Choosing the Right Estate Planning Options: The Marital Deduction, Trusts, and Estate Tax

The foundation of every family’s Estate Planning is formed from the same tools and strategies. No matter the size of your estate and how simple or complex it is, you’ll begin by choosing from this basic menu.

You don’t want a cookie-cutter estate plan. There are variations of these tools, and many plans need additional elements. But every estate owner with a family should start by considering these fundamentals. Your estate planning advisor will help you pick the combination that best meets your goals and suggest other features you should consider for estate planning.

Marital deduction. When an estate owner is married, a primary goal of the estate plan usually is to ensure the surviving spouse has sufficient assets to maintain the same standard of living. Regardless of the size of the estate, the easiest way to meet this goal and avoid estate taxes is to use the unlimited marital deduction. Any amount left to the surviving spouse is deducted from the gross estate and avoids estate taxes.

The key is not to overuse the marital deduction. Leaving everything to your spouse because it eliminates estate taxes is not automatically a good idea for every estate. Doing so means your spouse must do all the work to reduce estate taxes when passing the property to the next generation and will have to do so without the benefit of your lifetime estate and gift tax credit. In addition, you give up the ability to influence who benefits from the property after your spouse when you leave everything outright to your spouse.

The marital deduction is an essential part of estate planning of married people, but those with estates large enough to be taxable should not overuse it. They need to combine the marital deduction with other tools

Equalize your estates. Each spouse has a lifetime estate and gift tax credit that in 2009 exempts up to $3.5 million of assets from the taxes. Up to that amount of wealth can be passed to the next generation (directly or indirectly through trusts) tax free. What many people overlook is a spouse can use the credit only to the extent he or she has legal title to assets. If one spouse has legal title to all the assets and the other spouse dies first, the credit of that first spouse is lost.

This probably doesn’t matter if the family’s assets are worth less than $3.5 million and will remain so over the years. But two credits are needed to protect estates that exceed $3.5 million or are likely to over time after appreciation and savings are considered. To maximize the after-tax value of the estates, each spouse must own title to assets that can be passed to the next generation tax free using the estate and gift tax credit.

The bypass trust. You can take advantage of all or part of the lifetime estate and gift tax credit without depriving your spouse or giving assets directly and immediately to the next generation. The bypass trust (also known as a credit shelter trust and A-B trust) takes advantage of the credit while providing for your spouse.

The bypass trust usually provides your spouse will receive from the trust whatever is needed to maintain his or her lifestyle. You can set limits on or formulas for the distributions or leave it to the discretion of the trustee. After your spouse passes away, the trust remainder is transferred to your children (or other beneficiaries you named). Up to $3.5 million of assets transferred to the trust are protected from taxes by the estate tax credit.

Most estates are able to eliminate estate taxes by combining the marital deduction with the bypass trust. Decide how much money to leave directly to your spouse under the marital deduction and how much indirectly through the bypass trust.

The bypass trust also has non-tax advantages. It ensures the remaining wealth eventually goes to those you intended instead of perhaps the spouse or children of a subsequent marriage of your spouse (or children of a previous marriage) or charity. The wealth also is managed by a trustee, which might be desirable if there are doubts about the spouse’s ability to manage the wealth.

Marital deduction trust. You might want to provide for your spouse and use the marital deduction without leaving him or her direct control of and management responsibility for the property. The marital deduction trust fulfills these goals. The trust property is managed by the trustee. In the trust agreement you specify whether the trustee has discretion to pay or retain income and principal or whether distributions should be made under formulas or under certain conditions.

The trust qualifies for the marital deduction. The spouse receives income from the trust as needed, and may receive trust principal, even to the point of being paid the entire trust. Your spouse also can appoint who will eventually inherit what is left in the trust. Whatever remains in the trust is included in your spouse’s estate.

Qualified Terminable Interest Property (QTIP) trust. This trust also qualifies for the marital deduction if certain qualifications are met. In a QTIP, your spouse must receive all the income from the trust, paid at least annually. The trustee can dip into trust principal for your spouse under guidelines established by you, but your spouse has no right to decide who receives the property after his or her demise. You decide in the trust agreement how any remainder will be distributed. Most people direct it to their children. The trust property is included in your spouse’s estate when he or she dies.

The QTIP has several advantages. It qualifies for the marital deduction and provides for your spouse. Yet the property is managed by the trustee. In addition you control who receives the remaining property after your spouse. It often is used when one or more of the spouses is in a second marriage or is young enough that re-marriage for the other spouse is a real possibility. The QTIP also is useful when here is doubt the surviving spouse will be able to manage the property.

These are the classic and fundamental family estate planning tools.

A typical way to combine them is to leave a portion of the estate to a credit shelter trust with your spouse the primary beneficiary for life and your children the contingent beneficiaries who inherit the remainder after your spouse passes away. The rest of your estate is left to your spouse to qualify for the marital deduction. The bequest to your spouse can be direct, through a marital deduction trust, or through a qtip trust. This combination eliminates taxes on your estate and helps your spouse reduce or eliminate taxes. It also provides for your spouse and ensures your children receive the remaining wealth.

The trick is deciding how much to put in the bypass trust. Under the old estate tax law ? when the exempt amount was only $600,000 to $1,000,000 ? the tax law determined how much to leave in the trust. Now, leaving the entire exempt amount to the bypass trust could leave your spouse with little or nothing outright. You decide how much to leave to your spouse and set a formula in the will that leaves the excess to the trust.

Other elements may be needed for your estate planning when you own a business, have an estate worth more than $3.5 million, or want to leave a significant portion of the estate to charity. Blended families and other non-traditional families also might need variations or additions to the plan. But these are the basic tools and strategies, and almost every estate plan starts here. Many plans need only these tools, others build on them.