Certain types of trusts can be useful in building an estate plan that escapes taxes. While revocable trusts are transparent from a tax perspective and have essentially no benefits when it comes to avoiding inheritance tax, irrevocable trusts can be used to eliminate estate taxes. While there is generally not a time limit on when the trust can be set up, there are a few instances in which time limits apply.
When Inheritance Tax Applies
One factor to keep in mind is that, for many people, the inheritance tax isn't really a consideration. As of 2013, everyone gets a $5.25 million exclusion that they can apply to gifts that they give over their lifetime or to money that they leave behind for heirs. If you're single and your estate is worth $5 million, it's inheritance tax free. Married people who leave their assets to each other get to double the exclusion to, as of 2013, $10.5 million. When the surviving spouse inherits the deceased spouse's property, she also inherits his $5.25 million exclusion for when she leaves the remaining marital estate to her heirs.
Irrevocable Trusts and Tax
An irrevocable trust is a legal entity that owns property for you. Once you give property to an irrevocable trust, it becomes very hard for you to get it out. However, because the irrevocable trust isn't the same legal entity as you, when you die, it doesn't, and the money in it passes without inheritance tax. The drawback to an irrevocable trust is that the money you put in it is subject to the estate and gift tax, so if you put more than $5.25 million in, you'll have to pay gift tax on your withdrawals when you make them.
Two types of transactions with irrevocable trusts are specifically subject to time limits. First, if you set up an irrevocable life insurance trust to shelter the proceeds from a life insurance policy, the policy must be in the trust for at least three years to be estate-tax free. The second issue isn't tax-related, but does link to Medicaid, which is a government program. If you put money into a trust and you end up needing Medicaid, such as to pay for long-term care expenses, anything that you put in five or fewer years before you need Medicaid can be pulled out to defray Medicaid's costs for treating you. Finally, the closer you do anything to your death, the greater the risk that the Internal Revenue Service will scrutinize it or that it could be challenged by an unhappy family member.
Maximizing an Irrevocable Trust
On first glance, an irrevocable trust might not seem to be that valuable. If you put $6 million in, you'd pay inheritance tax on the same $750,000 that you would have if you didn't have a trust. To maximize an irrevocable trust, the assets need to sit in there long enough to appreciate. For instance, if you put $5 million worth of real estate into the trust, it would be tax-free. If the real estate appreciates to $10 million while it is sitting there, though, that $10 million in value will pass free of estate taxes while, if you still owned the real estate outside of an irrevocable trust, your heirs would have to pay taxes on the $4.75 million in value over the $5.25 million exclusion.
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