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1 Introduction
Retirees living in the US, whether as US citizens or as US residents (Green Card holders), need to think about the impact of US estate taxes on their surviving spouses.  Questions usually revolve around two issues
• the significance of the citizenship of the surviving spouse
• the tax treatment of the survivor’s pension

This note provides an initial orientation on both issues, while throwing some light on the rationale behind US regulations and practices that might seem arbitrary.  But the reader should be warned that this is a complicated area of tax law, and many details are omitted from this introduction to the topic. 

Retirees and spouses are encouraged to make plans for what will happen to their property after their deaths, and especially if the spouse is not a US citizen they should seek advice from qualified professionals.  The 1818 Society does not recommend specific practitioners, but it does maintain a list of estate and tax lawyers in the Washington area who are experienced in the circumstances typical of World Bank families.

This note will not help retirees or their surviving spouses who are not residents of the US, since different provisions of the US tax code apply to non-residents.

2 Estate Tax
The US, like many other countries, applies a tax to a person’s estate, meaning the value of the property he or she leaves upon death.  The notion behind the tax is that a democratic society will not flourish if very wealthy people can simply pass on great wealth to the next generation, perpetuating privileged dynasties.

For US citizens and residents, the estate includes all property, wherever it is located in the world, not just property in the US.  And it includes some items one might not usually think of, for example, the person’s share in a house or other jointly owned property that will become the sole property of the spouse upon the retiree’s death.  In such cases, 50% of the current value is normally included in the estate, provided the surviving spouse is a US citizen, as discussed in Section 5 below.  Another item that has to be included is any “death benefit” from the retiree’s employer, discussed further in Section 3 below.

The estate tax would be ineffective if it were possible simply to give property away to the next generation (or others) before death.  To prevent this, the US levies gift taxes on all transfers above a certain threshold.  Accordingly, estate tax is due on the combined value of the property left at death and any gifts above the threshold level made during life – less whatever gift tax was already paid.

Note that in addition to federal estate tax, many (but not all) jurisdictions in the US levy their own estate taxes on residents.  Currently DC and Maryland do so, but not Virginia.  Federal estate taxes are reduced by whatever amount has been paid in estate taxes to a local jurisdiction.

3 Inclusion in the Estate of Surviving Spouse Pension
One of the assets clearly included in the US definition of an estate is any “death benefit” under an employer’s retirement plan.  Such a death benefit might be a survivor pension that is paid directly by the employer to the surviving spouse (as in the case of “Gross Plan” retirees), or a lump sum payment, with an option to convert it to a regular annuity (as in the case of “Net Plan” retirees).  Either way, it is treated as part of the decedent’s estate.  In the case of a surviving spouse pension, a calculation is made of its present value, using actuarial tables and taking into account the age of the surviving spouse – the calculation results in a “capital component” and an “interest component”.  The value of the capital component (on which estate tax might be levied) can be surprisingly large.

4 Limits to the Application of Federal Estate Tax
The current rate of US federal estate tax is set fairly high, at 45%.  However, various allowances and exemptions are permitted, which sharply limit the number of estates that actually pay estate tax – in 2008, it was estimated that only about 15,000 deaths (0.6% of the annual total in the US) would result in payment of federal estate taxes.

One major limit is the threshold value of an estate below which no federal estate tax is levied.  The threshold value has varied over the past few years, and may be changed again, but is currently set at $3.5 million.[1]   This means that a US citizen or resident (Green Card holder) may leave an estate of up to $3.5 million without any federal estate tax being due – the tax will only be levied on amounts above the $3.5 million threshold.

The second is the “unlimited marital deduction.”  It allows whatever the estate leaves to the surviving spouse to transfer without incurring estate tax, regardless of the threshold value, provided the surviving spouse is a US citizen.[2]   If the estate is valued over the threshold value (currently $3.5 million), estate tax only has to be paid on the excess amounts left to children or other parties.  When the surviving spouse dies in due course, estate tax is again due on any amount above the threshold value.[3]

5 Citizenship of the Surviving Spouse
Until 1988, for purposes of estate tax no distinction was drawn between US citizens and non-citizens resident in the US.  Any surviving spouse who was a US citizen or resident (Green Card holder) could take advantage of the “unlimited marital deduction.”  However, the law was changed in 1988 to exclude non-citizen residents from the benefit of this provision.[4]

A related provision applies to the valuation of joint property in the estate – if the surviving spouse is not a US citizen, 100% of the property value is deemed to have belonged to the decedent, unless the surviving spouse can produce financial records to document his or her contribution to its cost.

The rationale for the change was apparently a fear that any surviving spouse who was not a US citizen would arrange to move, together with the assets in the estate, out of the country – thus depriving the authorities of the opportunity to tax the remainder of the estate on the surviving spouse’s death.  If the surviving spouse were a US citizen, on the other hand, there would be no such incentive.

This means that if the surviving spouse is not a US citizen, estate tax has to be paid immediately (within 9 months of the retiree’s death) on any amount by which the total value of the estate exceeds the threshold value, which is currently $3.5 million at the federal level, and lower in some states.  There is a way of postponing, although not preventing, this outcome by setting up a Qualified Domestic Trust – usually called a QDOT – and transferring the assets of the estate above the threshold into the QDOT.  In this event, the estate tax is not due immediately, but only as amounts are withdrawn from the QDOT.  

While it is possible to set up a QDOT after the retiree’s death, lawyers usually advise clients to do so while both parties are alive.  Among other things, the existence of a QDOT provides a breathing space for a surviving spouse who is not a US citizen to consider applying for citizenship, if that is an option.  Once US citizenship is acquired, the surviving spouse can take full advantage of the “unlimited marital deduction.”

6 Estate Taxes on the Surviving Spouse Pension
The surviving spouse pension or annuity is deemed to be part of the estate, but is actually paid out month by month by the Bank.  If no estate tax is due (because the surviving spouse is a US citizen and/or because the estate is below the threshold value), these payments are fully available to the surviving spouse.  However, if part of the estate has been transferred to a QDOT, the calculated “capital components” of any monthly pension payments that remain with the surviving spouse are deemed to be withdrawals from the estate, and attract estate tax, payable at the end of each tax year.  The surviving spouse has the option of making an agreement with the US tax authorities to deposit these payments in the QDOT, in which case estate tax will not be due until the funds are eventually withdrawn. 

An estate lawyer will usually advise clients to arrange their affairs so that the “capital component” of a surviving spouse pension is part of the estate falling below the $3.5 million threshold, and therefore not subject to federal estate tax.  If the total value of the estate exceeds the threshold value, assets that do not have to be drawn down regularly (such as a house or some other tangible property) can conveniently be assigned to the QDOT.

7 Income Taxes on the Surviving Spouse Pension
Even though surviving spouse pensions are considered part of the retiree’s estate, and may attract estate tax on his or her death, this does not exempt the recipient of the pension from income tax.  The surviving spouse will have to pay US federal and state income taxes on the monthly pension or annuity payments in essentially the same way as the retiree did previously. 

Note that “Gross Plan” retirees who were not US citizens during their service with the World Bank, but who remain in the US after retirement, have a significant portion of their pension tax-exempt.[5]  The exempt amount is calculated at the time of retirement on the basis of actuarial tables, taking into account life expectancy and how much the Bank contributed toward the retiree’s pension over the years.  The exempt amount is then spread over several years – if it has not been exhausted by the time of the retiree’s death, the tax exemption continues to apply to the surviving spouse pension.  When the exemption ceases, it will normally result in a significant increase in the amount of income tax payable each year.  Pension Administration can provide information to individual retirees or surviving spouses on when the exemption will be exhausted.

John Blaxall 6/09

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1  Under laws passed during the George W Bush Administration, the $3.5 million figure applies only to 2009 – federal estate tax would be eliminated in 2010, and then reintroduced in 2011 with the threshold value reverting to $1 million.  There is a very low probability that this will actually happen.  It seems more likely that legislation will be passed to keep the threshold value at $3.5 million for at least the next two or three years.  Note that both DC and Maryland apply a lower threshold value of $1 million – in those jurisdictions, any estate valued above $1 million must pay estate tax to the local jurisdiction even though no federal estate tax may be due. [Return to text]

2  The “unlimited marital deduction” applies to both federal and state level estate taxes. [Return to text]

3  A provision in the legislation now under consideration would allow the estate of a surviving spouse to take advantage of any portion of the exemption that was “unused” when the first spouse died.  Thus if the exemption is $3.5 million and a retiree leaves an estate valued at $2 million, the “unused” portion of $1.5 million will be added to the exemption for the surviving spouse, whose estate will pay tax only if it exceeds $5 million.  This proposal may or may not eventually be enacted into law. [Return to text]

4  The Bank was sufficiently alarmed by the 1988 change that a program was introduced to offset its financial effects.  The program covered active staff and those who had retired within the last 180 days, i.e. those who could be considered obliged to be in the US because of their World Bank employment.  The Bank considered that after half a year, retirees should take responsibility for making their own arrangements for residence, citizenship and estate planning. [Return to text]

5  The exempted portion is often more than 40% at the time of retirement, whereas for retirees who were US citizens, and therefore subject to US income tax during their service, the exempted portion is normally less than 10%.  The percentage exempted declines from year to year as cost of living adjustments (which are taxable) are added to the original pension amount. [Return to text]

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