Trusts

A trust is a contract among a grantor, who creates the trust by transferring property to the trustee, a trustee, who has legal title to the assets transferred and must discharge the obligations under the contract, and a beneficiary, for whose benefit the trust is created.

Trusts may be revocable (changeable) or irrevocable (non-changeable). A "testamentary trust" is a revocable contract contained within and as part of your will. The testamentary trust becomes irrevocable upon your death and the terms of the trust are then fixed.

If your estate is large enough to be subject to federal estate tax ($675,000.00), you may want to split your estate between property passing to your spouse and property passing to your children. Your estate will then consist of your spouse's part, which will qualify for the marital deduction in your estate, and a bypass trust.

The spouse's part may be left to the surviving spouse outright, or in trust. In certain cases the use of a QTIP trust may be appropriate. "QTIP" stands for "qualified terminable interest property", and is essentially a way of making property available to a surviving spouse with some strings attached. The surviving spouse gets an income interest only, and then when the surviving spouse dies the property passes to your children. This method of disposition is particularly useful in a second marriage.

The bypass trust is used to hold the estate tax exempt amount (up to $675,000.00) and generally provides the surviving spouse with an income interest and a right to invade principal in certain cases. Because only limited rights are given to the surviving spouse, the value of the bypass trust is not included in the surviving spouse's estate and will therefore escape the estate tax upon the death of the surviving spouse. It is the bypass trust which is the estate tax saving vehicle, as it is designed to "bypass" the surviving spouse's estate.

For example, assume that Harry and Wilma are a married couple with two adult children. They have assets worth approximately $1.5 million, including a $300,000.00 home, a $150,000.00 vacation home, $500,000.00 in joint bank accounts and investments, and $250,000.00 in Harry's pension plan with Wilma designated as beneficiary, and $300,000.00 in other assets.

Harry and Wilma both have wills leaving everything to each other. After they both die everything is left equally to their children. If Harry dies first, Wilma will inherit everything, under the terms of Harry's will, through beneficiary designation on Harry's pension, and because she is the survivor of the joint bank accounts and houses. There will be no federal estate tax due when Harry dies because of the unlimited marital deduction. However, when Wilma dies, assuming that there is no growth of the assets, Wilma's estate will be worth $1.5 million. The $675,000.00 exemption would be available to Wilma's estate, but there would be a tax due on $825,000.00. The federal estate tax on this amount would be approximately $277,500.00 at current rates, and this tax would be payable 9 months after Wilma's death.

If the value of the assets increased after Harry died, the taxes would be even greater.

On the other hand, assume Harry and Wilma each have a bypass trust clause in their wills. They have arranged their affairs so that each of them has approximately $750,000.00 of assets in his or her individual name. By doing this they each have assets to fund a bypass trust in the event they are the first to die. When Harry dies, $75,000.00 will go outright to Wilma, and the remaining $675,000.00 of his assets are placed in a bypass trust. Wilma will get the income from the trust for life, and the trustee can also use principal from the trust for Wilma's health, welfare and other needs. Harry and Wilma's two children will get the principal that remains in the trust when Wilma dies. The bypass trust in this case assures that both parties' lifetime $675,000.00 exemption is used. As a result, when Harry dies up to $675,000.00 of his estate will be protected by his unified credit, and the rest will be due. When Wilma dies, her estate will be worth approximately $825,000.00 (assuming the assets have not grown in value). Wilma's estate will be able to use her unified credit to shield $675,000.00 of her estate from tax, and only $38,800 federal estate tax will be due on the remaining $150,000.00.

In this example, by using the bypass trust estate taxes have been reduced by $238,750.

However, both Harry and Wilma must each have assets in their names at the time of their deaths in order to have funds to put in the bypass trust. This could be done by dividing the joint bank accounts, and changing the designation of beneficiary on Harry's pension to read one-half to Wilma and one-half to Harry's estate.

Additional steps that Harry and Wilma could take to reduce estate taxes would be to give away some of their assets that they do not think they will need. They can give $20,000.00 to each beneficiary that they choose for each year that they are both alive. They can also make unlimited charitable deductions to reduce the size of their estates.