An AB trust is an estate planning tool that can be used when leaving assets to a spouse. There are benefits to AB trusts, but because of the way the tax law is currently written, they may not be beneficial for many people.
What is an AB trust?
An AB trust is a joint trust set up by a husband and wife that controls how their property is distributed after each of their deaths. The trust allows avoidance of estate tax when the first spouse dies. When the first spouse dies, the trust transforms into two trusts: an irrevocable living trust in the name of the deceased spouse and a revocable living trust in the name of the survivor. Here’s an AB trust example. John and Mary are married and set up an AB living trust. If John dies first, his share of the trust turns into a living irrevocable trust. Mary is allowed to access the income from the trust during her life, but not the principal. After Mary’s death, the assets in John’s trust go to whomever has been named as trust beneficiary for him. During Mary’s lifetime, her portion of the trust can be accessed by her (both the income and principal) and she can make any changes she wants to the beneficiaries of her portion. When she dies, her beneficiaries receive her trust assets as well.
AB trusts and estate tax
AB trusts were originally created as a way to reduce federal estate tax. Because the first spouse’s share passes through an irrevocable trust and is never owned by the survivor, it avoids estate tax. If John and Mary have no trusts and have $2 million in assets ($1 million each), when John dies without a trust, Mary’s estate is then worth the full $2 million. No estate tax is owed on John’s portion when it passed to her because of the marital exemption. When Mary dies, the entire $2 million is in her estate, and estate taxes are applied. If they use a trust, John’s assets are never owned by Mary and so are not taxed as part of her estate at her death. Mary’s estate is only worth $1 million (her share of the trust) and if estate tax applied, that is the only portion that could be taxed. John’s portion passes tax-free.
How tax law has changed
While AB trusts were a great way to reduce estate taxes when they were created, today they are less useful. Each person now has a combined lifetime federal gift tax and estate tax exemption of $5.43 million. This means there is no tax applied to an estate that is valued at less than $5.43 million. Many states have also phased out their own estate tax provisions as well.
In addition to this, there is also now what is called a portability provision. This means that one spouse’s estate tax exemption can pass to the survivor. If John dies and leaves his entire estate to Mary, no tax is due because of the marital exemption. John does not use his estate tax exemption. When Mary dies, she can use her own estate tax exemption of $5.43 million and she can also use John’s $5.43 million exemption, allowing her up to $10.86 million in property that can pass tax-free.
AB trusts today
Given these changes, is an AB living trust relevant and useful at all? They are in some situations. If you want to be sure that certain people inherit from you, an AB trust allows you to ensure that they will receive your portion of the estate, since your spouse cannot alter your beneficiaries. If your state has an estate tax without portability for exemptions, an AB trust could save money by avoiding the state estate tax. If you want to preserve your portion of the estate because you fear your spouse could spend it or use it unwisely, an AB trust will allow you to do that.
Drawbacks of an AB trust
Although it might seem like an AB couldn’t hurt, it can in fact have some negative impacts. Because the portion that belongs to the first spouse to pass away become an irrevocable trust, this can limit the options and financial resources available to the survivor. If he or she needs that money, it is not available. There are ongoing legal costs involved with an AB trust because it must be split at the first spouse’s death. There are also recordkeeping requirements as well as tax filing requirements for the irrevocable trust.
Changing an AB trust
If you and your spouse are both still alive you can make any changes you would like to your AB trust, including revoking it. You’ll need to transfer any property in the trust back into your own names. Sign a document stating that you revoke the trust. As an alternative to your AB trust you might wish to create a simple revocable living trust, using living trust forms. This allows you to avoid probate but avoids some of the complications of an AB trust.
When deciding if you need an AB trust, weigh all of the options carefully. Your decision will have a long-term impact on many members of your family.
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