While the increase in the federal estate tax exemption is good news, it could trigger two bad things if planning is not addressed.

  1. A spouse could receive less.
  2. There could be an increase in state estate taxes.

How Much Will the Spouse Receive Now?

If you are married and have set up a typical credit shelter trust estate plan (also known as a by-pass trust), that should be reviewed now. Under this type of estate plan, amounts up to the federal estate exemption ($5,250,000 million in 2013) will go to the credit shelter trust and any excess over that amount will either go directly to your spouse or a marital trust for your spouse’s benefit.

In a perfect estate plan, each spouse would use their entire exemption amount, paying the lowest possible estate tax after both spouses die. But for many couples, this was set up when the estate exemption was much lower.

Many estate plans have credit shelter trusts that were set up when the exemption was $2 million (and some even have plans set up when the exemption was $600,000!). If a plan was set up when the exemption was $2 million and the estate was $4 million, that would have been perfect since $2 million would go to the credit shelter trust (using the first spouse’s $2 million exemption) and the other $2 million would go to the surviving spouse. When she died (assuming her estate at death was $2 million, just to keep our ideal example), her $2 million exemption would be used so the couple would pass their entire $4 million estate totally free of federal estate tax to their heirs.

But what would happen now if that same couple (with a $4 million estate) had a typical credit shelter plan? If they had a typical plan that says that assets up to the amount of the federal estate exemption will be placed in the credit shelter trust, then $5 million will be placed in that trust and the surviving spouse could end up with much less than expected, in this case, NOTHING! – and that assumes that the assets are worth what they once were, which is unlikely to be the case with the recent stock market devastation. That may be a worst case scenario but it is probably not what most couples in this position would want.

It is true that the spouse can most likely invade the principal of the credit shelter trust, but that may trigger legal issues as to exactly how much the spouse can take out of the trust (depending on the trust terms) and may cause friction with children, trustees or worse, children of a prior marriage who may be beneficiaries of that trust who might want to interpret a poorly written or ambiguous trust to limit the spouse’s access to the trust

The will and estate plan should be revised, either to state a specific amount that should go to the credit shelter trust or to divide the property so that the spouse receives the amount that he or she desires. IRAs that are part of a credit shelter estate plan should also be looked at now to see how much of the IRA you would want to pass to the non-spouse beneficiaries (or a credit shelter trust) and how much should go to the surviving spouse.

IRAs that are left to non-spouse beneficiaries will use up the credit shelter amount. This could have implications either way. Now you can revise the plan and leave up to $5 million of the IRA to the children and the rest to the spouse, continuing to have the maximum amount of the IRA pass to the children free of federal estate tax. But this could trigger state estate tax if your state has decoupled from the federal system (see below).

You might also want to lower the amount of the IRA going to non-spouse beneficiaries, even if it turns out to be less than the estate exemption amount, in order to leave the spouse with more of the IRA.

Disclaimer Planning Allows Flexibility

One strategy to put the surviving spouse in control and still gain the best possible estate tax outcome is to build a disclaimer plan into the estate plan. The spouse would inherit everything and disclaim the amount not needed. Amounts disclaimed up to the federal and/or state estate tax exemption amount would then pass to contingent beneficiaries free of estate taxes.

This gives the surviving spouse total financial security, not having to worry about asking a trustee for money later on. Naming contingent beneficiaries, say the children, grandchildren or a credit shelter trust, is essential for this disclaimer strategy to work. This disclaimer strategy allows the surviving spouse to change the plan after the first spouse dies taking into account the needs of the surviving spouse and whatever the current estate tax exemption is at that time.

This strategy won’t work for single individuals since they only have one estate tax exemption. They have no spouse to leave property to above the exemption amount. Also, make sure the IRA custodian or employer plan will allow a beneficiary to disclaim.

Each situation should be addressed now taking the 2013 $5,250,000 federal estate exemption ($10,500,000 per couple) into account.

Increased State Estate Tax Cost of Decoupling

Many states have decoupled from the federal estate tax system. These states want no part of the increasing federal estate tax exemption and have gone their own way by taxing estates of lower values. They generally chose to remain at the exemption effective under prior law (before EGTRRA 2001 increased the federal estate tax exemption beyond $1 million). An individual with an estate of $5 million in 2013 will have no federal estate tax; but if they live (or should we say “die”) in a state that has decoupled, the estate could be subject to state estate tax.

This scenario presented problems before, but now that the gap between the federal and state estate tax exemptions is widening, the state estate tax effect is growing as well. The heirs of someone dying in a state that does not allow the full federal estate exemption amount will pay a price if they want to use any of the federal exemption above the state exempt amount. For example, an estate of $5.25 million will be exempt from federal estate tax, but in New York and some other states that have decoupled, the state estate exemption will be only $1 million triggering a state estate tax of $420,800!

The same disclaimer strategy described in the section above on disclaimer planning could work here as well, where everything is left to the spouse, who can then disclaim the amount that will pass free of any state estate tax.

Review your clients’ estate plans now to make sure they take the increased 2013 exemption levels into account.

Disclosure: The information provided is for educational and informational purposes only. This should not be construed as tax or legal advice. Should you require tax or legal advice, please contact a tax or legal professional licensed to offer advice in your area.