Reviewing Your Will and Estate Planning

Your will and estate planning strategy need to be reviewed. Be sure they are ready for coming changes. A key tool in many Estate Planning strategies especially needs some re-working soon. Otherwise, you might be caught in a trap.

The current lifetime estate and gift tax exemption is $11.58 million per person in 2020. It rises in 2021 to $11.7 million.

Those changes will be great for many families, but they can causes problems for families that do not adjust their estate plans. The potential problem in many cases is the bypass trust and the formula for funding it.

Here is the classic estate planning strategy, which many of you have.

A married couple has wills in which the first spouse to pass away leaves most of the estate to the surviving spouse. A portion of the first spouse’s estate goes into a bypass trust, also known as a credit shelter trust or A-B trust. The wealth that goes into the trust qualifies for the lifetime estate and gift tax exemption.

The trust usually will pay its income to the surviving spouse as needed. In addition, the surviving spouse usually can be paid principal from the trust as needed. After the surviving spouse passes on, the trust principal goes to the children of the couple or of the first spouse. There is no additional estate tax on the trust assets.

The rest of the estate, as I said, passes to the surviving spouse directly. The marital deduction ensures there are no taxes on that property. The result is no taxes are due on the estate of the first spouse to die. The lifetime exemption of the second spouse protects at least part of that estate from taxes.

This classic plan has been effective for years. Yet, the changing tax law and other factors are creating several potential problems.

The first dilemma is how much wealth to put into the bypass trust, or how to determine how much wealth to put in the trust.

A standard formula for funding the bypass trust states that property up to the exempt amount goes into the trust, and the rest goes to the surviving spouse. The formula works fine when the exempt amount is relatively low. It creates problems when the exempt amount takes a big portion of the estate. That hasn’t been a problem for too many families in the recent past. It will become a problem for many families in coming years as the exempt amount increases.

If an estate is $2 million, under the standard formula half the estate would go into the bypass trust if the owner passed away in 2003. More than half and eventually all of the estate will go into the bypass trust if the owner passes away after 2003. The surviving spouse will be inheriting a minority of the estate instead of a majority. The spouse could end up with a lower standard of living than anticipated. He or she would have to go to the trustee regularly to establish a need for receiving additional income or principal from the trust.

This problem can be solved with a formula clause instead of a clause with a fixed amount or tax code reference. Decide how much of the estate you want the spouse to own directly, or the maximum amount you want to put into the bypass trust. Then, put that into a formula.

For example, suppose you have a $2 million estate and want no more than $700,000 going into the bypass trust. Your will can say that the bypass trust will receive the federal exempt amount or $700,000, whichever is less.

Or you can use a percentage clause. Suppose you want your spouse to get at least 60% of your net estate. The will can say that the bypass trust will receive the federal exempt amount or 40% of the net estate, whichever is less.
These formulas put your spouse’s needs ahead of tax reduction.

Another problem is that each spouse might not own enough assets to take advantage of the exemption. A spouse can only give away property that he or she owns, and the lifetime estate and gift tax exemption cannot be shared by spouses. If a spouse dies without owning enough property, the unused exempt amount is lost.

If all or most of the couple’s property is in the name of one spouse, then the other spouse’s lifetime exemption will be wasted unless he or she dies second.

The obvious solution is to change legal title to the property so that each spouse owns at least enough to take advantage of the lifetime exemption. If the joint estate is not large enough to use two lifetime exemptions ($2 million in 2003), divide the property equally or at least ensure that each spouse owns whatever amount can be safely put into the bypass trust without reducing the surviving spouse’s standard of living.

Unfortunately, these solutions cannot be implemented in every case. The largest asset of many people is an IRA or retirement plan. These assets present two potential problems. One problem is that an IRA cannot be given to a spouse during life without being treated as a distribution and incurring income taxes.

The other problem is that there can be trade offs if the IRA is used to fund the bypass trust. When a spouse inherits an IRA, he or she can rollover the IRA to a new IRA, name new beneficiaries, and set up a new required minimum distribution schedule. The schedule can minimize lifetime distributions and preserve as much of the IRA as possible for the next generation.

When a bypass trust becomes owner of the IRA, the results can be different. The trust has to begin distributions within one year after the owner’s death. That could mean distributions and taxes are accelerated if the owner was not taking required minimum distributions at the time of death. In addition, the distributions must be based on the single-life expectancy tables and use the age of the oldest beneficiary, who will be the surviving spouse. The result is greatly reduced income tax deferral from the IRA. On the other hand, your children might not be interested in tax deferral. You can safely put the IRA in a bypass trust if your children plan to distribute the balance and spend the after-tax amount.

A final problem with putting an IRA into a bypass trust is that trusts get into the highest income tax bracket faster than individuals do, though the 2003 tax law softened this. IRA distributions that are not distributed to the surviving spouse might incur higher taxes in the trust.

There is an estate planning strategy you can use to overcome many of the problems we’ve reviewed.

The estate planning strategy is disclaimer planning. Someone who inherits an estate has the option of disclaiming, or refusing, the inheritance. A spouse who gets good advice can use a disclaimer to maximize the tax benefits without the will having to anticipate every tax law change. For example, you could leave everything to your spouse and provide that any assets he or she disclaims go into a bypass trust. Then, your spouse can decide how much of the lifetime exemption would be used by disclaiming that amount and letting it go into the bypass trust. The surviving spouse needs good tax advice for this estate planning strategy to work.

The disclaimer estate planning strategy also works well when an IRA is the major asset. The surviving spouse can decide whether or not it makes sense to have part of the IRA go into a bypass trust.

Another essential tool, which deals with possible estate tax repeal in 2010 and reinstatement in 2011, is the “but if” clause. The will can provide that everything will go to your spouse if the estate tax is repealed for the year of your death but part of it will go to a bypass trust if the estate tax is still in place.

A final estate planning strategy to consider is second-to-die or survivorship life insurance. This pays benefits after both spouses have passed away. Instead of trying to manage around estate and income tax laws, simply leave your assets to whomever you want. The insurance pays the estate taxes, if there are any at the time. If there are no estate taxes, the children get a bonus by inheriting the insurance benefits. If you can afford the insurance, it makes things easier and more certain.