A Missed Portability Election, a Creditor-Exposed Child, and $4.1 Million of IRA
Your client is a 74-year-old widow with two adult children from her first marriage. Her assets: a traditional IRA of $4.1 million, a Roth IRA of $650,000, rental real estate worth $2.7 million with a $900,000 basis, and a brokerage account of $1.8 million with a $700,000 basis, for a total of $9.25 million. Her late husband died 34 months ago with an $11.8 million estate. His executor filed a Form 706 solely to establish the basis of jointly held property but never made a portability election, and no one has revisited it; she has no knowledge of any lifetime gifts by him. One child is a physician in the 37% bracket; the other is a teacher in the 22% bracket going through a divorce with significant creditor exposure. Her state imposes an estate tax with a $2 million exemption; her will leaves everything outright to the children equally.
1. Should the family pursue a late portability election? Show the analysis, not just the conclusion.
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The door is still open. Under Rev. Proc. 2022-32, an estate that was not otherwise required to file a Form 706 may make a late portability election by filing a complete return within five years of the decedent's death. At 34 months, they are inside the window. The cost is a professional-prepared 706 plus the DSUE computation.
But compute the benefit before paying for it. Deceased spousal unused exclusion equals the applicable exclusion amount at his death minus the taxable estate and any lifetime taxable gifts. If his exclusion was roughly $12 million and his estate was $11.8 million with no lifetime gifts, DSUE is only a few hundred thousand dollars. That is worth something but not much, and it does not touch the state estate tax, which is the real exposure here.
Where it matters: DSUE is portable and stacks on her own exclusion, sheltering a few hundred thousand dollars that would otherwise be taxed at 40% - meaningful but not transformative. If his gift tax returns reveal substantial lifetime gifts, the DSUE could be far larger and the math flips decisively.
Action steps: obtain his gift tax returns and the 706 as filed; recompute DSUE; compare the tax saved against preparation cost; if favorable, file the supplemental 706 with 'Section 2010(c)(5)(B) / Rev. Proc. 2022-32' across the top.
The lesson to state plainly: the missed credit shelter trust at the first death is the larger cost, and it cannot be undone.
2. How should the $4.75 million of IRA assets be allocated between the two children, and what structure protects the teacher?
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Allocation - direct the Roth to the physician. Roth distributions are income tax free to the beneficiary, so the highest-bracket child gains the most. Traditional IRA distributions are ordinary income, so they should go to the child in the 22% bracket, who can take them over the 10-year window without being pushed into a punitive rate.
The 10-year rule has an annual requirement. Because she is past her required beginning date, the surviving children as non-eligible designated beneficiaries must take annual required distributions in years one through nine and empty the account by year ten. The teacher cannot wait until year ten - a common and expensive error.
Protecting the teacher - trust, not outright. An outright inherited IRA is fair game for a divorcing spouse and creditors. A properly drafted see-through accumulation trust (not a conduit trust) satisfies the look-through rules, keeps distributions inside the trust, and shelters them. Requirements: the trust must be irrevocable at death, use valid trust beneficiaries identifiable from the document, and the trustee must file the required documentation and report the trust to the custodian by October 31 of the year following death.
Drafting cautions: do not name the child's spouse or the estate as a contingent beneficiary, do not give the child a general power of appointment, and confirm no non-individual beneficiary would shorten the payout. Coordinate the beneficiary designation with the will - the designation controls the IRA, not the will.
3. Beyond beneficiary designations, what transfer planning addresses the state estate tax and the asset selection for step-up in basis?
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The state tax is the dominant exposure. With a $2 million state exemption and a $9.25 million estate, roughly $7.25 million is exposed to state estate tax, and portability is federal only - it offers no relief here. A credit shelter trust at the first death would have absorbed that, but the election window for that planning has closed.
What still works, in order of efficiency:
- Annual exclusion gifts now: $19,000 per recipient, and gifting enough to reduce the state estate below the exemption over several years. Small, but free of federal gift tax and out of the state estate immediately.
- Discounted entity transfers: the rental real estate into a limited partnership and gifting limited interests with valuation discounts. Weigh this against the loss of step-up on gifted interests.
- Charitable remainder trust if she has charitable intent: removes appreciation from the estate, provides an income stream, and yields a deduction.
- Life insurance in an irrevocable trust - but note that at 74 the policy will be expensive and the three-year rule will apply.
Asset selection for the step-up. All four assets receive a new basis at her death; that is the reason not to gift the low-basis brokerage account or the rental real estate during life. The basis step-up on the real estate and brokerage (roughly $2.9 million of combined gain) is worth far more than the estate tax saved on those assets. Gift high-basis cash equivalents and the partnership units instead; hold the low-basis assets until death.