of your estate without impacting you or your spouse’s eventual estate tax deduction.

It’s best to do this within a trust because 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 what you want, which is to keep a portion of your assets out of your estate. Instead, you can do one of two things, depending on the amount of time you have for planning.

The first is to create a trust and gift a policy to it. The problem is, under the three-year rule, anything that you gift within three years of your death becomes part of your estate. The second option is to use the trust to purchase policies on your life with your spouse being a beneficiary. In either case, neither you nor your spouse can have any control of those policies.

Spousal estates are complicated because most of your finances are so intertwined. Portability makes it a bit easier to cover the cost, but it requires proper prior planning to ensure that it is used to its full advantage and beneficiaries won’t have to cover a major estate tax bill. Contact a Howard Kaye financial advisor or call 800-DIE-RICH today for more information on planning around estate and gift taxes.

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                        Funding a Charitable Remainder Trust Howard Kaye insurance agency llc in boca raton fl