It's possible to leave all or a portion of your total estate to your spouse without paying any federal estate tax, thanks to what's known as the "marital deduction." However, this may not be the best course of action from a tax perspective. That's because doing so doesn't allow your estate to take advantage of your estate tax exemption.
You may be wondering — what's the difference?
The difference is that a well-crafted estate plan that is optimized to take advantage of both the marital deduction and the estate tax exemption will not only free you from paying estate taxes when you die, it will also protect a portion of your assets from taxation when your spouse ultimately passes away.
Thus, if you are married, have an estate that exceeds the exemption amount ($5.49 million in 2017), and choose not to elect portability, it's best to try and coordinate the marital deduction and estate tax exemption rather than to simply rely on the former.
Setting Up a Marital and an Exemption Trust
One way to do this is to arrange for a living trust to split into two separate shares when you die: an exemption share and a marital deduction share. Usually, these will act as two separate trusts.
The exemption trust will be funded to the value of the maximum exemption amount. The remainder of your estate should go into the marital trust.
For example, in dividing the $8 million estate of a person who passes away in 2017, $5.49 million would go into an exemption trust and $2.51 million would be placed into the marital trust.
Together, a marital trust and an exemption trust maximize the estate tax exemption, optimize the marital deduction and minimize the portion of your surviving spouse's estate that must go through probate. You owe no estate tax when you die because you are using the entire estate tax exemption, while the rest of your estate qualifies for the marital deduction. When your surviving spouse passes away, assets in the marital trust are subject to estate tax, but assets in the exemption trust escape the tax no matter how much the value of that trust has grown.
Investing with the Marital and Exemption Trusts
To minimize estate taxes, it makes sense to limit the overall growth of the marital trust relative to the exemption trust. That means the marital trust should be invested for income rather than growth, favoring fixed-income securities over equities. Moreover, any unexpected expenses should be paid out of the marital trust. Because the exemption trust can be passed on free of estate taxes, your objective should be to seek growth by weighting its investments toward equities and to avoid any unnecessary distributions that could reduce its ultimate value.
Qualifying for the Marital Deduction
A marital trust must follow certain rules to qualify for the marital deduction. The most common form of marital trust is a qualified terminable interest property (QTIP) trust. A QTIP lets you control how trust assets are disposed of when your surviving spouse dies. Your spouse is the only permissible beneficiary of a QTIP trust as long as he or she is alive. All QTIP trust income must be distributed annually to the survivor, who may also receive distributions of principal. In addition, you can set up the QTIP trust to give your spouse the right to distribute assets remaining in the trust to other beneficiaries when he or she dies.
Managing the Exemption Trust
The exemption trust is designed to protect assets from estate taxation when the surviving spouse dies, and in order to do this, the spouse's control over the trust and access to its principal must be limited. Unlike a QTIP trust, your spouse technically does not even have to be a beneficiary, though most estate plans do provide for this. In fact, you may have multiple beneficiaries for the exemption trust.
Beneficiaries may be granted the right to annual income from the trust. They may be allowed to request an annual distribution of either 5% of the principal or a lump sum of $5,000, whichever is greater. Distributions may also be granted at the trustee's discretion, or according to a specific standard you've devised. This could include health care or educational needs, for example.
Dealing with Community Property: Survivor's Trusts
If you live in a community property state, your estate plan may include a survivor's trust in addition to the marital and exemption trusts.
To understand how a survivor's trust works, it's important to be familiar with the concept of community property. In community property states, each spouse owns half of the couple's community property assets — generally property either spouse acquired during marriage, other than assets received as inheritances or gifts. The spouses may also own separate property received before marriage or through inheritance or gifts. When the spouses die, each may include separate property and half of the community property in his or her estate.
A survivor's trust is set up as a vehicle to hold the surviving spouse's share of the couple's community property. Thus, a survivor's trust receives the survivor's share of the community property plus his or her separate property. Meanwhile, the marital trust and the exemption trust get the deceased spouse's separate property and his or her share of the couple's community property. If a survivor's trust isn't created, the surviving spouse's share of the community property immediately becomes his or her unencumbered personal property.
Community property states include: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.
Life Insurance Trusts
Using a living trust to optimize the marital deduction and estate tax exemption can be a great way to reduce the tax burden of the surviving spouse, but it doesn't eliminate it entirely. The assets in the marital trust will still be taxed upon the surviving spouse's death.
Fortunately, you can make sure funds are available to cover some or potentially even all of those taxes by creating a life insurance trust that pays out when the surviving spouse dies.
Estate plans that utilized the marital deduction to defer estate taxes generally use a special type of insurance called "second-to-die" or "joint-and-survivor" life insurance. This policy differs from traditional life insurance, which pays out when the insured person dies. With second-to-die insurance, the policy covers the lives of both spouses, but pays only on the death of the second spouse.
Since the policy insures two lives and doesn't pay until both spouses pass away, the insurance company's actuarial risk is lower. That makes premiums for these polices lower than those for standard life insurance.
Avoiding Estate Taxation on Your Insurance
Generally, payouts from life insurance are subject to estate tax. This is because usually the proceeds of the insurance policy are payable to your estate, and you have some sort of control over the policy — the ability to name beneficiaries, or borrow against the policy, for example. (These are known as "incidents of ownership.")
However, it's possible to shield life insurance proceeds from the estate tax by holding the policy in a separate, irrevocable trust. Your trustee would buy the policy using funds you transfer into the trust, name you and your spouse as the insured parties, and designate the new trust as the policy's owner and beneficiary.
Gift Tax Considerations
Transferring assets to the trust is technically a gift, and would be subject to gift taxes. Speak with an attorney to determine how you can best structure the trust in order to avoid or minimize the gift tax consequences of transferring your assets. Sometimes, simply giving the beneficiaries of the trust the right to withdraw any additions to the trust is enough. This is known as "Crummey withdrawal power," after a famous court case on this subject.
Using Life Insurance Proceeds to Pay Estate Taxes
Your estate's life insurance policy is owned by and payable to the life insurance trust. When the surviving spouse dies, the trust receives a payout from the policy. The trustee can use the proceeds to lend money to or buy assets from the surviving spouse's estate. In this way, the money from the life insurance trust can be used to pay all or part of any estate taxes owed.
Your irrevocable life insurance trust is part of your estate plan. By law, though, it is a legal arrangement that stands by itself outside your estate, separate from any trusts you have established in the estate. Its sole purpose is to use insurance proceeds to provide funds to your estate.
How an Irrevocable Life Insurance Trust Fits into Your Estate Plan