Credit Shelter Trusts – The Single Best Method for Reducing Estate Taxes

As a Massachusetts Estate Planning Attorney, one of my primary objectives is to reduce my clients’ estate tax liability. Currently, Uncle Sam lets individuals pass $5 million at their death, free of estate taxes. This number is somewhat fluid: in 2009 it was $3.5 million, in 2013 it could go down to $1 million (although few think this scenario is likely).  But wherever the Unified Credit (a commonly used misnomer for the amount that someone can pass tax-free) stands, anything above that amount is taxed at a very high rate (currently 35%, but recently as high as 55%).  Not to worry, with sophisticated estate planning techniques, and a bit of foresight, we can greatly increase the amount of wealth that passes free of the estate tax.

Please note, even if the $5 million federal unified credit is far beyond your own net worth, you may still be subject to Massachusetts estate tax liability. Unfortunately for many Bay State families, our great Commonwealth taxes anything over $1 million dollars, at a floating rate of up to 16%. For the vast majority of Massachusetts residents, $5 million is out of reach, but the $1 million Massachusetts estate tax threshold effects many more families.

For example, consider a hypothetical family with the following assets: a $300,000 house, a $100,000 life insurance policy, and an $800,000 401(k). This describes a fairly typical family, where one spouse is well into a professional career. Without any estate plan in place, this family is facing a Massachusetts estate tax liability of around $45,000.  That $45,000 could have paid for a year of tuition for a grandchild… instead it’s going to Beacon Hill, to pay for… whatever it is they do up there.

For families like this, the first tool of the estate planning is the Credit Shelter Trust. Here’s how it works: if one individual taxpayer can pass $1 million free of estate taxes ($5 million federal), then it stands to reason that two taxpayers can pass $2 million tax free. Unfortunately, what usually happens is that Husband passes all of his assets to Wife, and Wife passes all of her assets to their children. Therefore, only Wife’s unified credit counts towards reducing the tax liability upon the transfer to the children. Instead, estate planners create a system where Husband passes $1 million to the children, and the remainder to Wife. Later, upon Wife’s death, she passes everything that she has to the children. This allows each spouse’s $1 million unified credit to shield assets from the estate tax, effectively doubling the amount that passes tax-free.

In know what you’re thinking: “But my wife needs that money to live on!” That’s true, which is why Husband’s legacy to his children above doesn’t go directly to the children, instead, in this scenario, we send it into a Marital Trust (called a QTIP Trust), where it benefits Wife for the rest of her life, and eventually goes to the children after she dies. With careful estate planning and certain tax elections, the Marital Trust will offset Husband’s unified credit, and anything beyond Husband’s credit will count towards Wife’s unified credit. And that’s why it’s called a “Credit Shelter Trust.” And in case you were wondering, the same Marital Trust can serve as a credit shelter for the $1 million Massachusetts, and larger $5 million federal estate tax thresholds. Furthermore, we can create reciprocal credit shelter trusts, so that the function remains the same, regardless of which spouse dies first.

The technical aspects of trusts and taxation are beyond the scope of this brief post, so you’ll want to talk to a lawyer who specializes in estate planning to take advantage of this, and other, estate planning techniques. For those of you who are confused, please feel free to contact me, and I’ll walk you through it.

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