How Marital Trusts Work
Most marriage-oriented trusts postpone payment of estate taxes until both spouses in a marriage have died. A marital deduction trust allows you to put property in trust with your spouse as the beneficiary. Upon your death, your spouse has the right to use the property in the trust.
No matter how valuable the property in the trust is even if it exceeds that year’s federal estate tax exemption amount, your spouse won’t owe any federal estate taxes. When your spouse dies, any leftover amount transfers to the beneficiaries that your spouse determined.
One of the more popular uses for all trusts is to buy time on paying any applicable estate taxes until both spouses have died, or to skip over your spouse for purposes of transferring property but still your spouse the right to income from a trust. QTIP trusts and bypass trusts enable you to tailor your trust arrangements with your personal needs.
How do QTIP trusts compare to marital deduction trusts?
If you die first but want to determine who receives the trust property after your spouse dies, consider using a Qualified Terminable Interest Property trust, commonly known by its acronym as the QTIP trust. A QTIP trust operates much the same as a marital deduction trust, with one important exception: You, not your spouse, specify who receives the remaining property in the trust after your spouse dies.
When should you consider using a marital deduction trust instead of a QTIP, or vice versa? Consider the following: Suppose that you and your spouse were only married once (to each other); you have a happy, contented marriage; and both your children act like they stepped out of a 1950s or early 1960s TV show, such as Ozzie and Harriett or Leave It to Beaver. You both want the other provided for no matter who dies first and want to set up some type of trust to delay or diminish federal estate taxes, but then after the second spouse dies, you both want the remainder to go to your children.
In this case, either a QTIP trust or a marital deduction trust probably works equally as well, because you both agree (at least for now) about how you eventually want to distribute the remaining property in your estates.
If you set up a marital deduction trust and you die first, your spouse can later designate your two children as equal beneficiaries of the property left in the trust. Or, perhaps one of your two children makes millions of dollars in business or in the stock market; your spouse can decide to leave the entire leftover estate to the other child who wasn’t quite so fortunate or skilled. Whatever the rationale, a marital deduction trust allows the beneficiary-designation to be delayed as long as possible.
Now consider the following, however. You and your current spouse are each on your second marriage, and you each have children from your first marriage. You and your spouse’s first-marriage children (to put it delicately) don’t quite see eye to eye. The word freeloaders comes to mind every time you hear their names, but your spouse thinks of those first-marriage offspring as my angels.
Regardless of your cool relationship with your spouse’s children, you and your spouse have a happy marriage, and you want to provide for your spouse if you die first. And, because you both are fairly well off financially, a marriage-oriented trust makes sense to delay estate tax impacts.
But do you want your spouse to decide what happens with any leftovers from your estate upon his or her death, as would be the case in a marital deduction trust? Probably not.
A QTIP trust enables you to designate what happens to leftovers. After all, this estate is yours, and for all intents and purposes you are just loaning it to your second spouse for the duration of his or her life if you die first. Afterwards, you want the leftovers to go to your children, or your favorite charity — anyone but your spouse’s children from that first marriage, which is what may happen if you leave the decision up to your spouse by using a marital deduction trust.
How do bypass trusts work?
Married couples can also shelter property from estate taxes by using a bypass trust, which in effect bypasses the surviving spouse. Suppose that you die before your spouse does but instead of either a QTIP trust or marital deduction trust, you’ve set up a bypass trust.
Instead of the property being held in trust for your spouse (as in a QTIP or marital deduction trust), the property in a bypass trust bypasses your spouse (thus the reason for the often-used term) to someone else, such as your child, for whom the property is held in trust.
However, unlike the relatively simple process of giving property to your child as a gift or leaving your child property in your will, your spouse can still benefit from the property under a bypass trust. Although the property is held in trust for the ultimate benefit of your child, your spouse (while living) can have the benefit of the trust assets.
Because your spouse never takes possession of the property in a bypass trust, he or she never is considered to be the property owner and therefore never has to include the property in his or her estate — and possibly be subject to estate taxes on the property.
An incredible number of rules apply to bypass trusts and, specifically, the estate tax consequences. The IRS has all kinds of restrictions. To determine the exact amounts you want to use to fund a bypass trust, consider the exemption amounts, your estate’s value, the value of your spouse’s estate, and other factors.