Trusts are popular estate planning tools used to transfer assets to beneficiaries while minimizing the effect of estate taxes. Spousal trusts, also known as marital trusts, fall into a subclass of trusts that can help you reduce the size of your estate for tax purposes while providing financial security for your spouse, family, and other beneficiaries.

Generally, we categorize trusts under three primary classes: revocable, irrevocable, and testamentary. You can use these different types of trusts in concert to craft a harmonious estate plan. The spousal trusts we discuss in this article are irrevocable or unchangeable. This means that once you establish one and set the terms, it's done, and there's nothing you can change about it. Of course, this rule has situational exceptions, but for the most part, this is how they operate.

While the unchangeable nature of irrevocability may seem like a negative, this is what provides you with tax benefits. Because a properly structured irrevocable trust causes you to relinquish control of the assets you put within it, those assets do not count towards your estate tax exemption. One of the main benefits of utilizing spousal trusts in your estate plan is that you can use your assets to provide for your spouse or family after you pass away and save more of your estate tax exemption for other purposes.

Tax planning is a critical pillar of your financial plan, so it's essential to understand all the potential impacts of establishing a trust. This article will examine the four primary types of marital trusts and summarize the tax implications you'll want to look out for during your estate planning process. 

Estate Tax Exemptions Explained

An important prerequisite for understanding the tax implications of marital trusts is to know how estate tax exemptions work. In 2023, the federal estate tax exemption is $12.92 million per person, so unless your estate's value exceeds $12.92 million, you are not subject to a federal estate tax. However, suppose your estate's value is higher than this exemption amount. In that case, your estate is subject to the federal estate tax when you pass away, and your assets transfer to your beneficiaries. In 2023, federal estate tax rates range between 18% and 40%. Additionally, depending on which state you reside in, you may be subject to state-level estate or inheritance tax, which comes with varying exemptions that change state by state.

Tax Implications of an A Trust

Also known as a "Marital Trust," an A Trust is perhaps the most basic type of spousal trust, and it simply allows for trust-owned assets, or those designated as such in your will, to transfer to a trust for the benefit of the surviving spouse when the first spouse passes away.

The tax benefits of using an A Trust are twofold: First, A Trusts utilize the Unlimited Marital Deduction, which enables the donor spouse to transfer an unrestricted amount of assets to the surviving spouse upon death. This means you can delay estate taxes on those assets until the surviving spouse's death. As an important note, your spouse must be the only named beneficiary on the A Trust to use this deduction.

Second is something called a "step-up in basis," which can potentially provide a massive tax benefit. The cost basis of an asset is the value of the asset when you bought it. For instance, if you purchased the property for $200,000, the property’s cost basis is $200,000. When you sell the property, if its value appreciates to $500,000, you pay capital gains tax on the $300,000 difference.

When an asset is inherited through an A Trust, the cost basis of the asset is "stepped up" to its new market value. So, let's say that the property you purchased for $200,000 is put into an A Trust. If it's worth $500,000 at the time of your death and passes to your spouse through the trust, its new basis would be stepped up to $500,000. Then, if your spouse decides to sell the property for $500,000, they will pay no capital gains tax on the sale. This can result in tens of thousands of dollars in tax savings.

While a step-up in basis at the death of the first spouse is not unique to A Trusts, the additional step-up at the death of the second spouse is. Finally, given the post-mortem usage of A Trusts, they are also testamentary trusts by nature.

How B Trusts Can Minimize Tax Liability

A few different names, including Bypass Trusts, Family Trusts, or Credit Shelter Trusts, also known as B Trusts. Typically used in conjunction with an A Trust, a B Trust is another testamentary, irrevocable trust funded with assets equal to whatever the current estate tax exemption is. Upon the death of the donor spouse, the full allowable amount is transferred to the surviving spouse through the B Trust, and any remaining assets will transfer using other types of trusts (like an A Trust or a SLAT) that are set up alongside the B Trust.

If you choose, the assets in the B Trust can also be excluded from the surviving spouse's estate at the time of their death to avoid estate taxes again. You can achieve this by structuring the B Trust so the surviving spouse cannot access the trust principal. Instead, the B Trust would provide for your spouse through distributions or other income. The B Trust thereby allows the predeceased spouse to control the ultimate passage of assets while still benefiting their surviving spouse during their lifetime. This trust might be used to satisfy estate planning goals and to guarantee assets reach a specific class of beneficiary, such as children from a first marriage, etc.

Finally, the assets within a B Trust receive a step-up in basis upon the death of the donor spouse, which can provide the surviving spouse with a significant tax benefit. The downside is that there is no subsequent step up at the death of the second spouse, which could pose a problem if there has been significant asset appreciation since the first spouse's death.

Using a Spousal Lifetime Access Trust for Flexible Planning

A Spousal Lifetime Access Trust (SLAT) is an irrevocable marital trust that can benefit your spouse during your lifetime, which sets it apart from both A Trusts and B Trusts.

Here's how SLATs work: First, the donor spouse puts assets into the trust. Then, any named beneficiary (typically the donor's spouse, but it could be other family members or even a charity) can access the funds immediately, even when the donor's spouse is still alive. Finally, upon the death of the donor spouse, the assets pass to the beneficiary or beneficiaries.

Putting assets into a properly structured SLAT removes them from the donor spouse's estate for estate tax purposes, which makes them a popular choice for individuals with estates larger than the estate tax exemption. If they choose to, the donor spouse can load assets into the trust after it's established and uses their annual gift tax exemption to avoid gift taxes on these contributions. SLATs also provide a step-up in basis upon the passing of the donor spouse, making them a powerful tool for flexible estate planning.

Achieve Complete Control with a Qualified Terminable Interest Property Trust

Qualified Terminable Interest Property (QTIP) Trusts are functionally similar to A Trusts in that they are irrevocable, and the surviving spouse can be supported by income from the trust after the death of the donor spouse. However, there are three additional features and restrictions of QTIP Trusts that set them apart from the other types of marital trusts:

• Only the surviving spouse can be the beneficiary of the trust
• A QTIP Trust is required to pay income generated by the trust at least annually, which keeps the trust's assets in the surviving spouse's estate
• The donor spouse essentially maintains control of the trust even after their death

This third attribute is perhaps the most significant. QTIP Trusts also allow you to limit access to the trust's principal, which means you can dictate if or how much of the trust's assets can be used. You can also specify what should happen to the remaining funds after your spouse passes away, giving you peace of mind that your money will end up where you want it to go, no matter what.

As an important note, QTIP Trusts differ from the other trusts mentioned here because the assets within them are not eligible to be "stepped-up in value" upon the death of the donor spouse. However, the assets would receive a step-up in basis following the surviving spouse's death, as they are included in the surviving spouse’s estate, even though they have no control over where the assets pass.

Sort Out Your Tax Questions with a Financial Advisor

It's never too early to start planning for what happens to your assets when you're away. Using the right combination of marital trusts in your estate plan can give you the confidence that your wishes will be honored, even long after you pass away. However, establishing and managing trusts shouldn't be taken lightly, especially when estate taxes threaten to eat away what you've worked so hard to build. Marital trusts are used not only for individuals with estate tax concerns. Anyone looking to protect their assets for future heirs should evaluate how trusts can be incorporated into their estate plan.

That's where we come in. We take the time to fully understand your intentions so that we can apply our exceptional craft to your financial plan effectively. If you're ready to start, contact us for a free, no-obligation meeting with a financial advisor today.

This information is not intended to provide tax or legal advice. Discuss your specific situation with a qualified tax or legal advisor.