In prior postings, I wrote about the Deceased Spouse’s Unused Exclusion (DSUE), and the unintended consequences of a reduced DSUE when a surviving spouse remarries.

In today’s post, I’ll be writing more about Betty and Howard. You’ll recall that Betty’s first husband, Arnold, passed away in 2013, leaving $3 million to the couple’s children. Although his estate was not large enough to require that an estate tax return be filed, an estate tax return was filed anyway and an election was made allowing Betty to “inherit” the unused portion of the estate tax exemption from Arnold’s estate. As such, Betty’s total 2015 estate exclusion amount is $7.68 million (her own $5.43 million exemption for 2015 plus the $2.25 million DSUE).

This is the point at which smart couples recognize their mortality and take actions to protect their heirs. If Howard dies, he will become Betty’s “last deceased spouse,” and Betty’s estate would be forced to use his $0 DSUE instead of the $2.25 million DSUE she “inherited” from her first husband, Arnold. Betty’s estate would be able to shield only $5.43 million from taxation, rather than $7.68 million available to her while Arnold is still her “last deceased spouse.”

Fortunately, the DSUE Betty acquired through Arnold’s estate can be used as an additional gift tax exclusion instead of waiting for her estate to use the exclusion after she dies. This provision allows Betty to act now and gift $2.25 million to her children, using the DSUE she “inherited” from Arnold to shield the gift from taxation. The DSUE is used before Betty’s own exclusion, which is $5.43 million for 2015 and will continue to grow with inflation for the remainder of Betty’s life. If Betty lives a long and healthy life, that exclusion will grow as time marches on since it is indexed for inflation. If Howard passes away first and has an available DSUE, Betty can again inherit Howard’s DSUE and it can be used to further shield her estate assets from taxation.

By using the DSUE she received from Arnold’s estate while it is still available to her, she can protect her children from $900,000 in estate taxes ($2.25 million exclusion she would lose if Howard predeceases her x 40% federal estate tax rate). In addition, these gifts grow in the hands of Betty’s children (assuming they are properly invested), allowing them to enjoy the benefits of growth without incurring a potentially-taxable transfer of appreciated assets. Perhaps most importantly, Betty is still around to watch her children enjoy her gift!

As I’ve noted previously, everyone’s situation is different, and the solution that worked for Betty may not be the best course of action for you. State community property laws, how assets are titled (tenants in common verses joint tenancy with right of survivorship), and other specific circumstances may recommend a different course of action. The important lesson, however, is that the time to make a plan is before the plan is needed; the time to consider the tax consequences of your estate plan is before the tax man comes knocking on the door of your heirs.

In my last post, I explained how the Deceased Spouse’s Unused Exclusion (DSUE) can be “inherited” by the surviving spouse, helping to shield their heirs from federal and state estate taxes that can combine to exceed a rate of 50%.

But what happens when a widow or widower with a DSUE remarries? The answer may surprise you.

Tax rules stipulate that the surviving spouse can use the DSUE of their “last deceased spouse.” That’s an important phrase to keep in mind, because some important estate planning needs to be done before either spouse passes away.

A subsequent marriage to someone to someone who dies without leaving an exclusion available can actually foil the surviving spouse’s prior estate planning. The surviving spouse would then lose the DSUE from their first deceased spouse, and would instead be left with the diminished or non-existent DSUE they “inherited” from the second deceased spouse’s estate. Consider the following example:

Arnold and Betty have been married for 40 years and have three grown children. It was a first marriage for both of them, until Arnold died in 2013 at age 60. Betty owns $10 million in assets, while Arnold left $5 million to Betty and $3 million divided among their children. The estate tax exclusion when Arnold died in 2013 was $5.25 million, and Arnold’s estate used $3 million of the exclusion to shield all of the children’s inheritance from taxation. No exclusion was needed for the assets transferred to Betty, as there is an unlimited spousal exclusion available to all taxpayers. [Note that this example assumes that neither Arnold nor Betty had made gifts during their lifetime that would reduce the unified credit.]

An estate tax return was filed and an election was made allowing Betty to benefit from the $2.25 million exemption that Arnold’s estate did not use (the DSUE). The $2.25 million carries forward as a set number even as Betty’s individual estate tax exclusion is indexed and grows with inflation. For 2015, Betty is able to shield $7.68 million in assets from estate tax (her own $5.43 million exclusion for 2015, plus the remaining $2.25 million that was unused by Arnold’s estate).

Now, suppose Betty remarries. Her second husband, Howard, has $10 million in assets, which he intends to leave to his own children. Howard passes away shortly after they are married, and his $5.43 million exclusion is completely consumed by that $10 million. Because Howard – not Arnold – is now Betty’s “last deceased spouse,” her DSUE is zero. As such, the amount of Betty’s assets that can be shielded from estate taxes has been reduced from $7.68 million to her own $5.43 million exclusion. If Betty dies in 2015, the federal estate tax obligation would be $900,000 more than if she had never married Howard (40% of the $2.25 million exclusion she “inherited” from Arnold but lost when Howard passed away).

This example illustrates the importance of periodically reviewing your estate plan with your financial advisor. As you life’s circumstances change, adjustments in your estate planning may be necessary. Solutions are available to Betty, but the time to act is now. And that’s the subject of my next post.

Legislation enacted a few years ago (finally) set a $5 million estate tax exemption for 2011 and indexed it for inflation each year thereafter. This means that the exemption grows as costs rise. For 2015, the exemption is $5.43 million. Assets exceeding the exemption amount are subject to a hefty 40% federal tax, as well as estate or inheritance taxes (sometimes both) imposed by 19 states and the District of Columbia. With state rates as high as 16%, some estates could be subject to tax rates exceeding 50%. Ouch! Of course, there is no limit to the amount that can be transferred from one spouse to another, either during one’s life or upon death.

But there was also another important change that didn’t receive much public attention at all, even though it can dramatically reduce the estate tax burden for many couples. When someone dies, provisions made permanent in 2012 allow the surviving spouse’s estate to essentially “inherit” the unused portion of the decedent’s estate tax exemption. This option, known as a Deceased Spousal Unused Exclusion (DSUE), can be a particularly helpful estate-planning consideration when one spouse is expected to outlive the other by many years, as well as for couples with uneven asset holdings or poorly-constructed estate planning structures. The DSUE election may reduce the need to create credit shelter or bypass trusts solely to take advantage of each spouse’s federal estate tax exclusion amount (there may be other reasons for creating such trusts, however, such as to avoid state-level taxation). It can also serve as a corrective buffer when well-intentioned mistakes have been made in estate planning that are discovered only after the first spouse has passed away.

Here’s the catch: In order to make the election, an estate tax return needs to be filed – even if the deceased spouse’s taxable estate is below the basic exclusion amount. The return, filed on Form 706, must be filed timely (including extensions)—generally within 9 months of date of death (15 months including extensions). If there is any concern that a surviving spouse’s assets, including inherited assets, may grow to the point that they exceed the exclusion level, it is important that the decedent’s personal representative consider filing an estate tax return that makes a protective DSUE election.

What’s the downside? There are some. The executor’s option of making or not making the DSUE election can fuel existing family conflicts, just as these kinds of conflicts can present problems at all levels of estate planning. Selection of an executor that will carry out the decedent’s wishes is crucial.

Consider for a moment the appointment of an executor that was devoted to his/her parent but is hostile to the surviving spouse or their heirs (think stepchildren, half-siblings, or conflicts between family members). Such an appointment could result in an estate tax return being filed for the specific purpose of denying the DSUE to the surviving spouse, which would essentially subject more of the surviving spouse’s estate to taxation. For example, if the decedent’s son or daughter is executor of the estate and they aren’t exactly fond of their surviving stepmother, they could file an estate tax return that doesn’t make the DSUE election, thereby denying the surviving spouse the opportunity to benefit from the decedent’s unused exclusion.

Perhaps the biggest drawback may be that the DSUE election extends the statute of limitations, giving the IRS more time to challenge the decedent’s estate tax return. Normally, there is a three-year statute of limitations for the IRS to challenge an estate tax return. The DSUE election essentially extends that to three years beyond the due date for the surviving spouse’s estate tax return. That’s right – making the election extends the statute of limitations to an unknown date in the future, long after both spouses have passed away.

But what happens when the surviving spouse remarries? That’s the subject of my next post.