Portability's Effect on Planning for Retirement Benefits

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By Louis A. Mezzullo, Esq.  

Luce, Forward, Hamilton & Scripps, Rancho Santa Fe, CA


The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2011 (P.L. 111-312) included portability of the estate tax applicable exclusion amount of a deceased spouse, which is referred to as the "deceased spousal unused exclusion amount." Under portability, the survivor spouse is entitled to increase his or her gift and estate tax applicable exclusion amount by the excess of the predeceased spouse's estate tax applicable exclusion amount over the taxable transfers of the predeceased spouse, which is the sum of his or her taxable gifts and his or her taxable estate. For example, if the first spouse to die left his or her entire estate to the surviving spouse, thereby qualifying the entire estate for the marital deduction, and made no taxable gifts during lifetime, then assuming the death occurred in 2011, the surviving spouse would have a gift or estate tax applicable exclusion amount of $10 million (taking into account the decedent spouse's unused $5 million exclusion amount). It should be noted, however, that under current law, portability sunsets in 2013. Most commentators believe that portability will be made permanent, and the Obama administration's 2012 fiscal year revenue proposals would make portability permanent.


Planning to use portability instead of a so-called bypass trust to preserve a deceased spouse's applicable exclusion amount in most cases is not advisable. Using a bypass trust would exclude from the survivor's estate any increase in the value of the assets in the trust plus income on those assets. Note that the deceased spousal unused exclusion amount is not indexed for inflation. Because portability does not apply to the GST tax exemption, using a bypass trust is the most appropriate way to use the unused GST tax exemption of the first spouse to die and preserve the assets for the surviving spouse. Although the use of a reverse QTIP election would accomplish the same purpose, this plan would involve as much complexity as a bypass trust without the other benefits of a bypass trust. In addition, using a bypass trust will preserve the deceased spouse's unused exclusion in the event the surviving spouse remarries, the applicable exclusion amount is reduced, or portability sunsets. Finally, in a state that does not conform to the federal estate tax regime, a bypass trust may be necessary to use a state's estate tax exemption.


Using a bypass trust also provides the traditional benefits of an irrevocable trust, including protection from creditors, protection from the rights of future spouses, professional management, and preserving assets for children of the deceased spouse's prior marriage. In many states, because a revocable trust is often used to avoid probate, adding a bypass trust will not involve significant costs.


The use of a bypass trust also avoids the problem with the "last deceased spouse" requirement. Under this requirement, it is only the unused exclusion amount of the last deceased spouse that can be used by the surviving spouse. If the last deceased spouse has used his or her applicable exclusion amount, for instance, to make gifts to children by a prior marriage, the surviving spouse would not have any deceased spousal unused exclusion amount. If a prior deceased spouse had established a bypass trust to receive his or her applicable exclusion amount, the prior spouse's applicable exclusion amount would not have been wasted. In addition, even though a bypass trust has been established by a former spouse, the surviving spouse could remarry and then have the benefit of the new spouse's unused exclusion amount if the new spouse died before the surviving spouse and had not used all of his or her applicable exclusion amount. 


Nonetheless there are benefits to relying on portability, including simplicity, a step-up in basis at the surviving spouse's death of the assets that would have funded a bypass trust, the elimination of state estate tax in a state that does not permit a partial QTIP election, and the avoidance of the need to transfer assets from the wealthier spouse to the less wealthy spouse so each has enough to use the applicable exclusion amount. Portability will be helpful with regard to assets, such as qualified retirement plans benefits and IRAs, that are either difficult to transfer during lifetime or cannot be transferred without unfavorable tax consequences. In this case, without portability, if the less wealthy spouse dies first, his or her exclusion amount will be wasted.


For example, if one spouse has $10 million in an IRA and the other spouse has $1 million of assets and the spouse with $1 million dies first, the surviving spouse will have a gift and estate tax exclusion amount of $9 million (the sum of the surviving spouse's $5 million dollar amount and the deceased spousal unused exclusion amount of $4 million). Before portability, $4 million of the unused exclusion of the spouse with $1 million would have been wasted if he or she died first, unless the spouse with the $10 million IRA withdrew $4 million from the IRA and gave it to the other spouse before the other spouse died. The withdrawal from the IRA would have been subject to income tax, and perhaps a 10% premature withdrawal penalty.


In conclusion, while most people should not rely on portability when designing their estate plans, portability may be useful when one spouse has significant qualified retirement plan benefits and IRAs and the other spouse has insufficient assets to take advantage of his or her applicable exclusion amount.


 For more information, in the Tax Management Portfolios, see Streng, 800 T.M., Estate Planning,  and in Tax Practice Series, see ¶6180, Introduction - The Estate and Gift Taxation System, and ¶6350, Estate Planning.

© Louis A. Mezzullo, Esq.