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When people begin the process of estate planning, a subject often of primary importance is protecting the estate’s assets from taxes, particularly if the estate is large. In the United States, the federal estate tax is considered by many to be an inheritance tax, and there is an estate value ceiling above which a hefty tax is imposed when the estate’s owner dies. An estate may pass from one spouse to another without taxation, as long as the spouse is a U.S. citizen, but the surviving spouse’s heirs will have to pay the tax upon the second spouse’s death. It is possible, however, to avoid estate taxes — at least to a significant degree — through the establishment of a trust.
Estate and inheritance taxes are those from which large estates most often seek relief. Although the two terms are often used interchangeably, the difference between them is basically that estate taxes are paid by the estate of the deceased, while inheritance taxes are paid by those who inherit the wealth of the deceased. There are estate tax laws at the federal level and inheritance and estate tax laws at the state level, where there is quite a bit of variability.
The U.S. Tax Relief Act of 2010 raised the value of the federal estate tax ceiling to $5 million US Dollars (USD), with an effective tax rate of 35 percent. This means anything in an estate over the $5 million USD cap would be taxed at 35 percent unless going to a spouse. It is this over-the-cap amount that those with large estates wish to shield from inheritance tax with a trust.
Avoiding inheritance tax with a trust effectively transfers estate funds to heirs without subjecting them to inheritance tax. For tax years 2011 and 2012, married people in the U.S. will be able to meld their individual $5 million USD gift-tax exemptions to transfer up to $10 million USD to their heirs, tax free. Such exemptions can change, however, so those planning their estates may look to protect their assets and decrease inheritance tax with a trust known as an AB trust.
The "A" portion of an AB trust is commonly called the "marital" portion of the trust; the "B" part is known as the "bypass" or "family" portion. These trusts can be set up via a will or a revocable living trust. This type of trust allows the combining of the spouses’ two exemptions and, when one spouse dies, allows the surviving spouse to use money from the trust for living expenses. When the second spouse dies, the large exemption amount means that, for all but the very largest of estates, the heirs will pay either no or very little estate tax.
Inheritance taxes, levied by individual states, are a different matter. As of 2011, seven U.S. states collected an inheritance tax, which varied from approximately 1 percent to 20 percent of the estate's value. All seven states exempt spouses from this tax, and four exempt children and grandchildren, as well. It is usually not possible to avoid paying this inheritance tax with a trust, so some people put language in a will that directs the estate to pay any inheritance taxes for which the heirs might be responsible.
@Markerrag -- There are a couple of additional advantages to setting up a trust. For one thing, you can avoid probate because the assets effectively transfer to survivors during the lifetime of the grantors. That is not as scary as it sounds -- those assets transfer on paper, but the grantors are able to use and enjoy their property as they always have with virtually no restrictions.
Another advantage is that you avoid a lot of those challenges that can come with wills because there is more flexibility on which relatives get how much with a trust. In a will contest, you will typically see relatives claiming they didn't get as much as state law says they would have if the decedent died without a will and they want things distributed that way. Such messiness is avoided with a good trust.
When thinking about your estate, don't ever assume the federal government will keep that $5 million ceiling in place. And, don't ever assume that $5 million in assets will be worth as much 20 years from now as it is today.
A trust set up by an attorney who knows what he or she is doing leads to peace of mind. If you want to be sure what will happen, go for a trust. The laws may change on those in the future, too, but at least there is a smaller risk of that happening than the federal government revising the amount of assets that can be transferred before inheritance taxes kick in.
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