How changes in Bypass Trusts and Portability Rules could affect your Federal Estate Tax and Planning

While something of a ‘wait and see’ game, the portability rules governing a spouse’s unused estate tax exemption signed into (temporary) law in 2010 were all but guaranteed to become permanent in the new year. They provided an easier alternative to Bypass Trusts, which essentially became an extra step in securing estate funds that could otherwise, under the old rules, be taxed very heavily. As anticipated, the portability rules were signed into law permanently on January 2nd, 2013, under the American Taxpayer Relief Act, and Bypass Trusts are now much less necessary for ensuring the financial stability of your estate for you, your spouse, and your children.

The latest Taxpayer Relief Act has been permanently set at a baseline of $5 million, adjusted annually for inflation

Here’s a basic overview of what this means to you:

Estate tax exemptions have risen dramatically over the course of the last decade; rising from $600,000 up to $3.5 million and now after the signing of the latest Taxpayer Relief Act has been permanently set at a baseline of $5 million, adjusted annually for inflation1.  The exemptions themselves have been growing, but prior to the taxpayer relief act they had a peculiar caveat:  if a married couple had, for example, an estate value of $5 million each and the husband passed on, he would leave all of his money to his wife. Under the laws, if his wife then passed on, only $5 million of her now $10 million estate would be considered tax-exempt, and the remaining $5 million could be taxed for nearly half of its value when the government tax was at its highest.

This is where a Bypass Trust would come in, as it would allow a spouse to leave their estate to a trust (often established primarily to benefit their spouse) instead of simply leaving the money to their estate. A wife whose husband passed away would never directly receive her husband’s estate, but would instead receive it through the trust. Later, when she leaves her estate to her children, her husband’s assets wouldn’t be counted among her own and would therefore bypass the estate tax that would have eaten into their funds. All of this has become, in a sense, automatic (with appropriate and timely tax filing) as a result of the portability rules being signed permanently into law, taking a major step out of ensuring that your estate doesn’t get taxed too heavily. Now, a spouse’s exemption rolls over.  If, for example, we take the same couple with $5 million each and one passes on, their spouse will receive their own $5 million exemption as well as their spouse’s $5 million exemption. As long as the couple files on time, the government will handle the rest.

This isn’t to suggest that Bypass Trusts are entirely obsolete. They are still excellent ways of choosing where your money will go, limiting access to the funds and other methods of ensuring that your estate ends up where you want it to most. But overall, for the vast majority of couples, estate planning has become a lot easier. In addition, with the Taxpayer Relief Act setting the top tax at 40%, your loved ones will find themselves getting more of your earnings than ever before.

1The Internal Revenue Service recently announced that the federal estate-tax exclusion amount for estates of people who die in 2013 is $5,250,000.

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