Computers and phones aren’t the only things that are portable today. The gift and estate tax exemption is also “portable” for married couples. Portability simplifies estate planning by allowing a surviving spouse to use the deceased spouse’s unused portion of the $5.45 million gift and estate tax exemption amount. This means that married couples can maximize the benefits of their combined exemptions without the need for sophisticated estate planning involving multiple trusts.

Anatomy of an estate tax break

Let’s trace the history of this modern phenomenon. After a decade of gradual increases in the federal estate tax exemption — with a one-year moratorium on estate taxes in 2010 — the changes climaxed in 2011 with a generous $5 million exemption (indexed for inflation) authorized by the Taxpayer Relief Act of 2010. At the same time, the top estate tax rate dropped from a high of 55% to 40%.

But the 2010 tax law change did more than solidify the estate tax exemption and tax rate. Among other things, it created a portability provision allowing a surviving spouse’s estate to use any remaining portion of the exemption available from the deceased spouse’s estate. This amount is referred to as the deceased spousal unused exemption (DSUE) amount.

Although the portability provision technically expired after 2012, it was quickly reinstated (and extended on a permanent basis) by the American Taxpayer Relief Act. The tax law change also permanently preserved the inflation-indexed $5 million exemption and the top 40% rate.

The portability provision provides a “safety net” for couples with joint assets exceeding the exemption amount for the estate of the first spouse to die. It can be especially effective when combined with the unlimited marital deduction.

Portability in action

Suppose that Kevin and Debbie, who have two children, each own $3 million individually and $4 million jointly with rights of survivorship, for a total of $10 million in assets. Under their wills, all assets pass first to the surviving spouse and then to the children.

If Kevin dies in 2016, the $3 million in assets he owns individually is covered by the unlimited marital deduction. His entire $5.45 million exemption is unused. When Debbie dies, her estate can use Kevin’s unused exemption, plus the exemption for the year in which she dies, to shelter the remaining assets of $10 million from tax, with plenty of room to spare for some appreciation in value.  

Here’s what could have happened without the portability provision: Let’s assume that Debbie dies later in 2016. Without being able to benefit from the unused portion of Kevin’s exemption, the $5.45 million exemption for Debbie in 2016 would leave $4.55 million still subject to estate tax. At the 40% rate, that’s a staggering federal estate tax bill of $1.82 million.

Although techniques such as a traditional bypass trust may be used to avoid or reduce estate tax liability, this simplified example demonstrates the potential impact of the portability provision. It’s important to know that portability isn’t automatic. The estate of the surviving spouse must make a valid election to realize the benefits. (See “A timely tax election this year.”)

Also be aware that this discussion covers only federal estate taxes. State estate taxes on inheritances may also have a significant impact, particularly in states where the estate tax exemption is low as compared to the $5.45 million federal exemption.

Does this mean that portability is always the best option? Absolutely not. All the relevant factors should be taken into account, including nontax reasons that might affect distribution of assets under a will. For instance, a wealthy individual may want to divide assets in a way that doesn’t maximize portability benefits, including bequests complicated by divorces, second marriages or other circumstances. Also, portability is less of a concern for state death tax purposes in community property states.

Determining the right path

Portability has the benefit of simplicity, but carefully review your situation before taking action. Your estate planning advisor can help you determine if portability is your best course of action.

Sidebar: A timely tax election this year

This could be an election year of a different sort for some affluent families. For portability to apply, it must be elected by the executor of the surviving spouse’s estate.

The executor must make the election of the deceased spousal unused exemption (DSUE) amount on Form 706, “United States Estate (and Generation-Skipping Transfer) Tax Return,” as well as include a computation of the DSUE amount. The election is effective only if made in a timely fashion. Thus, it must be made on an estate tax return filed within nine months of death, plus any allowable extension. There is, however, an exception to allow for late elections in certain situations.

On the timely filing of a valid estate tax return, the executor of an estate of the deceased survived by a spouse will be treated as having elected portability of the DSUE amount, unless the executor opts out based on prevailing regulations.