Because of changes to state and federal laws in the last few years, most couples no longer need to worry about federal estate tax. But what if you set up a tax-avoidance trust years ago? You may want to act now to get rid of it and avoid unnecessary expenses and hassle for your family.
Several big developments in the law have made AB trusts—the most common kind of tax-avoidance trust—much less desirable or needed.
Increased exemptions for federal estate tax. The amount that is exempt from federal estate tax has increased enormously. For deaths in 2023, each person can give away or leave $12.92 million without owing tax. This exemption amount rises each year to adjust for inflation. As a result, fewer than one-half of one percent of estates will owe federal estate tax. So unless your family is one of the richest in the country, you don't need to worry about federal estate tax.
Big tax breaks for married couples. Wealthy married couples can combine the federal estate tax exemption of each spouse, giving the couple a total exemption of $25.84 million for deaths in 2023.
Repeal of state estate taxes. Several states have abolished their own estate taxes. Of the states that impose them, some exempt as much property as does the federal government, but some exempt less. State estate tax rates are generally much lower than the federal ones, and it may not be worth it to create an AB trust just to avoid state estate taxes.
Marriage equality rulings. Same-sex couples now get the same federal tax breaks as other married couples. After a 2013 Supreme Court ruling invalidating parts of the federal Defense of Marriage Act, the IRS announced that it would treat all legally married couples the same for tax purposes, whether or not a couple lives in a state that recognizes same-sex marriage. And in 2015, the Supreme Court made same-sex marriage legal across all states.
If you created an AB trust a few years back, when the estate tax exemption was much lower and many more people paid the tax, you may think that there's no harm in keeping the trust. After all, it will ensure that your assets avoid probate, and if there's no estate tax to pay, so much the better, right? But the truth is that an AB trust has some significant costs—and if you don't need to avoid taxes, they probably aren't worth it.
A refresher, if it's been a while since you've thought about how these trusts work: When one spouse dies, the trust is split into two trusts, Trust A and Trust B. One is irrevocable; the surviving spouse can't change its terms.
Restrictions on the surviving spouse's use of the property. Probably the most important drawback of an AB trust is that the surviving spouse has only limited rights to use the assets that are in the irrevocable trust. Typically, the survivor gets only the income generated by the trust assets.
Cost. When one spouse dies, the survivor must hire a lawyer or accountant to determine how to best divide the couple's assets between the irrevocable trust and the surviving spouse's revocable living trust. This decision can have important tax consequences.
Trust tax returns. The irrevocable trust is a separate, tax-paying entity. The surviving spouse must get a taxpayer ID number for it and file an annual trust income tax return.
Recordkeeping. The surviving spouse must keep separate records for the irrevocable trust property.
As long as both spouses are alive, you can revoke your trust and avoid the expense and hassle that will come after one spouse dies. To do it right, follow these essential steps:
For most families, a simple probate-avoidance trust is better than the much more complex AB trust. A simple revocable trust is, basically, a substitute for a will. It isn't designed to continue past the death of a spouse; instead, the trust assets are quickly distributed to the people who inherit them. No probate court proceedings are necessary after the death, which saves money and hassle. And because the trust doesn't stay in existence for years, no trust tax returns are necessary.
Most people can make a revocable living trust themselves without hiring a lawyer to draft the paperwork. But even if you do hire a lawyer to create the trust or to review your work, the cost will be significantly less than you'll pay either to create an AB trust or to administer it after a spouse dies.