Now that the federal estate tax exemption has been set permanently at an inflation-adjusted $5 million (currently, $5.25 million), fewer people are subject to federal estate tax. But that doesn’t mean estate planning is any less important. Out-of-date formula clauses, in particular, can create unwelcome surprises. This article shows how an outdated plan can end up effectively disinheriting the very person it’s supposed to benefit.

Estate Planning Red Flag

Your Will contains a formula clause

Now that the federal estate tax exemption has been set permanently at an inflation-adjusted $5 million (currently, $5.25 million), fewer people are subject to federal estate tax. But that doesn’t mean estate planning is any less important. Out-of-date formula clauses, in particular, can create unwelcome surprises.

Consider this example: Dave executed his will in 2007, when the exemption was $2 million. At the time, his estate was worth $2.5 million. His will contained a formula clause providing that an amount up to the current exemption would be placed in a credit shelter trust, with the balance going to his wife, Ann. Had he died in 2007, $2 million of his estate would have gone to the credit shelter trust and Ann would have received $500,000.

Fast-forward six years: Dave dies in 2013, never having amended his will. Let’s assume that his estate is now worth $3 million. Because the exemption has climbed to $5.25 million, the formula clause causes his entire estate to go into the credit shelter trust, essentially disinheriting Ann. From a practical perspective, though, if Ann is the income beneficiary of the trust, the technical disinheritance might not have an impact. If, however, Dave’s children from his former marriage are the beneficiaries of the trust, Ann will, in fact, have been disinherited.

State estate taxes can create additional headaches. Suppose Dave and Ann live in a state that, instead of adopting the federal exemption, has established its own $2 million exemption and taxes the excess at a 10% rate. Under Dave’s will, the amount transferred to the credit shelter trust exceeds the state exemption by $1 million, triggering a $100,000 tax liability.

In light of the many changes to federal and state law over the last several years, it’s important to review your estate plan and adjust it, if necessary, to avoid these types of surprises.