Tuesday, September 29, 2009

Estate Planning Tip of the Week

What is a Credit Shelter Trust?

A credit shelter trust, also known as a bypass trust, is designed to shelter up to one full federal estate tax exemption amount.  All citizens are allowed an exemption from federal estate taxes, which represents the amount that can pass tax free to beneficiaries.  In 2009, the federal exemption amount allows up to $3.5 million in assets to pass to beneficiaries before federal estate taxes kick in.  However, too often people lose their exemption because they do not plan ahead.

For instance, suppose you and your spouse are together worth $4 million, which includes real estate, financial accounts, life insurance proceeds, recent inheritance from parents and various other assets.  If you and your spouse each have a simple will that passes the assets of the first to die to the survivor, the survivor could end up with a $4 million estate, but only one exemption.  If the exemption amount hasn’t changed at the time when the survivor dies, the estate may have a federal estate tax liability on the amount over $3.5 million.

One of the principal aims of trusts is to ensure that the first decedent’s exemption is not lost.  By creating a trust to preserve the first decedent’s exemption, money can later be placed in the decedent’s credit shelter trust such that it is not later included in the surviving spouses taxable federal estate.  For example, with the couple owning $4 million, half of that might be placed in the decedent’s credit shelter trust, and the surviving spouse’s trust would own the other half.  When the second spouse died, their taxable federal estate would amount to only $2 million, and thus even if the estate had grown in the intervening years, it would be unlikely to exceed the exemption amount of $3.5 million.

In 2011, under current law the federal exemption amount is scheduled to drop to $1 million per person, which makes planning ahead to avoid unnecessary federal estate taxes even more important.