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To Trust or Not to Trust

Investors make significant efforts to maintain a disciplined saving approach throughout their lives in order to meet long-term financial goals such as retirement, saving for children’s education, or passing an estate to grandchildren. Thinking about what will happen when you are no longer here is not pleasant; it is important, however, to plan how you and your spouse will pass your assets to your family.

The most important issue that arises in estate planning concerns estate taxes, which can be very high indeed. When a spouse dies, the tax law stipulates that an unlimited amount of property and money can pass to the surviving spouse free of federal estate taxes. However, when an estate is passed on to children or family members other than a spouse, federal estate taxes have to be paid on amounts exceeding $5.25 million for individuals or $10.5 million for couples (American Taxpayer Relief Act, enacted in January of 2013). The balance is subject to a 40% tax rate. For individuals or couples with estates exceeding these limits, one option is to establish a trust.

A trust is a legal entity through which you transfer control (not ownership) of your estate to a trustee (this is usually an institution or a corporate entity, such as a bank). The term “estate” generally refers to your assets—everything you own (or have certain interests in), such as real estate property, cash, securities, insurance, retirement plans, and business interests.

Let’s assume that Mr. and Mrs. Smith have a $12 million estate to leave to their children. Without a trust, if Mr. Smith passes away and leaves everything to his wife, she will not have to pay any taxes. However, when she passes away and leaves the $12 million to her children, they will have to pay federal taxes on $1.5 million. With a 40% tax rate, this can mean as much as $600,000 paid in taxes.

If Mr. Smith establishes a trust before he dies, however, the situation is different. Suppose Mr. Smith, in his will, establishes a $12 million trust with his wife as the beneficiary. This means that Mrs. Smith is able to receive income from the trust for the remainder of her life and even retrieve an amount of the principal, if necessary. When Mrs. Smith passes away, the balance of the trust would be passed to the children, and—here is the most interesting part—since the trust is not considered part of Mrs. Smith’s estate, it escapes (or bypasses) federal estate taxes. This is why such trusts are usually called “bypass trusts.” By establishing the trust, Mr. and Mrs. Smith are able to pass to their children $600,000 that would otherwise have been paid in taxes.

Also, the marital deduction can now apply to same-sex couples after U.S. Supreme Court’s 2013 decision in United States v. Windsor.

Of course, there is always the possibility that tax laws will change. In 2001, President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act, a decade-long tax act that was set to expire at the end of 2012. However, on January 2, 2013, President Obama signed the American Taxpayer Relief Act that maintained most of the “Bush-era” estate tax provisions. As a result, the estate-tax-exempt amounts were kept at the 2011 level ($5 million) and will be adjusted for inflation each year. The estate tax rate, however, was increased from 35% to 40%.

All this tax and legal jargon can be confusing and intimidating, but it is important to learn about which laws apply to you and what will happen to your estate in the event of your death. It is highly recommended that you consult a financial or legal professional to discuss your options and see if establishing a trust might be the right move for you.

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