Unbeknownst to most financial advisors is the value of a disclaimer trust. Just what is a disclaimer trust? In the world of estate planning documents, it is a form of a credit shelter trust (CST). Instead of the CST being a trust that will be funded (mandatorily) at the death of a testator, it is set up to be used as an "optional" plan where its use may not be known until after the death of the testator.
In other words, it will be drafted today as any other CST, but whether it will be funded will not be determined until the surviving spouse makes an affirmative decision that he/she desires that it be utilized. Stated another way, its funding will be optional and the final decision does not have to be made until nine months after the death of the testator. During this nine-month period, it will be very important to advise the surviving spouse not to “taint” any of the assets that may be disclaimed. More on this later. (For more, see: Estate Planning for Beginners, Part One.)
Estate Tax Exemption
For those of you too young to remember, the estate tax exemption at one time was less than $600,000. In those days the funding of a credit shelter trust was used as a tool to eliminate or at least minimize the estate tax in the estate of the second spouse to die. If the surviving spouse died with an estate in excess of $600,000, there would be a federal estate tax due.
Compare that with today's federal exemption of $5,490,000 per person in 2017 and combined with "portability," the surviving spouse can leave a total of $10,980,000 before any federal estate tax (not counting state taxes), if any is due. And all of this without the need for a credit shelter trust.
My experience over the past few years with some experienced estate planning attorneys indicate that they are using the ongoing increase in the estate tax exemption as a reason to bypass the need or desire for the use of a credit shelter trust. Personally, I think this “may” be a big mistake and misses the more important reasons a CST has value to clients and their families.
Competent estate planning attorneys may use language that limits the funding of the CST to the state limits and others may want to use disclaimer trusts and allow the surviving spouse the option to make decisions based upon her circumstances at the death of the first spouse.
Advantages of Credit Shelter Trusts
So you might ask, what are the advantages of a credit shelter trust? I'm glad you asked and I will touch briefly on the topic here with more to follow in our next piece. Let's begin with the estate tax advantages. As we get into this, let's keep in mind that there are potentially two sets of estate taxes. The first is the federal estate tax and then there may be a state estate or inheritance tax in the state of your residency. (For more, see: Estate Planning for Beginners, Part Two.)
It should be clear that at the federal level, we have an exemption of $5,490,000 during 2017 and this amount is now being indexed annually for inflation. Unbeknownst to many people, there are a number of states that also have an estate tax. As a side note, let’s not place too much confidence in our elected politicians. During the election process, Hillary Clinton had proposed reducing the current federal exemption back to $3,500,000 while Donald Trump suggested he would do away with estate taxes.
I reside in New Hampshire. We have no state estate tax and this becomes very attractive to retirees in New England and elsewhere as an ideal place to retire if you can deal with our winters and shortly thereafter, mud season. In addition, we have no income tax or sale tax.
But suppose you live in New Jersey where the exemption, for years, has only been $675,000 or Massachusetts where the exemption is $1 million or Vermont where the exemption is $2,750,000. Estate planning and the use of trusts may become more important at the state level. In these cases, we may want to leave a credit shelter trust up to the limits of the state tax exemption to avoid some state estate taxes in the estate of the second spouse to die. Keep in mind that laws are constantly changing and a qualified estate planning attorney can take this into consideration during the drafting of the will and trust agreement.
What we often want, in the long run, is to avoid any and all estate taxes whenever possible. This is easy in New Hampshire, especially for estates up to $5,490,000 for a single individual and $10,980,000 for a married couple. However, for those in a state where the state exemption is $1 million like Massachusetts, we may want to leave $1 million to a credit shelter trust so that this first million is exempt from taxation in the estate of the second spouse to die.
For families who have been fortunate enough to have accumulated assets of substance, these limited exemptions at the state level are one of the many reasons that in retirement couples move to New Hampshire or Florida where the state does not impose an estate or inheritance tax. (For more, see: Estate Planning for Beginners: Part Three.)
Since the laws are constantly changing, we are using more and more disclaimer trusts for our clients. This eliminates the credit shelter trust from being mandatory and instead, allows the surviving spouse an option to use this trust if his/her circumstances warrant its use at the death of the first spouse.
The major disadvantage of the use of a disclaimer trust is that the surviving spouse may elect not to take advantage of this planning opportunity. Once provided with the option, the surviving spouse can then turn to his or her financial advisor and/or estate planning attorney for guidance as to whether the disclaimer trust is worth considering, and then he or she has nine months to make a formal decision.
In all cases with a disclaimer trust, the assets are directed to be distributed to the surviving spouse outright. However, it is the option to disclaim that has value and the decision does not have to be made when the documents are being drafted. Competent estate planning attorneys may use language that limits the funding of the CST to the state limits and others may want to use disclaimer trusts and allow the surviving spouse the option to make decisions based upon circumstances at the death of the first spouse.
Further Estate Planning Issues
There are two issues I would like to leave you with:
- Tainting the assets: For the surviving spouse to disclaim an asset during the nine-month period following the death of the first spouse, the asset or the account cannot be touched for any reason prior to the formal “disclaimer” being executed. An example may help: Husband has a $50,000 saving account in his name alone that credits interest ever quarter. Each quarter the surviving spouse removes the interest to live on and does not touch the original $50,000. This account has now been “tainted” and is no longer eligible to “disclaim.” An exception to this rule is a jointly-owned home and yes, the spouse can continue to live in it and if necessary, disclaim the husband’s 1/2 interest.
- Anyone inheriting an asset may disclaim the asset. However, only a spouse can disclaim an asset and still be the beneficiary of the disclaimed property passing into a trust for her benefit.
We will continue with the advantages of credit shelter trusts in our next piece.