Does Your Estate Plan Work?

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During the past five years, changes in federal estate tax law have meant good news for wealthy Americans. Reductions in tax rates imposed on estates and increases in the threshold at which estates are subject to the estate tax have substantially reduced the burden on families wishing to pass on wealth to their children, grandchildren, and other heirs.

Along with the favorable developments, however, there may be some unintended consequences from plans that were put into place before the changes took effect. Take some time to examine your estate planning strategies and documents to ensure they still make sense in light of changes in the law and possible changes in your family situation.

New Landscape, Old Plans

The legislation passed by Congress and signed into law by President Bush on June 7, 2001, was significant because of its profound effect on the taxation of wealth transfers. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) introduced a 10-year schedule of declining marginal estate tax rates and staggering increases in the amount that individuals can exclude from estate and generation-skipping transfer taxes.

Prior to EGTRRA, individuals could exclude $675,000 of their estate from taxation (now called the “applicable exclusion amount”). Married couples could effectively exclude twice that amount – $1.35 million – if both the husband and wife utilized their individual exemptions. The mechanism for doing so involved the creation of a so-called bypass trust at the death of the first spouse. This instrument preserved the individual exemption of the first spouse who died and held assets for the benefit of heirs while providing lifetime income and limited access to the principal for the surviving spouse. The balance would pass outright to the spouse or to a marital trust.

Under the new regime, individual applicable exclusion amounts are much higher than they were prior to 2001 -$2 million from 2006 through 2008, and rising to $3.5 million in 2009. This can cause a problem for estate plans that were created before EGTRRA took effect.

“Typically, the language in estate planning documents would call for funding the bypass trust on the first spouse’s death with assets equal to the applicable exclusion amount,” says R. Tracy Page, an advisor with Lincoln Financial Advisors in Windsor, Conn. “Less than six years ago, that was a relatively modest $675,000, but today that amount has nearly tripled, to $2 million.”

Unintended Consequences

Page says many wealthy families set up two trusts: a marital trust and a bypass trust. Typically, the bypass trust is funded to the maximum applicable exclusion amount ($2 million in 2006) with any assets in excess of the maximum applicable exclusion funding the marital trust. Two issues are:

1. The maximum applicable exclusion has increased faster than the growth on most people’s assets. Therefore, situations can arise where the bypass trust is fully funded but there are few or no assets to fund the marital trust. This could inhibit the surviving spouse’s ability to gift or dispose of assets to heirs in a different way due to changes in circumstances.
2. The bypass trust may be a generation-skipping trust for the lifetime of the heirs. The martial trust may have distributions of money to heirs at various ages. If the assets end up in the bypass lifetime trust and not the martial trust, is the result acceptable?

“If the first-to-die spouse’s estate is worth somewhere just north of $2 million, the second-to-die spouse may have very few assets to plan with since they all went into the first-to-die spouse’s bypass trust,” says Page. “This means your immediate heirs could receive very little assets when both you and your spouse are gone.”

Here are some questions to consider, says Page:

• Does the potential shift of assets to the residual trust concern you because more money is being held in a lifetime trust for your children than you had anticipated?
• Does the trustee have the flexibility to distribute principal to children?
• Does the trustee have discretion to not make a full generation-skipping election for all assets?
• Is your state death tax different (decoupled) from the federal tax?

Page advises updating language in your documents so that amounts flowing into both trusts provide enough assets for both your surviving spouse and your children, while taking maximum advantage of the applicable exclusion amounts to the extent it helps achieve your goals.

Family Considerations

In addition to considering tax law changes, you should also review your personal circumstances. Obviously, divorce or the death of a spouse will significantly

alter estate planning decisions. Also, the financial situation of your children may influence the decision to leave money outright or keep it in a trust to help minimize the potential estate tax burdens of your heirs.

“Trust planning can not only take care of tax issues, but also non-tax issues,” says Page, referring to the asset protection characteristics of trusts. “There is a huge difference between delivering money to your children and delivering financial security to your children.”

Schedule some time to review your estate plan to make sure it will still accomplish your objectives.

Talk to Your Financial Planner About:

• How recent tax law changes may affect your estate plans.
• Whether your estate plans are affected by a change in your family situation.
• Whether a bypass trust will help reduce estate taxes.

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