At the time when couples are celebrating the beginning of their lives together, the last thing most are thinking about is death and estate taxes. However, as married couples accumulate wealth over the years, many make the common mistake of not establishing a proper estate plan to protect the wealth that they have built. Most couples understand that they can transfer assets at death to the surviving spouse, estate tax free. However, what they may not understand is that this can lead to a tax trap when the second spouse dies and the assets are passed on to beneficiaries. Without proper planning, those assets may be exposed to estate taxes, which could result in a 41 to 49 percent reduction in their value.
Under current law, a person can pass any size estate to his or her spouse without federal estate tax because of the unlimited marital deduction granted by IRC Section 2056. Also, the IRS grants each spouse a unified credit, which can be used to reduce the amount of estate taxes due. For 2004, the unified credit of $555,800, will protect approximately $1,500,000 of taxable estate assets. The credit amount will gradually increase to $1,455,800 in 2009, thus excluding approximately $3.5 million of taxable estate assets.
If, upon the death of the first spouse, all assets are transferred to the surviving spouse using the unlimited marital deduction, when the surviving spouse later dies and passes the combined estate to his or her beneficiaries, there is only one unified credit to reduce the estate tax.
To preserve the unified credit of the first spouse to die, couples can use a credit shelter trust (also called a 'by-pass' or 'exemption' trust). When the first spouse dies, an amount equal to the approximate amount protected by the unified credit (currently up to $1,500,000) is placed into the shelter trust. This trust is not taxed at that time or at the later death of the surviving spouse, even though it may appreciate in value. By utilizing a credit shelter trust that takes advantage of federal credits, sometimes twice as much can be transferred to beneficiaries free of federal estate taxes.
Assume Jim and Mary's combined taxable estate is worth roughly $2 million and is divided equally between them. Jim dies in 2004. Without a credit shelter trust, all of his assets would pass to Mary estate tax free because of the marital deduction, making Mary's total estate worth $2 million. If Mary were to die in 2005, the first $1,500,000 of her estate would be exempt from estate taxes. However, the remaining $500,000 would be subject to $225,000 in taxes, leaving only $1,775,000 for her beneficiaries. This taxable event would happen because only one unified credit was used for Jim and Mary's joint estate.
With a credit shelter trust. Jim would stipulate that at his death $1,500,000 would go directly into a credit shelter trust, to help provide lifetime income for Mary. Because Jim's assets had been put into the trust, Mary's estate would be worth $1,500,000. If Mary were to die in 2004, her $1,500,000 would not be subject to federal estate taxes because it would be equal to the amount protected below her federal tax credit. Hypothetically, Jim and Mary could save their beneficiaries $225,000 in federal estate taxes.
You've worked hard to accumulate your assets. There may be something you can do to make sure that they are passed on to your beneficiaries. If you are married and have a net worth of $1,000,000 or more, a credit shelter trust may help you transfer more assets free of estate taxes. Remember that your situation is unique and fees, charges and tax consequences should be evaluated carefully. In order to have an appropriate estate plan developed for you, consult your financial professional. A financial professional will be able to talk to you about how personal trusts can help you develop effective wealth preservation strategies for you and your family.
The author is a CLU and ChFC designee, a Registered Investment Advisor and registered representative of Jefferson Pilot Securities Corporation, member NASD, SIPC.