Tax Savings from Trusts

In a previous article I went over the very basic overview of what a trust is, and why trusts are used in estate planning. Now let’s focus on something else: tax savings from a trust.

Saving on Taxes with Trusts

US citizens have an estate tax exemption just for living and breathing. This estate tax exemption obviously has a lot of value.

So think about it this way: you and your spouse each have $5 million in estate tax exemptions.

That totals to $10 million between the two of you. Ordinarily, each individual gets $5 million and the exemption cannot be transferred. Transferring it would allow the first person who passes to claim the second person’s exemption early.

Tax efficiency with trusts is based on the time value of money. If you have two options to pay Uncle Sam $2 million today or $2 million in 10 years, which would you choose? Obviously the longer you can defer a tax payment, the better – especially for sums in the millions.

AB Trusts

AB trusts are the most common type of trust structure for family estate planning. In an AB trust setup, two trusts are formed, one per person in a married couple.

Let’s use an example where a couple has $12 million in assets.

Assume one person in the couple were to pass away this year with $6 million in assets to his or her name. Of that $6 million in assets, $5 million should flow into the B trust, which can be used however one pleases. This is a tax-free event. Ordinarily, the remaining $1 million should be hit with a 35% estate tax, since it is in excess of the $5 million exemption.

This is where trusts come into play. The remaining $1 million will be taxed eventually, but not right now. See, by moving the $1 million in excess assets to an A trust, estate taxes on that $1 million are deferred until both individuals pass away. And until both pass away, the assets in the A trust will pay an income to the surviving spouse. The surviving spouse will only be able to claim $4 million in exemptions – the first person used $1 million of the combined benefit.

So, of the $6 million in assets, $5 million go to the B trust, which has little restriction as far as use. The remaining $1 million will be taxed eventually, but for now it flows tax-deferred into the A trust, which pays an income to the surviving spouse. Notice: the surviving spouse gets all the benefit of the excess $1 million in assets without paying estate taxes right now.

Since he or she would normally have to pay $350,000 in estate taxes on the excess $1 million amount, he or she benefits from the income derived from that $350,000 in assets until he or she passes and the estate tax is paid.

Estate Tax Portability

In 2009, estate tax exemptions were made portable. The amount of the exemption was also increased from $1 million to $5 million. Portability is the objective of an AB trust system. Couples with less than $10 million have no need for an AB trust system, since assets will pass through tax free as the law currently stands.

Remember that tax law is always subject to change.

If Congress does not act to extend the larger exemptions and lower tax rates, the estate tax exemption will fall to $1 million per person in 2013, while the rate will rise from 35% to 55% if. No one can predict what Congress will do, but without action, far more savers will have to turn to the AB trust setup to maximize their tax efficiency by deferring tax payments on their estate.

In short, AB trusts – and trusts in general – create an excellent way to defer tax payments on estates for high net worth couples. The only problem is that of visibility, which is why so many couples wait so long to make an estate plan. The future for estate tax law has never been so unpredictable. Years ago, the exemption rose regularly each year while rates dropped precipitously. After changes in 2009, and an upcoming sunset of the law in 2013, building out a trust system right now makes very little sense: it’s not at all clear what the future holds.

In short, unless you really absolutely expect one family member to pass away in 2012 – in a year with very high exemptions and low rates – there just isn’t enough visibility to say whether or not a trust or trusts will be worth the time and legal fees.

But remember the AB system in 2013, when Congress will hopefully be friendly enough to give American savers a little bit of predictability.  For more tax planning, investing and retirement tips, visit our Retirement Center.