The marital deduction is a widely used, but often misused, Estate Planning tool. It’s powerful, but it also can create problems and headaches when not used properly. Here’s how to achieve your goals while avoiding the minefield of potential marital deduction problems.
The marital deduction is simple and has two advantages.
Under the estate tax, all your assets are added to arrive at the gross estate. All the assets left to your spouse are subtracted from the gross estate to arrive at the taxable estate. That’s the marital deduction, and it’s unlimited. When you leave your entire estate to your spouse, the marital deduction ensures there are no estate taxes regardless of the value of your estate. In addition, leaving everything to your spouse ensures he or she is taken care of.
Most people aren’t concerned about estate taxes because estates worth up to $5 million are exempt from federal estate taxes, and married couples have a true $10 million exemption because of the portability provision. But if Congress doesn’t take action, the $1 million estate tax exemption returns for 2013. In addition, some states have estate or inheritance taxes that kick in at much lower levels than the federal tax, and the marital deduction usually can avoid those taxes.
The standard estate planning goal is to leave all or most of an estate to the spouse regardless of taxes.
Despite the benefits of the marital deduction, there are some cautions about leaving an entire estate outright to the spouse.
One caution is the spouse might not be able to manage the assets effectively and might be overwhelmed by the responsibility. Mismanagement can range from bad investment decisions to excessive spending to being manipulated into giving everything to an unrelated individual or a charity or a scam.
Another caution is you lose control over final distribution of the assets. For example, a common fear is the surviving spouse will remarry and leave the estate to the new spouse and other members of the new family. Or, if the surviving spouse has children from a prior marriage, he or she could favor those children over those from the current marriage or a prior marriage of the estate owner. Or if you have children from a prior marriage your surviving spouse might not leave them much.
These problems can be overcome without losing the advantages of the marital deduction.
You can use a qtip trust instead of leaving the estate outright to your spouse. The tax law defines Qualified Terminal Interest Property, or QTIP. The inheritor has right to all the income from QTIP property, but all rights to the property terminate at his or her death. After that, the property goes to whomever the original owner designated to receive it. QTIP property qualifies for the marital deduction when you attach the right conditions.
For QTIP property to qualify for the marital deduction, your spouse must be entitled to all the income from the property for life, payable at least annually. In addition, your spouse cannot have the right to designate who ultimately gets any part of the property. Finally, you or your executor must elect to have the property treated as QTIP. Any portion or all of your estate can be treated as QTIP. And you can have your executor decide after your death how much of the property to designate as QTIP.
QTIP property doesn’t have to be left in a trust, but it is easier to qualify for QTIP status with a trust.
The price for the QTIP trust is that after the surviving spouse passes away the property left in the trust is included in his or her estate. The tax result would be the same if all the property were left outright to the spouse. With the QTIP trust, however, you retain control over how the property eventually is distributed and who manages it.
The QTIP trust should not be your only estate planning tool and is not for everyone. A QTIP trust is ideal in any of the following situations:
? At least one spouse has children from a prior marriage, and that spouse wants to ensure they receive property after both spouses are gone.
? You are concerned that your spouse might remarry after your death and leave his or her estate to the new family.
? You want at least some of the property eventually to go to someone other than your children (brothers, sisters, other relatives, friends) and are not confident your spouse would make the same choice.
? You want to ensure that the property eventually is inherited by members of your immediate family and not by relatives or friends of your spouse.
? You want to be sure the property is managed well and also take advantage of the marital deduction. When you don’t care about the marital deduction, you can leave the property to a trust without worrying about qualifying it as a QTIP.
Initially the QTIP seems limited, because the surviving spouse receives only income from the trust. But you can give the trustee or your spouse discretion to tap the principal in circumstances named by you, including giving property to charity or others. It’s common to combine the QTIP with outright bequests to your spouse, a Bypass Trust, or other tools to ensure that lifetime income isn’t a problem.
A QTIP trust also adds a layer of flexibility that could be important in light of the shifting estate tax law.
You can state in your will exactly how much property will be in the trust. An alternative is to give the trustee discretion to decide how much of your estate goes into the QTIP. The decision doesn’t have to be made until the estate tax return is due to be filed, including extensions. That gives the executor up to 15 months to decide (the original nine month deadline plus a possible six month extension.)
There are several potential disadvantages to the QTIP. Put too much wealth into the QTIP trust, and over time the estate of the surviving spouse might increase enough to trigger estate taxes down the road, especially if the law is changed. Plus, his or her planning options would be limited because the wealth is locked in the trust.
If your estate’s primary asset is an IRA, be careful of the QTIP. It is possible to put an IRA in a trust that qualifies for the QTIP election. But the trustee must be able to withdraw all IRA income each year and distribute it to the surviving spouse. Some estate planning specialists believe it isn’t possible to meet all the hurdles. You need an experienced estate planning advisor to attempt it.
A QTIP trust should be drafted by an experienced estate planning advisor. The tax law has very precise requirements for QTIP status. Many estates had to pay unexpected taxes because of stray words or phrases in wills or trusts that disqualified them as QTIP. Of course, the trust won’t do your spouse any good if the trust property doesn’t generate income to be distributed.
RW February 2012.