What Credit Shelter Portability Means to You

Good Morning Relaxing Retirement Member,

As we roll through this election season, taxes have taken center stage.

While very little consensus has been reached on income and capital gains tax rates, there has been progress on estate taxes since the 2010 election.

To refresh your memory, estate taxes are levied at your death on your assets above a certain amount. In other words, even after a lifetime of paying dozens of taxes, the largest of which is income tax, the federal government then taxes your heirs on what remains.

In tax year 2012, the amount that each of us can pass on without estate taxes is $5 million. After that, your heirs will pay a 35% estate tax or more to the federal government. (However, on the state level in Massachusetts, that threshold is still only $1 million.)

The better news, however, is that estate planning for most of our Relaxing Retirement members is now much simpler.


The provision that most particularly impacts our members is a brand new concept called “portability of the estate tax exemption”. What exactly does this mean?

It means a husband and wife can leave their federal estate tax exemptions to each other. The first spouse to die can automatically leave his/her $5 million estate tax free exemption to the surviving spouse, so the surviving spouse will have a $10 million exemption.

No longer do you have to create "credit shelter trust" estate plans to make full use of each of your exemptions.

This makes estate planning much easier, especially when most of your assets are in IRAs.

A Real Life Case Study

Let me give you a very simple, clean-cut case study. This will take a moment to clarify, but please bear with me because it’s all good news:

John and Mary Independent are married with three children. John’s only asset is a $5 million IRA, and Mary’s only asset is her $5 million IRA.

With $10 million of combined assets, they obviously want to make sure they take full advantage of their estate tax exemptions, so the full $10 million can eventually pass to their three children with no federal estate tax.

Without portability of the estate tax exemption, the only way they could have taken advantage of their exemptions was for the first spouse to die NOT to leave his or her $5 million IRA to the surviving spouse.

Under the old way of saving estate taxes for a married couple, we would tell John not to name Mary as beneficiary of his IRA!

If he did, Mary would wind up with $10 million of assets and only $5 million of exemption!

Under the old way of estate tax planning, the only way John could make use of his federal estate tax exemption would be to leave his IRA either directly to the children or to a "credit shelter" or "bypass" trust for the life benefit of Mary.

Leaving the IRA directly to the children could be a good tax move, but most members in my experience don’t like that because it takes money away from the surviving spouse.

Leaving the IRA to a credit shelter trust for the surviving spouse seems to protect the surviving spouse financially, and it definitely saves estate taxes for the children by keeping the IRA out of the surviving spouse’s estate.

However, on the flip side, it causes a huge loss of income tax benefits. There is no spousal rollover and no “stretch or inherited” IRA payout over the children’s life expectancy.

Instead, the entire IRA gets dumped out into the credit shelter trust over the single life expectancy of the surviving spouse, a much shorter period of time.

Prior to the new tax policy, members like John and Mary had to make a hard choice: Do we go for the income tax benefits of the spousal rollover by leaving the IRA outright to the surviving spouse, even though that costs extra estate taxes by wasting the first spouse’s estate tax exemption?

Or, do we save estate taxes by leaving the benefits to a credit shelter trust but give up on the long term deferral that would otherwise be available via the spousal rollover?

Thanks to the new law, you no longer have to make that particular hard choice.

Instead, John can leave his $5 million IRA outright to Mary and still leave her his $5 million estate tax exemption.

They can now get the income tax savings of long-term deferral of distributions via the spousal rollover, without having to waste one spouse’s estate tax exemption to get it. When Mary later dies, she will have a $10 million IRA and a $10 million estate tax exemption!

Two Caveats

First, as they do with many tax improvements, Congress left themselves a “sunset” clause, so this great benefit expires at the end of this year!

However, we’ll be keeping our eyes on their progress after the election as it’s highly likely that it will be extended.

Second, this doesn’t negate my recommendation from last week to create and fund a revocable living trust.

I still strongly recommend it for probate avoidance and estate management reasons so don’t take this to mean that you shouldn’t have created living trusts. They still have significant benefit.

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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