Are you married? Did you plan on leaving anything to your spouse when you are gone? If so, you have lots of options. There are many ways to leave an inheritance to your spouse. If your spouse is going to get nothing, then you can stop reading now. Otherwise, read on.
The four most common ways that I have seen used to leave an inheritance to your spouse are outright distribution, convenience trust, family trust and marital trust. What are they and what do they do?
Outright Distribution
You and your spouse may have one of the most common type of estate plans between married couples which is the “Honey I love you, I leave it all to you” plan. With this type of plan, you leave all of your assets outright to your surviving spouse. The kids or other beneficiaries only get something after you are both gone.
This type of plan may initially seem attractive to you because it is fairly simple and economical to draft. However, there are disadvantages.
Firstly, all of the assets you leave to your spouse are available to satisfy claims against your spouse from lawsuits, bankruptcies and other creditors. In addition, if after your death, your surviving spouse marries Thor, her Swedish personal trainer, or Bambi, his aerobics instructor, and then predeceases the new and quite often younger spouse, Thor or Bambi may have a claim against your assets. This could limit the amount of assets that are inherited by your children or other beneficiaries.
Secondly, since the assets are going directly to your spouse, you have forfeited your estate tax exemption. Although the estate tax exemption is $5 million in 2011, it is scheduled to go back to $1 million in 2013 and thereafter.
With a “Honey I love you, I leave it all to you” plan, you and your spouse could only pass $1 million estate tax free to your beneficiaries upon the survivor’s death in 2013 or thereafter. With a properly drafted trust-based estate plan, you could easily double that to $2 million by using both spouse’s estate tax exemption.
Thirdly, any assets that are in your sole name at the time of your death would need to go through probate in order to get them into your spouse’s name. Your assets will then have to be probated again upon your spouse’s death in order to go to your ultimate beneficiaries. Probate takes time, often a year or more, can tie up your assets during administration and also can be expensive.
Fourthly, if you or your spouse do not have properly drafted financial powers of attorney and you or your spouse became incapacitated, then you or your loved ones may have to petition the probate court for a for a probate court supervised conservatorship to pay bills or to sell property.
Convenience Trust
A common alternative to outright distribution of an inheritance to your spouse is to set up a lifetime convenience trust for your spouse. This trust is also called a general power of appointment trust. By setting up this type of trust and titling or funding your assets into the trust, you avoid two of the four pitfalls of outright distributions. You no longer would need to have a probate court supervised conservatorship upon you or your spouse’s incapacity for those assets in the trust and similarly avoid probate court estate administration upon you and your spouse’s deaths.
In your convenience trust, you can give your spouse the power after your death, to reallocate the trust assets among your trust beneficiaries or name other beneficiaries of your trust, which would take effect after your spouse’s death. I call this the “children honor your mother (or father)” clause “because mom (or dad) can disinherit you after I’m gone.” It is also called a limited power of appointment.
What are the risks of a convenience trust? A convenience trust does not offer protection for claims against your spouse from lawsuits, bankruptcies or other creditors. Upon your surviving spouse’s death, the new spouse Thor or Bambi may also have spousal claims against your assets that you left to your surviving spouse in this type of trust. Also, as in an outright distribution, you forfeit your $1 million estate tax exemption to leave assets estate tax free to your children or other beneficiaries in 2013 or thereafter ($5 million in 2011 and 2012).
Family Trust
A more attractive alternative is to use an asset protection family trust for the benefit of your spouse. This trust is often called a credit shelter trust or the A trust of an A-B trust. You can use this type of trust even if you do not have a taxable estate. After you are gone, during your spouse’s lifetime, he or she gets income or principal whenever needed for health, education, maintenance and support.
As with a convenience trust, the assets in this type of trust avoid probate upon your or your spouse’s incapacity or death and you can have a “children honor your mother (or father)” clause. In addition, your spouse’s inheritance is protected from claims against your spouse from lawsuits, bankruptcies and other creditors. Your spouse’s inheritance is also protected from divorce or death claims from the new spouse, Thor or Bambi.
Furthermore, you can put remarriage protection in your family trust. For example, in my family trust, I put a provision that states that after I am gone, all distributions to my wife Emily stop when she marries Thor, unless Thor signs a pre-nuptial agreement waiving any claims to Emily’s assets. This does two things. It protects our entire marital estate for our children Luke and Elizabeth, and it takes the pressure off of Emily when requesting a pre-nup from Thor. She can blame it on me. Well Emily said fair is fair, so she put Bambi protection in her family trust.
If you limit the amount of assets that go into your family trust to the estate tax exemption amount of $1 million in 2013 and thereafter ($5 million in 2011 and 2012), all assets in the trust pass estate tax free not only to your spouse, but to your children or other beneficiaries upon your spouse’s death, even if the assets have substantially increased in value. For example, lets say you left $1 million in this type of trust for your spouse in 2013 or thereafter and your spouse survived you for 14 years and did not need any amounts in that trust. The trust may have doubled in 7 years to $2 million and doubled again by year 14 to $4 million. The entire $4 million would pass estate tax free to your children or other beneficiaries.
Marital Trust
If your estate is in excess of the estate tax exemption of $1 million in 2013 or thereafter ($5 million in 2011 and 2012), you could avoid all estate taxes upon your death by setting up a special marital trust for the benefit of your surviving spouse for all of such excess. This trust is also called a Qualified Terminable Interest Property (QTIP) trust or the B trust of an A-B trust.
With this marital trust, your surviving spouse would receive all the income during lifetime. Your surviving spouse may also get principal if needed for health, education, maintenance and support.
This marital trust has all the benefits and protections of an asset protection family trust for the benefit of your spouse and in addition, since it qualifies for a marital deduction, there is no estate tax on the assets upon your death. However, upon your spouse’s death, the assets in this marital trust, are added to your spouse’s taxable estate for estate tax purposes.
Although a “Honey I love you, I leave it all to you” plan may seem efficient, it may not always be the best type of plan to give what you have to whom you want when you want the way you want. You have options to not only provide for your spouse, but also you can provide them with creditor, tax and other protections.
By: Matthew M. Wallace, CPA, JD
Published edited March 13, 2011 in The Times Herald newspaper, Port Huron, Michigan as: Keep assets out of grasping hands