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Estate Planning Update: Reviewing Your Marital Trusts

October 01, 2015

In the current estate tax environment, it’s time to revisit your traditional estate planning strategy.

A traditional estate planning strategy for married couples is a combination of a bypass trust and a marital trust. But in the current estate tax environment, it’s time to revisit this strategy.

The Traditional Two-Trust Strategy

On the first spouse’s death, assets up to his or her available estate tax exemption transfer to the bypass trust, and the remaining assets pass to the marital trust. Both trusts benefit the surviving spouse, but different rules apply to each. There are no estate taxes on the first spouse’s death because the transfer to the bypass trust is covered by his or her exemption and the transfer to the marital trust is covered by the marital deduction (assuming the surviving spouse is a U.S. citizen).

On the surviving spouse’s death, assets in the bypass trust pass to heirs tax free because they’re protected by the first spouse’s exemption. Assets in the marital trust will be included in the surviving spouse’s estate, and the amount within his or her available exemption will pass to heirs tax free. Any excess will be subject to estate taxes.

A couple of significant tax law changes in recent years, however, have made this two-trust strategy less important for some couples and problematic for others.

What Has Changed

First, exemption portability between spouses means that a bypass trust isn’t necessary to preserve the estate tax exemption of the first spouse to die. But a bypass trust offers many benefits that portability doesn’t, such as protecting asset growth from federal estate tax, savings on state and generation-skipping-transfer taxes, and remarriage and creditor protection.

Second, with the estate tax exemption now at $5.43 million (compared to only $1.5 million just 10 years ago) and annually indexed for inflation, the two-trust strategy can produce some unintended — and undesirable — results.

Unexpected Consequences?

If your estate plan was drafted when the exemption was much lower, it might include a clause that calls for assets up to the available exemption amount to be transferred to the bypass trust and the remainder to pass to a marital trust. Let’s say your estate is worth $5.5 million. When the exemption was only $1.5 million, this would have still left $4 million to fund the marital trust.

But if you were to die this year, $5.43 million would go to the bypass trust and only $70,000 would go to the marital trust. You might wonder why that’s a problem, since your spouse is also the beneficiary of the bypass trust.

The issue is that your spouse won’t have unlimited access to the bypass trust assets. Why? Because, if your spouse did, it would no longer qualify as a bypass trust and the trust assets would be included in your spouse’s taxable estate, defeating the purpose of the trust.

Funding the bypass trust allows you to ensure that the trust assets will be distributed according to your wishes after your spouse’s death. But with the estate tax exemption now at $5.43 million, your surviving spouse could be left with little or no assets to make his or her own choices about future gifts or bequests.

Review Your Trusts

So the lesson is that, while a two-trust strategy still has benefits for many married couples, an estate plan review in light of the current estate tax environment is critical to ensure that the plan will produce the desired results. We’d be pleased to review your plan and work with you and your attorney to revise it as needed to best achieve your estate planning goals. Questions? Contacts us.

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