Leaving your estate to your spouse? Here’s what you need to know Tax Matters by David A. Katzman Many people believe they do not need estate planning between spouses because all assets will automatically transfer to the surviving spouse—with no estate tax liability—due to the marital deduction allowed by the Internal Revenue Service (IRS). While this is a correct assumption and a simple approach to estate planning, it may not be the best way to manage your assets because it could leave the next generation of heirs with an unnecessarily high tax liability. The reason the tax bill for the next generation could be inordinately high is because each member of a married couple is entitled to transfer a specific amount of assets free of federal estate tax. When couples with significant assets use the marital deduction, they are essentially forgoing this entitlement for the spouse who dies first. The amount of this deferral depends on the year of death because the federal estate tax schedule is a moving target. For 2009, each individual is entitled to a “unified” credit, which allows a transfer of up to $3.5 million in assets to heirs free of federal taxes. As of January 1, 2010, the estate tax is repealed and unlimited assets can be transferred free of estate tax—until January 1, 2011. On that date, the estate tax will be reinstated with a much lower exemption rate of $1 million per individual. Of course, all of these figures could change if congress changes current law. For the sake of illustrating the potential pitfalls of the marital deduction, let’s assume that a couple has accumulated $7 million in assets and both spouses die in 2009. The husband dies in January and the couple’s entire estate transfers to his wife, who dies before the end of the year. Using the simple marital deduction, the husband’s half of the estate transfers to his wife free of estate tax in January. However, when the wife dies she now has an estate valued at $7 million and is entitled to transfer just $3.5 million to her heirs without incurring estate taxes. If the couple had a more sophisticated estate plan, however, the husband could have also used his $3.5 million exemption to transfer half of the estate upon his death directly to his heirs. This would leave just $3.5 million in estate value when the wife died, so her half of the estate would also pass to her heirs free of estate tax. In this case, how much did the lack of estate tax planning cost the couple’s heirs? The answer is a disheartening $1.6 million, approximately, at a tax rate of 45 percent. As this example illustrates, the marital deduction can be a costly estate planning approach for couples with significant assets. Sometimes couples face these tax consequences inadvertently because some assets transfer to a surviving spouse automatically. For example, jointly owned property and life insurance, if the spouse is the beneficiary, are two types of assets that transfer automatically. A well executed estate plan will anticipate these automatic transfers and set other assets aside to ensure that both spouses are able to transfer the maximum amount to their heirs. For couples concerned about transferring assets to next generation heirs when the surviving spouse may need to use the money, a trust may be an effective solution. A properly executed trust allows the surviving spouse to use the income from the assets for life, with the assets transferring to heirs upon the surviving spouse’s death. As you can see, a marital deduction may sound like simple estate planning, but it can be a costly error for couples with significant assets. David A. Katzman is a certified public accountant licensed to practice in the State of Florida and the Commonwealth of Massachusetts. He is also a certified financial planner and certified senior advisor. Please consult your tax advisor for details and assistance in applying this general information to your specific situation.