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Asian couple checks their trust documentsA credit shelter trust is used to help married couples with significant assets pass their estates after their deaths to children or other beneficiaries without incurring estate taxes. Credit shelter trusts are also useful for avoiding probate, shielding assets from creditors and ensuring the wishes of a deceased spouse are carried out. While they are mostly useful for large estates, couples with sizable financial assets can get important benefits from using credit shelter trusts as part of overall estate plans. Consider working with a financial advisor as you create or update your estate plan.

Estate Tax Background

The primary purpose of a credit shelter trust is to reduce federal estate taxes levied on assets transferred to heirs. Death or wealth transfer taxes, as they’re also known, have been around in various forms since the early days of America. They’ve existed in their current form since 1916.

Estate taxes can be significant. The top rate, which is levied on amounts more than $1 million over the exemption amount, is 40%. The exemption amount is indexed to inflation and for 2021, it’s $11.7 million for individuals or $23.4 million for couples. Since few estates are that large, not many Americans actually pay any federal estate tax, sometimes derisively referred to as the death tax. However, for married couples who have enough assets, credit shelter trusts can be real money savers.

The estate tax exemption is currently slated to expire in 2025. While it may be renewed by Congress, it’s likely that it will be different. Estate tax law changes frequently at both the federal and state level, so it’s important to stay current on legislation in order to plan effectively.

How Credit Shelter Trusts Work

A credit shelter trust, also known as a bypass trust, B trust, exemption trust or family trust, is an irrevocable trust. Like all trusts it consists of a contract between a trustor and a trustee. The trustor is the person who sets up the trust and provides the assets. The trustee is the person charged with overseeing the trust and making sure the terms of the trust are followed. The trust contract lays out all the assets that will be included in the trust. These can be any form of property, including cash, stocks, bonds, real estate and collectibles. The trust documents also describe how these assets will be distributed to the beneficiaries. For instance, a trust may specify that assets won’t be distributed to a beneficiary until he or she reaches a certain age.

A credit shelter trust is created after one partner in a marriage dies. Any assets that are put into the trust are considered separate from the estate of the spouse who is still alive. This allows them to go to the beneficiaries after the surviving spouse’s death without incurring any tax. While the surviving spouse is still alive, he or she can receive income from the assets held in the trust.

Credit Shelter Trust Benefits

"TRUSTS" key on a PC keyboardA credit shelter trust works as a tax management tool because assets transferred to a surviving spouse are exempt from federal estate taxes. There’s no limit on this amount. After the second spouse dies, taxes would normally be levied on any assets from that spouse’s estate that are passed on to beneficiaries. However, assets placed in a credit shelter trust are not considered part of the surviving spouse’s estate. As a result, they are eligible to pass on to beneficiaries without being taxed after the second spouse dies. Any appreciation in value in the trust assets can also be bequeathed without taxes.

As an example of how this works, consider a married couple with a $15 million estate. Without estate planning, on the death of the second-to-die spouse, the estate would be $3.3 million over the 2021 $11.7 million federal estate tax exemption. At the top tax rate of 40%, the estate would pay $1.32 million on the $3.3 million excess. In addition, there is a base tax of $70,800 charged on the first $11.7 million. Total estate tax would come to $1,390,800. A credit shelter trust would avoid all this tax.

In addition to reducing taxes, a credit shelter trust can help ensure that the surviving spouse honors the wishes of the deceased spouse. The trustee will make sure that terms of the credit shelter trust are followed. For instance, if the first-to-to-die spouse wants part of his or her estate to go to children of a previous marriage, the trust document can specify that. Trust assets are also protected from creditors. And assets placed in the trust don’t have to go through probate.

Credit Shelter Trust Limits

Credit shelter trusts are most useful when each spouse has enough assets to reach the amount of the estate tax exemption. They are not generally used when estates are less than the amount of the exemption.

A credit shelter trust is an irrevocable trust, meaning the terms of the trust cannot be altered. That means the needs of the surviving spouse have to be carefully considered when setting up the trust, since the surviving spouse has limited control over assets in the trust.

Credit shelter trusts also have to file federal income tax returns. This can be time-consuming and costly and has to be provided for in the trust documents.

Bottom Line

Family doing estate planning

A credit shelter trust is one of several different types of trusts, and can be effective tax management tools for estates large enough to trigger the federal estate tax. They can also be helpful for making sure surviving spouses follow a deceased spouse’s instruction for the disposition of assets. Credit shelter trusts can keep assets from going through the time-consuming and costly probate process. And they can shield a married couple’s assets from creditors after one spouse dies.

Tips on Estate Planning

  • Credit shelter trusts are just one tool that can be used for estate planning. Working with an experienced and qualified financial advisor can help make sure your estate is distributed according to your wishes, including minimizing estate taxes. SmartAsset’s free financial advisor matching tool can connect you with up to three local advisors. Get started now.
  • A free, easy-to-use retirement calculator can give you a good estimate of how you are doing in reaching your financial goals.

Photo credit: ©iStock.com/yongyuan, ©iStock.com/Artur, ©iStock.com/wilpunt

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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