As time goes by and wealth accumulates, one of the most costly mistakes I believe a married couple can make is not establishing an estate plan to protect their assets. While it's true that married couples can generally transfer assets at the death of one spouse to the surviving spouse on an estate-tax-free basis, this may lead to a tax trap when the second spouse dies and those assets are passed on to children or other beneficiaries. Without proper planning, those assets may be exposed to federal estate taxes up to 45 percent of the total estate value, not to mention possible state estate taxes on top of that. Here's why:
If you are married, you generally receive an unlimited federal estate tax marital deduction that allows all of your assets to be transferred to your spouse estate tax free. In addition, you have a federal tax credit that you can use to offset estate taxes. For 2009, this credit is equivalent to the amount of federal estate taxes due on assets up to the estate exemption amount of $3,500,000. (Under current law, in 2010, federal estate taxes are scheduled to be repealed, but unless further legislation is passed, federal estate taxes will return in 2011 with the estate exemption amount at $1,000,000.) At death, if you simply transfer all assets to your spouse using the unlimited marital deduction, you'll forfeit use of your estate exemption amount. By having a plan in place that takes advantage of each spouse's estate exemption amount, you and your spouse may be able to transfer twice as much to your children or other beneficiaries free of federal estate taxes. I think a great way to take full advantage of these credits is to establish a credit shelter trust.
A credit shelter trust is an estate planning tool commonly used by married couples to maximize the wealth they transfer to their beneficiaries. This trust is funded at the first spouse's death, and the amount transferred to the trust should be roughly equal to the amount protected by the estate exemption amount ($3,500,000 in 2009). In the trust document, you may name your spouse as the life income beneficiary with the right to income generated by the trust. Should the trust income be insufficient to meet your spouse's needs during his or her lifetime, you can grant the trustee discretion to use the trust principal for your spouse's benefit. When your spouse dies, the trust assets pass to those you name as remainder beneficiaries (typically your children).
Thus, while your spouse may receive income and even principal from a credit shelter trust, he or she does not retain control of the trust. This enables assets in the trust (including any potential appreciation of those assets) to be excluded from your spouse's estate at his or her death and pass estate tax-free to your beneficiaries.
Note that because one can never know which spouse will survive the other, it is important for each spouse to have sufficient assets in his or her own name (i.e., not in joint name) to fund a credit shelter trust.
If you are a married high-net-worth investor, a credit shelter trust may help you transfer more assets to your beneficiaries free of estate taxes. However, I recommend you first talk to your tax advisor about tax planning and to your legal advisor about personal trusts and estate planning before making any tax-related or legally related decisions.
• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior vice president-wealth management and senior investment management consultant with Morgan Stanley Smith Barney LLC. He can be reached at william.a.creekbaum@smithbarney.com or 689-8704.