A credit shelter trust is sometimes referred to as a bypass trust. The credit shelter trust is intended to allow married couples to take full advantage of the lifetime exemption for estate taxes and minimize federal tax on their combined estates. This trust allows each individual a one-time exemption from estate or so-called death tax and gift tax. Nonetheless, the lifetime exemption is calculated as a credit against the estate and gift tax and is sufficient to offset the tax due on an estate of a specific size. The exempt amount is $3.5 million, which provides for a combined exemption of $7 million. This type of trust is suitable for those couples who have combined assets that exceed the exclusion amount of $3.5 million.
How Does the Credit Shelter Trust Work?
Usually, this type of trust is funded via assets that are adequate to fully utilize the federal estate tax exemption, which is often called the applicable exclusion amount of $3.5 million of the first spouse to pass away. The credit shelter trust may be funded during the lifetimes of the spouses, or at the time of death of the first spouse to die. A surviving spouse may be given restrictive access and control over the assets in the credit shelter trust. The trust can be set up to give the surviving spouse an annual income that is earned by the trust, to withdraw $5,000 or five percent of the trusts’ principal for any reason that he or she sees fit, to use the trusts’ principal when necessary for health, support, education, or maintenance.
Let’s look at a real world example. Let’s assume that Bill and Hillary have a little over $6 million in assets. If Bill were to pass away, leaving everything to Hillary, there would be no federal estate tax incurred because existing law allows for an unlimited amount of money and property to pass to a spouse without such tax being due. Now, let’s assume that Hillary will live off the earnings and interest on her $6 million estate for her remaining lifetime. When Hillary dies, her entire estate passes to her children. If Hillary were to pass away in 2010, $3.5 million of her estate would be exempt, but the excess ($2.5 million) would be subjected to an estate tax of around forty percent. At that rate, the Internal Revenue Service would see a nice, fat check for over one million dollars. Bill and Hillary’s children would receive around $1.5 million of the un-exempt amount.
Had Bill executed a will that left an amount that was equal to the available exemption in a credit shelter trust, and the remainder of his estate was left to Hillary. Let’s also assume Bill passed away in 2008. Bill’s estate ($3 million) would pass to the trust without incurring tax. Hillary can then live off the earnings of her estate and also on income earned from the trust, tapping into the trust when she needs to for approved purposes. Then when Hillary dies, her estate would be able to use the $3.5 million exclusion so that her children do not lose a big part of the estate to estate tax.
In a nutshell, that is how a credit shelter trust works. Many couples fail to realize the true worth of their estate and thus don’t properly plan their estates and take advantage of the credit shelter trust. Once you factor in payouts from life insurance policies, homes and real estate investments, as well as other assets, your estate can quickly skyrocket to the $3.5 million range. Talk with an estate planner to find out if the credit shelter trust is right for your financial future.
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