Why Portability, and Estate Taxes, are Important for You

Let’s face it: it’s an unfortunate fact that the vast majority of people, because of recent changes to the estate tax system, won’t ever have to worry about estate taxes, because they won’t even have enough in the bank to justify attracting the notice of the IRS. I say “unfortunate” because, through informal polling, I’ve determined that 99% of people won’t own enough stuff to trigger estate taxes, and 100% of people would be happy to own enough assets to qualify to pay those estate taxes, even if they weren’t happy about the tax itself.

The reason is because, after the “Fiscal Cliff” negotiations at the end of 2012, the amount of assets that an individual can pass along in their estate without having to pay tax on the transfer is $5 million, adjusted for inflation. In 2013, the exclusion amount is $5.25 million, to be exact.

Over the last 15 years, the entire face of estate taxation has changed drastically, and for the better, for the vast majority of the American people. An incredibly small number of estates will need to pay taxes on the transfer of assets in the future (assuming no retrograde changes), which is terrific, especially for a small number of small Family Limited Partnerships and family farms that, due to the rising value of real estate, could possibly have been in danger of being broken up to pay taxes.

Now, while most people don’t need to worry about hitting that $5.25MM threshold, there is at least one of the aspects of the Fiscal Cliff deal that is important to many, many more people: Portability.

Portability is the name estate planning folks have given to the ability, under law changes that went into effect in 2011 (and have been extended through 2013 and beyond) for a surviving spouse to elect to “port” any unused estate tax exclusion amount to themselves for future use.

Here’s a simple example, and let’s ignore the many, many ways this couple could use other methods to minimize their tax burden: let’s say we have a married couple, worth $6 million together, and the husband passes away.(Isn’t it telling that these examples always have the husband die first?) When he passes, he leaves a will giving away his half of the assets, worth $3 million. That amount comes in well short of the $5.25 million threshold level for estate taxes to be due.

And ignoring any other planning measures, it also leaves $2.25 million worth of the exclusion amount unused. Previously, that amount was lost, and the surviving spouse could only give away $5.25 million allowed under general estate tax law.

But returning to this example, and the new Portability: with law changes from 2011 on, the surviving spouse in this case can elect to file an estate return for her late husband, and transfer the unused exemption amount over to herself for use in the future. So, in our example, the surviving wife would be able to leave $7.5 million without worrying about estate taxes.

Now why, you might ask, would the surviving spouse worry about being able to give away that much tax free when she’s only worth $3 million now? Well, let’s say she lives another 20 years, and invests wisely. At the end of her life she’s worth $7 million. With the ported exclusion amount she saved from her late husband, her beneficiaries won’t pay a nickel of federal estate tax on that amount.

Now, if she hadn’t filed that election when her husband passed 20 years earlier, her estate would have owed 40% tax on the amount above the exclusionary amount for that year. Just for this hypothetical, assume it’s still $5.25 million: the estate would owe approximately $700,000 in taxes at her death. That’s not chump change.

“But who cares,” you’re saying. “All I have is my house and my car, and an IRA worth $100k.” Well, let’s fast-forward into the future: the value of the house, and the IRA has shot up, and then your long-lost rich uncle dies and leaves you $10 million. Or you win the lottery. Or you’re kid is a left-handed fireball-throwing phenom for the Texas Rangers and inexplicably gives his $8 million signing bonus over to his dear old dad. Or, simply, you invent the next Temple Run or Pocket Fisherman.

That extra amount you can leave your loved ones would come in handy then, wouldn’t it.

There are a truckload of rules, of course, that come along with slipping all that extra money past Uncle Sam, as well as deadlines and the like, so talk to an estate planning attorney to help out with the details. And here’s hoping this is a problem you are fortunate enough to need to address.