Many people are concerned about the chunk of their estate that Uncle Sam will take after their passing. You worked hard to create a financial legacy for your beneficiaries, so it only makes sense that you would look into tax-exempt trusts. Exemption trusts are one option for married couples who want to make the most of a sizable estate.
What do you need to know about exemption trusts, their benefits, and their limitations?
Learn more about what you can expect with these financial planning tools and let Magellan help guide you through the process.
What to Know About Exemption Trusts
First and foremost, it helps to have a detailed understanding of what exactly an exemption trust is before we can dive into how it works, the requirements, and even a real-world example.
This type of irrevocable trust handles a married couple’s property a bit differently than other types of accounts. In this situation, the trust holds the assets of the deceased spouse. It is not entirely estate tax-exempt, but it is likely the closest you can get.
Of particular note, it does not pass along assets to a surviving member of the couple.
Benefits of an Exemption Trust
Exemption trusts have several excellent benefits for married couples who want to protect their assets for future beneficiaries. One of the main benefits is that you can place almost anything you want in an exemption trust including cash, stocks, and other investments as well as real estate, life insurance, businesses, and even alternative investments like art or antiques.
Because this is an irrevocable trust, it will also remove the assets placed in it from the taxable estate. This benefits the surviving spouse and the family because it decreases the tax liability for the overall estate, which can be quite sizable for wealthy couples who have high-value assets.
Of course, the surviving spouse does not take possession of the assets that are contained within the exemption trust. However, that does not mean that they cannot still access those items. In fact, the surviving spouse can use the trust’s income and the principal in order to cover certain types of expenses such as medical or educational needs.
Exemption Trust Example
Exemption trusts can take different forms, but the most popular tends to be an AB trust where each spouse has their own irrevocable trust funded in mostly the same way. Think of this example using an exemption trust set up by John (A) and Lauren (B).
When John passes away, his assets are immediately transferred to his trust A,with Lauren as the trustee and the lifetime income beneficiary.. If John were to reach the exemption limit (which was $12.92 million for 2023), the excess funds and assets would be transferred to Lauren’s trust B.
After Lauren’s passing, the maximum from trust B can move along tax-free to her beneficiaries. This utilizes Lauren’s federal exemption limit, passing along up to $12.92 million without the need for a beneficiary to pay taxes on what they inherit. Anything above and beyond this amount will be taxed.
Whatever remains in trust A is also passed along tax-free to its final beneficiary.
Is an Exemption Trust Entirely Tax-Exempt?
Many people are drawn to exemption trusts because they boast powerful tax benefits for couples who have a high net worth. However, it is important to note that they are not entirely tax-exempt and do have some limits to what you can shelter from the federal government.
The latest tax law passed by Congress back in 2017 bumped up the exemption limit when it comes to estates. Whereas the previous tax limit was just $5.5 million per person, it has nearly doubled. Now, in 2023, the tax exemption applies to these exemption trusts if they are at $12.92 million or less.
The value of the exemption trust will be adjusted each year through 2025 for inflation, which means that this number will creep higher over time.
What does this really mean then?
As long as the value of the exemption trust is under this figure, no estate taxes have to be paid. If you create an exemption trust worth more than $12.92 million, it will be taxed on the amount that is in excess of this figure. For example, a trust worth $13.92 million would only be taxed on the $1 million overage.
Limitations of Exemption Trusts
With all of this being said, there are still some limitations on this type of trust that you should keep in mind when deciding whether this estate planning tool is right for you.
First, you need to remember that it is an irrevocable trust. Once the trust has been formed, you will not be able to make any future changes. You need to be absolutely certain that this is what you want to do and how you want to structure it.
You may also lose some access to assets if you are the surviving spouse. Since it would be difficult to predict which member of the couple will pass first, it could put the surviving spouse in a real financial bind. These assets are going to bypass them, though they can still use the trust to pay for certain educational or medical expenses.
If they need the money for something else, they will have to find another means of paying for the final bill.
Another strategy would be to allow the surviving spouse to disclaim any assets at the time of the first spouse’s death, with the contingent beneficiary being the decedent’s trust. This gives the surviving spouse maximum flexibility.
Consult with Estate Planning Experts about Tax-Exempt Trusts
Not sure what type of trust would be best for you? Coming up with a financial plan that secures your future and gives the most benefit to your beneficiaries is a complex process. Magellan can help analyze your financial situation and decide the best path forward, whether that is an exemption trust, charitable remainder trust, or something else altogether.
When you are ready to start thinking about your financial future and legacy, schedule your consultation with Magellan today!
Tax services offered by Magellan Tax, LLC. Legal services offered by Magellan Legal, LLC. Tax and legal services offered separately from Cetera Advisor Networks LLC which does not provide tax or legal advice.