Estate Taxes: The Marital Deduction

One of the basic tax rules in estate planning is that there is no tax due for transfers between spouses. This is known as the “unlimited marital deduction” and applies to both Massachusetts and Federal estate taxes. While property transferred between spouses is not ultimately exempt from taxation, the marital deduction has the effect of deferring payment of estate taxes until the death of the surviving spouse.

Under the “American Taxpayer Relief Act of 2012” an individual is presently allowed an exclusion from Federal estate tax of $5,490,000 for 2017. That means that an individual can give away up to $5.49M in taxable gifts to anyone during life and at death without incurring a gift or estate tax. Transfers in excess of $5.49M will incur a 40% Federal Estate tax. The Massachusetts exclusion amount is $1M, with a graduated tax due on the entire estate for estates in excess of that amount.

The Personal Representative of the first deceased spouse’s estate can transfer that first spouse’s unused Federal exemption amount to the surviving spouse, which is known as “portability”. The Massachusetts exemption amount is not portable between spouses. You either “use it or lose it” as the saying goes.

Due to the high Federal exemption amount and the portability of a deceased spouse’s unused exemption amount, very few couples would owe a Federal estate tax even without the unlimited marital deduction. However, it is quite easy for a Massachusetts couple to have a taxable estate, particularly in light of local home values and the affordability of life insurance. Consequently, many middle class couples might find themselves with taxable estates.

Most people will agree that the state has no business taxing transfers between spouses, who are, after all, considered a single economic entity. This is precisely what the unlimited marital deduction accomplishes. Take the following example: Husband and Wife own a home worth $700,000, have joint savings of $200,000 and own term life policies on one another’s lives for $1M each. Upon Husband’s death, his taxable estate is $1,450,000. All of this property passes to Wife. Without the marital deduction, Husband’s estate might owe an estate tax of roughly $60,000. However, because Wife receives all of Husbands property, the entire amount can be deducted from the taxable estate, resulting in no estate tax due.

To be sure, the deduction merely defers payment of the tax until the death of the surviving spouse. Picking up with the above example: Wife’s estate now includes Husband’s $1.45M plus her own property. Upon her death, Wife’s taxable estate is $2.9M, which she leaves entirely to her children. Wife’s estate must pay a Massachusetts estate tax on the entire $2.9M, which may amount to an estate tax of roughly $175,000.

There are standard estate planning techniques designed to minimize the estate tax due upon the death of the surviving spouse by using certain revocable trusts intended to take further advantage of these tax rules. These trusts will be addressed in a later blog.

If you or your spouse have any questions about your own estate plans and how to prepare to minimize or avoid estate taxation, please give us a call.