Estate Planning for Beginners – Part 4: Estate Taxes

Estate Planning for Beginners: Part 4 | Estate Taxes
Unbeknownst to most financial advisors is the value of a “Disclaimer Trust.” In the world of estate planning documents, a Disclaimer Trust is a form of a Credit Shelter Trust.

Instead of the Credit Shelter Trust being funded “mandatorily” at the death of the testator, it is set up to be used as an optional plan where its use may not be known until after the death of the testator.

In other words, it will be drafted today as any other Credit Shelter Trust, but whether it will be funded will not be determined until the surviving spouse makes an affirmative decision that he/she/they desire that it be utilized. Stated another way, its funding will be optional and the final decision does not have to be made until nine months after the death of the testator. During this nine-month period, it will be important to advise the surviving spouse not to “taint” any of the assets that may be eligible to be disclaimed. More on this later.

The Federal Estate Tax Exemption

For those of you who are too young to remember, the estate tax exemption at one time was $60,000 (1942 thru 1976). In those days, the funding of the Credit Shelter Trust was used as a tool to eliminate or at least minimize the estate tax in the estate of the second spouse to die. If the surviving spouse died with an estate in excess of $60,000, there would be a federal estate tax due at that time.

Compare that with today’s federal exemption of $12,060,000 per person in the year 2022 and combined with “Portability,” the family can leave a total of $24,120,000 before any federal estate tax, if any, is due.

Many estate planning attorneys indicate that they are using the ongoing increase in the estate tax exemption as a reason to bypass the need or desire for the use of the Credit Shelter Trust. We feel this misses the more important reason a Credit Shelter Trust has value to clients and their families.

Some estate planning attorneys may use language that limits the funding of the Credit Shelter Trust to the state estate tax limits and others may want to use a Disclaimer Trust and allow the surviving spouse the option to make decisions based upon their circumstances after the death of the first spouse.

Advantages of the Credit Shelter Trust

What are the advantages of a credit shelter trust? Let’s begin with estate tax advantages. Keep in mind that there are potentially two sets of estate taxes. The first is the federal estate tax and then there may be a “state” estate tax or inheritance tax in the state of your residency.

At the federal level, the exemption of $12,060,000 is now being indexed annually for inflation. There are a number of states that also have an estate tax or inheritance tax. As a side note, as of this writing, the law that brought the larger exemption in place has a cliff, whereby if nothing else is done, the estate tax exemption will be reduced to $5,490,000 on January 1, 2026.

We’re located in the state of New Hampshire. We do not have estate tax. This is very attractive to retirees in New England, and elsewhere, as an ideal place to retire if you can navigate our winters and shortly thereafter, mud season. In addition, we have no income tax and no sales tax. However, we do have a dividends and interest tax.

Suppose you live and die in the state of Massachusetts, where the exemption has been limited to $1 million. Or Vermont, where the exemption is $5,000,000 in 2022. New Jersey did away with their “estate” tax, though the state still has an inheritance tax. That tax is based upon your relationship to the deceased.

In all 50 states, the federal estate tax may have no effect up to $12,060,000 per person, but the state estate or inheritance taxes may warrant limiting the use of the Credit Shelter Trust to the amount of the state exemption to avoid taxes in those states. Always keep in mind that laws are constantly changing. A qualified estate planning attorney and/or a financial advisor with estate planning credentials can take this into consideration during the planning/drafting of the will and trust agreements.

Avoiding Estate Taxes

As advisors, we often want to avoid any and all estate taxes whenever possible. In the state of New Hampshire, this is simple for those families with combined assets under $24,120,000 for married couples and $12,060,000 for single individuals.

This is accomplished by allowing the first spouse to create a Credit Shelter Trust up to the level of their personal exemption. The assets in the Credit Shelter Trust, at the time of the second spouse’s death, are not taken into consideration at the death of the second spouse. Why? Because the assets in the Credit Shelter Trust do not belong to the spouse. Instead, they may have had “life use” of the trust assets, including the income and possibly principal distributions, but they did not own them when they died. Only those assets in the second spouse’s own name at the time of their death will be taxed and they get an additional $12,060,000 exemption at that time.

Let’s now turn our attention back to the Disclaimer Trust. Further, let’s assume we are dealing with a family that, including life insurance or retirement benefits, has assets from $1 million-$12,160,000. At the higher levels, the use of a Credit Shelter Trust can be extremely important, especially in states with estate or inheritance taxes.

But, the question arises, should the Credit Shelter Trust be funded mandatorily with assets at the death of the first spouse?

When this question arises, the Disclaimer Trust comes into play in the following manner:

Let’s suppose that partner one’s will and revocable trust leave everything outright to the surviving spouse. After partner one’s death, the surviving spouse’s advisors suggest that they may want to consider “disclaiming” some of the assets they’re about to inherit at which point they would go into the Credit Shelter Trust that’s been sitting dormant for years.

The disclaimer, to be effective, must be acted upon within nine months of death. Let’s assume that one of the assets is a $500,000 portfolio, in joint name. Two months after death, the surviving spouse needs access to cash and takes $50,000 out of this joint portfolio. This particular action will negate any possibility that the deceased spouse’s portion of the joint account could be disclaimed. This is called “tainting,” and this is where care has to be taken after the death of the spouse to be sure we don’t taint too many assets before a decision is made as to whether the surviving spouse will disclaim or not.

When the language of the Credit Shelter Trust provides significant options for the surviving spouse, their children and grandchildren, the Credit Shelter Trust can be one of the most effective tax planning tools ever developed. Unfortunately, someone is to die and as tragic as this may be, leaving the surviving spouse with options and time to make decisions, may open up future possibilities for tax savings.

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