Why should I make a trust? This is a common question. In this series of posts, here’s twenty great reasons to have a trust!
Part D: Trusts Offer Better Tax Planning.
15. A trust allows you to take advantage of marital exclusions from estate tax while still preserving your children’s inheritance.
California does not presently charge an estate tax, but the federal government does. As of January 2013, the tax
applies to estates over $5 million (adjusted for inflation). If your spouse dies and his or her share of the marital estate does not exhaust the $5 million exemption, it is sometimes possible to carry forward the unused portion and add it to your own exemption when you die. Because of these changes in the amount and carry forward of the exemption, fewer estates will trigger an estate tax.
For those that do, however, the maximum tax rate is a whopping 40%! And even if you don’t expect your own estate to trigger a tax, keep in mind that tax reform is a popular area of congressional legislation. There is no guarantee that the current tax structure will remain in place. The previous maximum rate was 55% (!) and only a decade or so ago the exemption was less than $1 million. Because of these factors, tax planning is often a concern for folks planning their estates. Luckily, anything left to the surviving spouse passes free of estate tax. This is one of the easiest planning methods, but if you just leave everything to your spouse, without a trust, there are some definite drawbacks.
First, if you leave assets to the surviving spouse outside of a trust, he or she is free to do anything with those assets, including deciding to whom they shall pass upon the spouse’s death. This may be less than ideal if you have children from a prior marriage or you are concerned that children from this marriage not be accidentally disinherited if your spouse remarries. A trust can give you the best of both worlds. It can be structured to set aside assets in excess of the $5 million exemption and hold them for the benefit of the surviving spouse. The spouse receives all income from the assets, and so much of the principal as necessary for support. When the surviving spouse passes, anything left will be subject to estate tax, but only if the surviving spouse’s own estate exceeds the exemption amount. After any taxes are paid, the remaining assets from the trust pass to whomever the first spouse had designated — children, charity, relatives, etc. Nothing passes to a new spouse or the new spouse’s family.
Second, even if you have no concerns about the passage of your property after the second spouse dies, using a trust can prevent inadvertently “wasting” the exemption of the first spouse to die. This may be less of a concern now that spouses are allowed to carry forward the first spouse’s unused exemption, but it is still a worthy consideration. In order to carry forward the first spouse’s unused exemption, you must file an estate tax return on the first spouse’s death, which can be expensive. And when the second spouse dies, the IRS has another “shot” at auditing the estate tax return from the first spouse, as well as the second. Consider using a trust to segregate the assets qualifying for the estate tax exemption on the first spouse’s death. The surviving spouse can be given all income, and can be given use of the principal for support, but whatever he or she does not use can be sheltered from tax. If you don’t use a trust, there may be a significant tax hit when the second spouse dies.
16. A trust can help avoid repeated taxation on the death of a non-spouse beneficiary.
Suppose you leave an inheritance to your child. When that child dies, he leaves the inheritance to your grandchild. Unless qualified for an exemption, the inheritance was subject to estate tax when you died, and again subject to estate tax when your child died. Tax laws allow you to avoid this second tax for inheritances up to $1 million. A trust is the way to do it. The trust can be structured so that the inheritance is left in trust for the benefit of your child until his death, then passes to your grandchildren free of further tax. (This is the GST, or generation skipping transfer tax. Anything above the $1 million exemption will trigger a second tax if it passes to anyone two or more generations removed, such as direct gifts to grandchildren when the parent is still living.)