When starting life as a married couple, the last thing most are thinking about is death and estate taxes. However, as married couples accumulate wealth over the years, many make the common mistake of not establishing a proper estate plan to protect the wealth they have built. Most couples understand that they can transfer assets at death to the surviving spouse, estate tax free. However, what they may not understand is the tax trap revealed when the second spouse dies and estate assets are passed on to beneficiaries. Without proper planning, those assets may be exposed to estate taxes, which could result in a large reduction in their value.

Under current law, a person can pass any size estate to his or her spouse without federal estate tax because of the unlimited marital deduction granted by IRC Section 2056.

Also, the IRS grants each spouse a unified credit, which can be used to reduce the amount of estate taxes due. For 2007, the unified credit of $780,800 will protect approximately $2,000,000 of taxable estate assets. The credit amount will increase to $1,455,800 in 2009, thus excluding approximately $3.5 million of taxable estate assets.

If, upon the death of the first spouse, all assets are transferred to the surviving spouse using the unlimited marital deduction, when the surviving spouse later dies and passes the combined estate to his or her beneficiaries, there is only one unified credit to reduce the estate tax.

To preserve the unified credit of the first spouse to die, couples can use a credit shelter trust (also called a “by-pass” or “exemption” trust). When the first spouse dies, an amount equal to the approximate amount protected by the unified credit (currently up to $2,000,000) is placed into the shelter trust. This trust is not taxed at that time or at the later death of the surviving spouse, even though it may appreciate in value. By utilizing a credit shelter trust that takes advantage of federal credits, a larger percentage of your estate can be transferred to beneficiaries free of federal estate taxes.

Hypothetical Example:

Assume Bob and Barbara’s combined taxable estate is worth roughly $2.5 million and is divided equally between them. Bob dies in 2007. Without a credit shelter trust, all of his assets would pass to Barbara estate tax free because of the marital deduction, making Barbara’s total estate worth $2.5 million. If Barbara were to die in 2008, the first $2,000,000 of her estate would be exempt from estate taxes. However, the remaining $500,000 would be subject to $225,000 in taxes, leaving $2,225,000 for her beneficiaries. This taxable event would happen because only one unified credit was used for Bob and Barbara’s joint estate.

With a credit shelter trust Bob would stipulate that at his death $2,000,000 would go directly into a credit shelter trust, to help provide lifetime income for Barbara. Because Bob’s assets had been put into the trust, Barbara’s estate would be worth $500,000. If Barbara were to die in 2008, her $500,000 would not be subject to federal estate taxes because it would be below the amount protected below her federal tax credit. Hypothetically, Bob and Barbara could save their beneficiaries $225,000 in federal estate taxes.

If you are married and have a net worth of at least $2,000,000 currently, a credit shelter trust is an excellent idea to help transfer more assets free of estate taxes. Remember that your situation is unique and fees, charges and tax consequences should be evaluated carefully. Speak with your financial advisor today to determine the best way to ensure your beneficiaries receive the greatest percentage of your assets.

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