Spouses benefit from an unlimited marital deduction, meaning they can pass an unlimited amount of assets to one another without triggering estate taxes. But if an estate is worth more than the exemption amount, it's worthwhile to set up an "A-B trust." In 2007 and 2008, every individual can pass on $2 million without paying estate tax. But unless a marital bypass trust is set up, the exemption for the first spouse to die will be lost. Trusts allow you to preserve that exclusion.
The following scenarios show what happens when a wealthy couple does not use estate planning versus what happens if they do. Curtis Chen, a Certified Financial Planner at Chen Financial Group in Belmont, Calif., explains how costly the unplanned scenario becomes for beneficiaries.
A couple has $5 million of assets and the current estate tax exemption is $2 million. Thanks to the unlimited marital deduction, if the wife dies first, her half of the estate goes to the husband estate-tax free. (Assume both are U.S. citizens.) The husband is worth $5 million now. When he dies the following year, $2 million goes to the next-of-kin estate tax-free because of his exemption; the remaining $3 million is subject to estate tax. Even though each spouse was entitled to a $2 million estate tax exemption, the next generation benefits from only one of them.
Planning with a trust
The couple can double the amount passed estate-tax free with a little advance planning. They should set it up so that when the first spouse dies, $2 million goes to an A-B trust (also called bypass trust or credit shelter trust) for the benefit of the next-of-kin. After the wife passes, $2 million belongs to this trust and the husband now has $3 million. When the husband dies, the next-of-kin gets an additional $2 million estate-tax free. Only $1 million is subject to estate tax.
"People always ask what happens if the husband runs out of the $3 million," Chen says. "He has rights to use the bypass trust for living expenses, basically. So this trust arrangement is for people who are worth more than the estate-tax exemption amount, which is changing."