Preserve assets for heirs after second marriage

What is the best way to ensure that an estate passes to the heirs in the event of a second marriage?

Even with the many favorable changes under the American Taxpayer Relief Act of 2012 (ATRA), comprehensive estate planning still remains a challenge. Fortunately, a relatively simple technique called the spousal lifetime access trust (SLAT) has proven especially advantageous and popular among those who have remarried and want to provide for children from a prior marriage.

The concept of the trust is very straightforward. The SLAT is an irrevocable trust established for the benefit of a living spouse, with the remainder going to heirs, such as your children and grandchildren, at the time of the spouse’s death. Although the transfer of assets used to fund the trust is treated as a taxable gift, any gift-tax liability may be avoided or reduced with proper planning. In doing so, those assets will be removed from your taxable estate. In addition, a SLAT offers protection from creditors or an ex-spouse who is trying to reach your assets.

Generally, distributions are made to your spouse during his or her lifetime as needed. To preserve a larger nest egg for your heirs, you may also choose to use funds outside the trust first for this purpose.

What are the main tax consequences of this arrangement? The transfer of assets can be sheltered from gift tax by the lifetime gift-tax exemption. Under ATRA, the exemption is now up to $5.25 million in 2013. Thus, the assets included in the SLAT are not subject to federal estate tax. In addition, the SLAT is considered to be a “grantor trust” for income tax purposes. That means a couple must pay tax on the earnings on their personal tax return, but the assets can continue to grow inside the trust without any tax reduction. Be aware that the grantor will be required to file a gift-tax return with the IRS. But with the proper professional assistance, you can structure the trust to take full advantage of the $5.25 million lifetime exemption.

There is, however, a potential estate-tax complication to consider. Frequently, a couple will establish a SLAT to benefit one another, even if one spouse is significantly younger than the other. In that way, protection is ensured should the younger spouse predecease the older spouse. Under special tax rules, so-called “reciprocal trusts” must be different in a meaningful way. If they are identical, the assets will be included in the taxable estate of the grantor. This can be avoided by setting up SLATs at varying times, employing different terms, and funding the trusts separately.

Other planning aspects may also come into play. For example, if you set up a SLAT and then get divorced, you will lose access to the assets you have transferred to the trust. Remember that the trust is irrevocable, so you cannot take back the assets for any reason whatsoever.

In order to prevent the IRS from questioning the gift that funds the trust, the SLAT needs to be carefully drafted to prevent those gifted assets from being brought back into your taxable estate after your death. It must be very clear to all parties that you no longer have any control over the trust assets and that you receive no direct benefit from the trust. It is also important to look at how your SLAT is funded. The assets put into trust should belong to you alone, and they should not be owned jointly with your spouse. In this manner, you are gifting property to your spouse; your spouse will have no retained right in the property; and you may avoid an IRS challenge to bring the trust’s assets back into your estate after you die.

If this arrangement seems appealing to you, please be sure to consult with your estate tax planning advisers to determine whether you are an appropriate candidate for the SLAT strategy.

If interest rates increase, is it better to own an individual bond or a fund?

Some investors prefer individual bonds to mutual funds since they believe that individual bonds protect them from rising interest rates. If rates rise, then the price of the bond falls, but the investor can hold the bond until maturity and receive his expected income and principal. A traditional bond fund or exchange-traded fund (ETF) doesn’t have predefined income or principal payments. But the income coming from a bond fund or ETF in a rising interest rate environment generally increases, while an individual bond’s income is fixed. Over time, the higher income paid out by the fund or ETF can compensate an investor for the initial price decline they realized when rates initially rose.UT

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