By J. Brendan Ryan
For married couples worried about estate taxes, a very common planning technique is the marital-deduction trust.
Consider Tom and Mary's case. They own $5 million in assets, equally divided. Assume that Tom dies before Mary.
Tax law says that any asset owned by Tom at death in excess of a certain "exempt amount" ($1.5 million in 2004) will be subject to estate tax. But tax on such excess can be avoided to the extent that the excess assets are passed to Mary. This is the "marital deduction" amount.
(At Mary's later death with assets that she owns or controls, her exempt amount will be calculated, and the balance will be subject to estate tax in her estate. But here, we concentrate just on what happens to Tom's assets after his death.)
In the planning process, the marital-deduction amount and the exempt amount are typically arranged in two trusts. The marital-deduction trust, or "A" Trust, receives all assets left directly to Mary or for her exclusive benefit. The exempt amount goes into the "B" Trust.
The B Trust is written such that Mary does not control the assets; but only earnings and even a certain amount of the principal can be used by or for Mary. In this way these B Trust assets will not be taxed later in Mary's estate.
Thus, such an arrangement drawn up in 2004 would plan to set aside $1.5 million for the B Trust at Tom's death and plan to place the balance of his assets in the A Trust, the marital-deduction trust for Mary. At Mary's later death, the assets in the B Trust would not be counted as part of her estate because she did not own or control it. Usually, those assets are distributed to the children or other heirs after both spouses are gone.
The assets in Tom's B Trust will typically be invested to create income for Mary's lifetime, while at the same time preserving or even growing the asset value for the later benefit of the younger generation.
In cases where the surviving spouse has sufficient income and does not need maximum distributions from the B Trust, it is possible and often beneficial to use the leverage of life insurance to increase the amount of assets ultimately passed to the children.
If Tom's B Trust is drawn up so that life insurance is an allowable asset, the trustee can purchase a policy on Mary's life. The policy owner and beneficiary would be Tom's B Trust. But, of course, the heirs are trust beneficiaries and would receive the final benefit from the trust, including the life-insurance proceeds. This could easily triple the size of the funds distributed to the heirs.
An added benefit of this technique is that it would likely lighten the federal-income-tax burden of the B Trust. Trusts are heavily taxed on interest income received from such instruments as certificates of deposit, taxable bonds and cash. But growth in a life-insurance policy's cash value is tax-deferred and can even be accessed by the trustee without tax through policy loans.
Tom's A Trust, the marital-deduction trust, should not own the policy. Because assets in Tom's A Trust could be subject to estate taxes when Mary dies, life insurance purchased by that trust would increase the tax burden and would be somewhat counterproductive.
But, purchased by Tom's B Trust, the insurance will pass to the heirs tax-free and can even replace for the heirs the dollars drained from the A Trust by taxes levied on that portion of the overall wealth.
J. Brendan Ryan is a Cincinnati insurance agent. His column appears every other Saturday. Contact him at 2212 Victory Parkway, Cincinnati 45206; 221-1454; fax 221-3447; or e-mail email@example.com.
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