Can portability help preserve retirement benefits?

The American Taxpayer Relief Act of 2012 (ATRA) made the estate tax exemption "portability" feature permanent. This allows a surviving spouse to take advantage of a deceased spouse's unused federal gift and estate tax exemption. The main advantage of portability is simplicity. It lets married couples make the most of both of their exemptions without the need for "bypass" trusts or other estate planning maneuvers.

But there are several disadvantages to relying on portability. For example, unlike trust-based strategies, portability doesn't shield future appreciation and income from estate tax or protect assets from creditors. Also, portability doesn't apply to the generation-skipping transfer (GST) tax exemption, so, for couples who wish to preserve the GST tax exemption of the first spouse to die, a bypass trust is the way to go.

One area where portability may provide an advantage, however, is in planning for retirement benefits.

No need for estate equalization

Before portability, married couples who wished to preserve their exemptions and minimize estate taxes generally needed to "equalize" their estates. Here's an example that illustrates why, absent portability, estate equalization is important:

Rich and Samantha are married with two children1. They have $10 million in assets, all of which is Rich's separate property. Rich's estate plan can avoid tax in both spouses' estates by transferring the exemption amount (currently $5.25 million) to a bypass trust for the benefit of the kids and the $4.75 million balance to a marital trust (assuming the exemption hasn't been reduced when Samantha dies).

If Samantha dies first, however, there's no estate tax, because she owns no assets. But under the old rules, when Rich died later, his estate would owe $1.9 million in estate taxes — $4.75 million × 40% (assuming the exemption amount and tax rate haven't changed). Samantha's exemption would be wasted.

To avoid this result, preportability estate planning techniques would call for Rich to transfer $5 million to Samantha to equalize their estates. That way, regardless of who died first, both of their exemptions would be preserved and estate tax would be avoided. But what if Rich's $10 million is in an IRA? To equalize their estates, Rich would have to withdraw $5 million from the IRA — subject to income taxes and, possibly, a 10% penalty — and transfer the funds to Samantha. To determine whether this is a good strategy, they would have to weigh the income tax cost against the potential estate tax benefits.

Portability eliminates this problem, because there's no need to equalize estates. If Samantha dies first (and her estate files a portability election), Rich can combine her unused exemption with his own to shield his entire $10 million estate against tax. And if Rich dies first, the marital deduction allows him to leave his entire estate to Samantha tax-free without using any of his exemption. Portability then allows Samantha to use their combined exemptions to avoid estate tax.

Maximizing tax deferral

Portability provides another important advantage. Generally, leaving retirement benefits to your spouse is the most effective way to maximize their tax-deferral benefits. Why? Because a spouse can roll those benefits over into his or her own IRA, name new beneficiaries, and stretch out the deferral period over many years.

If you leave retirement benefits to a credit shelter trust, however, the funds will have to be distributed sooner and some of the benefits of tax deferral will be lost. Portability allows you to leave retirement benefits to your spouse without wasting any estate tax exemptions.

Weigh your options

If you have significant assets in IRAs or other retirement plans, ask your advisor whether relying on portability is a good strategy. He or she can help you weigh the potential benefits of portability against those of other strategies.