Protect Spousal Assets With These Estate Planning TipsSubmitted by MIRUS Financial Partners on September 23rd, 2021
When a spouse loses their partner, they may also lose much of their marital assets to taxation. Taxes associated with the death of a husband or wife can be especially severe for high-net-worth marriages, but couples in almost any income bracket may face similar challenges.
Here are five strategies to consider to protect your spouse from excessive taxation in the event you pass away first.
Step-Up in Basis
Sometimes one spouse is significantly older or likely to pass first. In these cases, appreciated assets such as real estate, stocks, bonds, and currency can be transferred to the older spouse so that the surviving spouse can obtain a step-up in basis. Because an asset’s current value often exceeds its original purchase price, the step-up in basis adjusts the value of an asset when it passes to an heir and can reduce the beneficiary's capital gains tax.
A qualified terminable interest property (QTIP) provides for a surviving spouse while still allowing the deceased to maintain control of how the trust's assets are distributed once that surviving spouse/heir dies. The QTIP is a type of trust that distributes its income to a surviving spouse. Sometimes the principal is also distributed.
For example, a younger spouse funds the QTIP for the older spouse using heavily appreciated assets (such as Apple stock bought at $3,000, now worth $125,000). The trust agreement could require that dividend income is distributed to the older spouse during their lifetime using preset distributions or payments. Assuming that the older spouse stays alive for at least one year from the date the trust is funded, the assets in the trust will get a new fair market value basis when the older spouse passes.
A QTIP is complex, but it can be an effective estate planning tool if set up correctly. The first spouse to die has control over the disposition of their property after the surviving spouse's death, and the QTIP is excluded from the probate process. This type of trust ensures that the first spouse can give a qualified income interest in the property to their spouse without incurring the federal gift tax. It’s also protected from any challenges by family members, creditors, or other outsiders.
If maintaining control of the assets is not a consideration, a Transfer On Death (TOD) allows beneficiaries to receive assets at the time of the person's death without going through the probate process. A TOD enables the holder to specify the percentage of assets each heir receives but doesn’t give recipients access to or control over assets as long as the account holder is alive.
401(k) accounts and IRAs are automatically TOD accounts; when these plans are set up, the contributor must choose a beneficiary or beneficiaries. TOD is also available for stocks and bonds and bank accounts. Importantly, TODs supersede designations outlined in a last will and testament.
It is important to note that for the beneficiary to receive a step-up in basis on the assets in a TOD account, the account owner must have held the TOD account for at least one year.
Revocable Living Trusts
Unlike the other options detailed above, Revocable Living Trusts (RLTs) are not helpful in reducing taxation, but they simplify the transfer of assets. RLTs help avoid the sometimes complicated probate associated with an out-of-state property. RLTs also allow the holder to name a successor trustee in case one or both spouses pass prematurely.
A Spousal Lifetime Access Trust, or SLAT, is a gift from one living spouse (the donor) to an irrevocable trust for the benefit of the other living spouse (the beneficiary). The beneficiary can receive distributions from the SLAT, and the SLAT will not be subject to estate tax when the beneficiary spouse dies. However, SLATs don’t qualify for the gift tax marital deduction. Instead, the donor spouse’s exemption from the gift and estate tax is applied to the value of the assets transferred to the SLAT, sheltering the transfer from gift tax and locking the asset's value.
SLATs also allow for the possibility of multiple beneficiaries. For example, a SLAT can be drafted to require the beneficiary spouse to receive the trust’s income for life in some cases but may have multiple beneficiaries in other situations, such as the couple’s descendants. In these cases, upon the beneficiary spouse's death, the assets pass to the benefit of the remaining beneficiaries tax free.
In addition, the SLAT provides an exemption equivalent in the year of the gift, but in a way that still benefits the spouse. This is analogous to a “deferred” gift to children or grandchildren—to occur upon the beneficiary spouse's death whether or not the other spouse is then living. Significantly, the value of the assets transferred to the SLAT must not exceed the amount of the donor spouse’s available gift tax exemption or a gift tax will be charged.
SLAT is an irrevocable trust, and if not drafted extremely carefully, it could actually undo the estate-tax exemption planning. For example, a divorce may end the grantor’s indirect access to the SLAT assets through the former spouse. However, even when divorced, a grantor could remain liable for the taxes on the SLAT income payable to a former spouse. Additionally, assets could pass to the remainder beneficiaries and skip the surviving spouse if the first spouse passes away.
Ready to Start Talking About Your Estate Plan?
Each couple is different, and what works for some spouses may not be helpful for others. Mirus Financial Partners can help you create an estate plan that simplifies the transfer of assets while minimizing estate taxes. Contact us today to learn more.
*For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.