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Estate Tax Marital Deduction: Don’t “Overqualify”

By Parag P. Patel, Esq.

This article is for my clients who mistakenly believe that they do not need estate planning advice because they plan to leave all their assets to their spouse and will have no estate tax liability due to the marital deduction. In this regard, it’s important to understand one danger the marital deduction poses in estate planning: that of “overqualifying” for it.

There are no limits on how much of a marital deduction your estate can qualify for. Thus, if your entire estate goes to your surviving spouse, your estate will owe no federal estate tax. Many people take this simple approach. In the long run, however, it can cost your family hundreds of thousands of dollars in extra estate taxes. Here’s what’s involved.

Every individual is entitled to a “unified” credit entitling him to transfer $650,000 in cash or property free of federal estate or gift taxes (“transfer” taxes). A husband and wife, therefore, should be able to transfer to their children (or other beneficiaries) a total of $1,300,000 in assets free of transfer taxes: $650,000 each. If the first of them to die leaves everything to the surviving spouse, however, he will have failed to take advantage of his unified credit. At the later death of the spouse, her credit will “shelter” $650,000 in assets passing to the children, but the remainder of the “parental” estate will be taxed.

Example (1). Husband dies with an estate of $2 million which he leaves in its entirety to his surviving spouse Wife. Husband’s estate has no estate tax liability due to the marital deduction. Wife dies later with the $2 million comprising her estate. After applying her unified credit, the estate tax bill will be roughly $600,000.

Example (2). The facts are the same as above except that Husband leaves only $1,350,000 to Wife and $650,000 to their children. Here, Husband’s estate will still owe no estate tax due to the combined effect of the marital deduction and unified credit. At Wife’s later death, her estate is $1,350,000, instead of $2 million in the earlier example. Now, after applying her unified credit, the estate tax bill will be roughly only $300,000. By having Husband keep $650,000 from qualifying for the marital deduction, roughly $300,000 in estate taxes are avoided.

Property passing to the spouse: One reason an estate may overqualify for the marital deduction is there are ways for property to go the spouse automatically that is, not via the taxpayer’s will or through his probate estate. Two common examples are jointly owned property and life insurance.

If a married couple owns property jointly with survivorship rights, the surviving spouse obtains complete ownership by operation of law outside the estate. Under the estate tax rules, half the value of the property is included in the gross estate but qualifies for the marital deduction since it goes to the surviving spouse. Similarly, if the surviving spouse is the beneficiary of life insurance which is included in the estate, the marital deduction applies.

Accordingly, to avoid “overqualifying” for the marital deduction, it is important to know what property is already targeted to go to the surviving spouse. Then steps can be taken within your estate plan to make sure enough assets are set aside to take advantage of the unified credit.

If you are hesitant to remove $650,000 of your assets from your spousal bequest for fear of leaving your spouse with insufficient property to meet her needs after your death, special arrangements can be made to achieve your goals. One way is to place assets in trust with your spouse receiving the income interest for life and with your children receiving the assets at the spouse’s death. The trust can be set up to avoid qualifying for the marital deduction at your death, thus avoiding inclusion in your surviving spouse’s estate at her death.

My experience indicates that for most clients this is an issue. If you have an estate plan, review your documents to ensure proper estate tax planning is in place. If you have no estate plan, you should talk to an estate planning attorney to minimize your estate tax bill and maximize your estate assets for your family.