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In Association with
Living Trust

Will a Living Trust Meet Your Needs?


by Denis Clifford

Ask people why they work hard and save their money, and often you'll hear that it's not only because they want to raise their own standard of living--they want to leave something behind for their children, too. Understandably, they don't want a big chunk of that money to be used up for probate lawyers' fees or death taxes.
That's where living trusts come in. They don't save you a penny while you're alive, but after death they can eliminate the need for probate--and probate fees--and they can also reduce or eliminate federal estate (death) tax. More of the property you leave goes to the people you want to inherit it.
But there is a confusing variety of living trusts. Most people aren't exactly sure how they work or who needs them. And paying a lawyer to explain it all may leave you more in the dark--not to mention poorer--than when you started.
Here's a rundown of the basics, so you can decide whether or not you need a living trust and if so, what kind.
The two most common types of living trusts are:

  • a basic living trust (for an individual or couple), which avoids probate.
  • "living trust with marital life estate" or "A-B" trust, which both avoids probate and saves on estate tax.

A Basic Living Trust

Unless you expect to owe federal estate tax at your death or your spouse's, a basic living trust to avoid probate may be all the trust you need. It allows property to avoid probate and to pass to the beneficiaries you name quickly and efficiently, without the hassles and expense of probate court proceedings.
A married couple can use one basic living trust to handle both co-owned property and the separate property of either spouse.
To create a basic living trust, you (called the grantor or settler) transfer ownership of some or all of your property to the living trust. Because you make yourself the "trustee," you don't give up any control over the property you put in trust. If you and your spouse create a trust together, you will be co-trustees.
In the trust document, you name the people or institutions you want to inherit trust property after your death. You can change those choices if you wish; you can also revoke the trust at any time.
When you die, the person you named in the trust document to take over--called the successor trustee--transfers ownership of trust property to the people you want to get it. In most cases, the successor trustee can handle the whole thing in a few weeks with some simple paperwork.

Tax-Saving Trusts

First, the good news: Most people don't need to think about federal estate taxes, which kick in only when someone dies owning more than $625,000 to $1 million worth of property, depending on the year of your death. But if you (or you and your spouse) expect to own that much property, consider creating a living trust that will both avoid probate and also save on federal estate taxes.
If you don't, there may be a big estate tax bill when the second spouse dies. That's because the survivor's estate includes his or her share of the couple's property plus the property inherited from the deceased spouse.
If you can't leave your spouse property without also saddling his or her estate with a large tax bill, one obvious alternative is to leave much of your property directly to your children or other beneficiaries. But most people want to provide financial security for the surviving spouse--which may not be possible if they leave much property to others.
A life estate trust lets a couple pass the maximum amount of property to their children or other beneficiaries after both spouses die, while at the same time ensuring the surviving spouse is financially comfortable. It's one of the few times in life you really can have it both ways.

Here's how it works.
Instead of leaving property outright to the survivor, each spouse leaves most or all of his or her property to a "marital life estate trust." When one spouse dies, the surviving spouse can use that property, with certain restrictions, but doesn't own it outright. That's the reason behind the big tax savings: The property isn't subject to estate tax when the second spouse dies, because the second spouse never legally owned it.
When setting up a marital life estate trust, each spouse names final beneficiaries who will receive that trust's property when the surviving spouse dies. Spouses often name the same people--the couple's children--as final beneficiaries, but it's not mandatory.
Example: Christine and Thierry have a combined estate of $1,100,000, all shared ownership property. If each left his or her half, $550,000, to the surviving spouse outright, that spouse would be left with an estate of $1,100,000. If the surviving spouse died in 2002 with an estate worth $1,100,000, $400,000 would be subject to estate tax.
But if Christine and Thierry each leave their half of the trust property in a living trust with marital life estate, naming their five children as the trust's final beneficiaries, no estate taxes will be due. This is because when the first spouse dies, her $550,000 goes into the marital life estate trust, and is subject to estate tax at this time. But because the amount in the marital life estate trust is less than the federal estate tax threshold, no tax is due. Similarly, when the surviving spouse dies, his $550,000 is not subject to tax.

The Surviving Spouses's Rights

The surviving spouse has limited power over the assets in the life estate trust. The extent of this power depends on the terms of the trust, within certain limits set by the IRS. If a surviving spouse is given more power than IRS rules allow, the surviving spouse becomes the legal owner of the trust property--exactly what you don't want.
When the maximum powers are granted, the surviving spouse:

  • receives all interest or other income from the trust property
  • may use the property--for example, she can live in a house owned by the trust
  • may spend the trust property in any amount for his or her health, education, support and maintenance, in his or her accustomed manner of living. (IRS Reg. 20.2041-1(c)(2).)
In other words, the surviving spouse has the right to use all of the trust principal for what really concerns most older couples: the surviving spouse's health care and other basic needs.
After the death of the surviving spouse, the marital life estate trust property is distributed to the final beneficiaries, chosen by the deceased spouse in the original trust document. The surviving spouse's property is also distributed to her beneficiaries.

Drawbacks of a Life Estate Trust

Before creating a living trust with marital life estate, couples should understand what they're getting into. Once one spouse dies, a marital life estate trust cannot be changed.

Possible drawbacks of a marital life estate trust include:

  • Restrictions on the surviving spouse's use of the property. As discussed above, the surviving spouse has only limited rights to use trust property in the marital life estate trust.
  • Expense of legal or accounting help. When one spouse dies, the survivor may need to hire a lawyer or accountant to determine how to best divide the couple's assets between the irrevocable marital life estate trust and the surviving spouse's revocable living trust. How the property is divided can have important tax consequences.
  • Trust tax returns. The surviving spouse must get a taxpayer ID number for the marital life estate trust and file an annual trust income tax return. This isn't a big deal, but like any tax return, it requires some work.
  • Recordkeeping. The surviving spouse must keep separate records for the marital life estate trust property.
  • Given these disadvantages, it's obvious that not all married couples with a combined estate over the estate tax threshold should use a life estate trust. It's generally not advisable, at least not without the advice of an experienced estate planning lawyer, for:
    • Many couples under 60. People in this age group don't want assets to be tied up in a trust if one spouse dies unexpectedly.
      Commonly, younger couples create a basic shared living trust. When they're older--say in their later 50s or 60s--they revoke it and create a living trust with marital life estate. And if one spouse unexpectedly dies soon, the survivor will inherit everything estate-tax-free, no matter what the amount. The surviving spouse will probably have years to use the money--and to find other methods of reducing eventual estate tax.
    • Couples where one spouse is considerably younger than the other. There's generally no need to burden the second spouse with a trust designed to save estate taxes when he or she is likely to live for many years.
    • Many couples in second or subsequent marriages. There may be concern about conflicts between the surviving spouse and the deceased spouse's children, who must essentially share ownership of property for many years. Despite its possible drawbacks, a living trust with marital life estate does work very well for many families. Many older couples conclude that the relatively minor accounting and recordkeeping hassles are outweighed by the benefits.

Family Conflicts

With a marital life estate trust, there is an inherent possibility of conflict of interest between the surviving spouse and the final beneficiaries. The final beneficiaries may want all the trust property conserved, no matter what the needs of the surviving spouse. But the surviving spouse may want to spend trust principal.
A living trust with marital life estate works best when the final beneficiaries understand that taking the trouble to create the trust is a generous act by parents. After all, the parents do not benefit themselves, but their inheritors receive much more of the couple's combined estate than they would if the spouses simply left property to each other. The final beneficiaries should also understand that all property in the marital life estate trust should be available for the surviving spouse

Why Worry About Estate Tax?

You can leave any amount of property, no matter how much it is worth, to your surviving spouse free of federal estate tax. So why concern yourself with avoiding estate tax, even if your combined estate is large enough to owe tax?
The problem comes if, as is common, you want to leave most, or all, of your property to your spouse. Suppose you have a combined estate worth $1 million. Each spouse's share is worth $500,000. When the first spouse dies, there are no federal estate taxes, no matter who the property is left to, because that spouse's $500,000 estate is under the tax threshold.
But if the deceased spouse leaves all his property to the surviving spouse, the survivor's estate is now worth the entire $1 million, over the federal taxable limit until the year 2006. When this spouse dies, stiff federal estate tax rates apply.
Estate planners call a tax due on the death of the surviving spouse the "second tax." A living trust with marital life estate can eliminate this second tax.

From Make Your Own Living Trust by attorney Denis Clifford. Copyright Denis Clifford. Excerpted by arrangement with Nolo Press. $24.95. Available in local bookstores or call 800-992-6656 or click here.

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