AB trusts were originally created with the main purpose of helping to reduce estate taxes. In this article, we will go over how AB trusts work, additional benefits they offer, as well as drawbacks you should be aware of.
Original Purpose
AB trusts got their start under old estate tax laws. In the past, each spouse had their own estate tax exemption. Typically, the first spouse to pass would not use their exemption. The money could pass to the surviving spouse estate tax-free. The issue arises when the surviving spouse passes. Often the extra value from the first spouse’s estate would push the value of the surviving spouse’s estate over the estate tax exemption. This would cause taxation upon the death of the surviving spouse.
AB trusts sought to solve this issue. How did they work? At the death of the first spouse, the joint trust breaks into two separate trusts, an A and a B trust. The A portion, the deceased spouse’s portion, is an irrevocable trust. The surviving spouse can access income from the A trust, but usually, they cannot access any principal. However, what is in the B trust they can access completely. Since the surviving spouse never owned the property in the A trust, it will not be included in their estate.
Effect of New Tax Laws
New tax laws have greatly affected how AB trusts can be utilized. The first law change came about in 2011. A portability provision was created. This allows a deceased spouse’s estate tax exemption to pass to the surviving spouse, which doubles the exemption amount for the survivor. The second change happened in 2018 when the estate tax exemption was raised. It is now at $11.2 million for an individual. This means a surviving spouse could have up to a $22.4 million exemption. Most individuals’ estates do not come anywhere near that amount. AB trusts were more useful in the past when exemptions were much lower.
Other Uses for AB Trusts
Even though AB trusts are no longer effective estate tax planning tools, they can help with other estate planning issues.
- Unmarried Couples: The estate tax portability provision is only available to legally married couples. So if you just have a partner, you may still find an AB trust to be advantageous.
- Second Marriage: Often, people with second marriages want to make sure their funds go to their children and not their spouse’s children. An AB trust can help accomplish this. They can allow your spouse to benefit from the income of your trust after your death but ensures that they cannot make changes to your trust so that your funds will ultimately go to your beneficiaries.
- State Estate Tax: If your state imposes an estate tax, you may still need to utilize an AB trust to avoid it. State tax exemption amounts are usually lower than the federal amount and often do not offer the portability provision, this makes planning necessary. Currently, the State of Arizona does not impose an estate tax.
Cons of AB Trusts
As with all decisions, there are some potential cons to creating an AB trust.
- Limited Access: One of the main issues to arise is that the surviving spouse has limited access to the funds in the A trust. Sometimes this can cause financial hardship for the surviving spouse.
- Tax Returns: The surviving spouse will need to obtain a Trust Identification Number for the A trust and file an annual tax return for it.
- Record Keeping: The surviving spouse will need to keep two sets of records, one for each trust.
Creating an AB Trust
If you think that an AB Trust is right for your situation, the next step is to meet with a qualified estate planner and start the process.
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