Contrary to popular belief, trusts and trust funds aren't always guaranteed to shelter your estate from inheritance tax. Revocable trusts, which you can revoke at any time while you are alive, don't give you any tax shelter, while irrevocable trusts, which are generally locked-down and almost impossible to change or de-fund once you create and fund them, do. On the other hand, despite having a large-enough estate to be able to create trust funds, it also might not be large enough to trigger estate tax liability. With all of this in mind, planning for the estate tax can be complicated.
As of the 2013 tax year, the gift tax and estate tax are combined. You can give up to $14,000 per year tax-free per recipient, and if you're married, each of you can make the gift. In addition to the tax-free gift, you have a lifetime exclusion of $5.25 million that applies both to taxable gifts and to your estate after you die. For example, if you give $2 million in gifts before you die, the first $3.25 million of your estate will be tax-free. If you're married, the surviving spouse will get both spouse's exclusions, so up to $10.5 million can transfer free of estate taxes. If your estate stays below this threshold, you won't have to worry about estate tax.
Revocable trusts, which are legal shells that hold assets for you and survive your death, do essentially nothing to help with estate tax deferral. However, these trusts keep your assets out of probate, and they are flexible when compared with an irrevocable trust. While you're alive, you're in total control of a revocable trust and can take assets in and out at will. You also get to define what your beneficiaries get after you die.
An irrevocable trust, on the other hand, does shelter anything that is in it from estate taxes. If you put assets into an irrevocable trust to support a trust fund for your children or other beneficiaries, the assets aren't considered to be yours anymore. Because they're no longer part of your estate, they aren't subject to estate taxes. The drawback to using an irrevocable trust is that once you put something into it, it's out of your control. For the trust to maintain its status, it must be managed by an independent trustee that follows the rules that you set up when you first create the trust.
Because an irrevocable trust is a separate legal entity, the money that you put into it is subject to gift tax. There are two ways to at least partially get around this and preserve some or all of your lifetime exclusion. One is to fund the trust with assets before they appreciate. The other is to send out Crummey letters. While these letters might not be popular, they're only called that because they're named after the winner of a tax court case, Clifford Crummey, a California minister who went to court in 1962. As a result of the case, when you put money into a trust for a beneficiary, like a child, sending the child an annual letter letting him know that he has 30 days to pull out the money turns the trust donation into a current gift, making it eligible for the $14,000 exclusion.
If your estate is large enough to be subject to the estate tax, estate planning can be very complicated. There are additional types of trusts that potentially can help you defer taxes, including generation-skipping trusts that let you leave money to grandchildren as a way of saving your children from paying taxes, and irrevocable life insurance trusts that help shelter life insurance proceeds from taxes. In addition, you can use other types of investments to further shelter the income that your heirs receive. Working with an experienced estate attorney and financial planner may save you thousands or millions of dollars of tax liability over time.
- IRS: What's New - Estate and Gift Tax
- Kitces.com: Permanent Portability Of The Estate Tax Exemption -- Is It Time To Bypass the Bypass Trust For Good?
- MetLife: Establishing a Trust Fund
- Bloomberg: Romney ‘I Dig It’ Trust Gives Heirs Triple Benefit
- Will and Trust Center: Irrevocable Trusts
- The Wealth Counselor: Irrevocable Life Insurance Trust (ILIT)
- Cornell University Law School: Generation-Skipping Trust
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