How does a trust reduce estate taxes?

Trusts can generally reduce estate taxes in two ways:

1: USE SPLIT TRUSTS TO DOUBLE YOUR EXEMPTION

The first way is what I call split trusts - meaning you split up your assets equally (or at least enough to get the full tax benefit) between you and your spouse in two separate trusts. If structured properly, the surviving spouse (last to die) can still benefit from the assets held in the predeceased spouse’s trust without such assets being considered part of the surviving spouse’s estate for estate tax purposes.

So let’s take the example of a married couple in Massachusetts. Not to get too into the weeds on state specific tax law, but in Massachusetts there is a $2 million estate tax exemption for each spouse. If you are above that threshold then you would generally be taxed somewhere between 8% to 16% on those incremental assets (the value above the $2 million). However, if you set up trusts with your spouse prior to one of you dying, then you effectively each can create separate $2 million buckets of assets so now your children pay no estate taxes on those assets unless the value exceeds $4 million (because 2 + 2 = 4).

But what about federal estate taxes?

In practice, very few clients have been concerned about federal estate taxes since 2017 because that is when the exemption was drastically increased (once again for federal estate tax purposes, not for state specific purposes). However, in 2026 we are expecting the federal estate tax law to revert to what it was, which means the federal exemption will be cut in half to around $7 million.

The number of clients who are concerned about federal estate taxes is still relatively low compared to the average household, but when you add up home equity (especially if you own multiple properties that you bought decades ago) and then add in retirement accounts and potentially life insurance proceeds, then I think you’d be surprised at how many married couples are quickly approaching that threshold. And, unlike the Massachusetts estate tax, which has a lower progressive tax rate structure, with the federal estate tax, once you go over that limit you could be paying about 40% in estate taxes, which tends to get the attention of virtually all my clients.

So what do you do?

Same idea as with the Massachusetts example - just make sure you have split or separate trusts set up with your spouse to ensure you fully capture your exemption amount and to make sure it’s not part of the surviving spouse’s estate upon his/her death. Once again, you’ve now effectively doubled your exemption from around $7 million to $14 million based on the expected estate tax laws (although it wouldn’t surprise anyone if they actually decrease the federal estate tax exemption further over time to make up from the extreme budget deficit our country is currently dealing with - in other words, the more pressure there is to get tax dollars, the more likely we will see increase in estate taxes by lowering the exemption amount and thereby making more households subject to estate taxes).

One important thing to note - some clients may ask about something called federal estate tax portability and using that instead of doing split trusts (it’s a way to add the first spouse’s exemption to the surviving spouse), but in practice I’ve found that it doesn’t work very well when the surviving spouse fails (or even remembers) to file the correct paperwork to capture that portability option, plus you don’t get the benefit of freezing your assets (to be discussed below) and you may be losing out on creating fully exempt trusts for generation skipping transfer tax purposes (that’s right, there is actually another tax applied if your grandkids inherit the property in the wrong way) - so while I like the concept of portability, I would look at it as a fall back option only if your parents never got around to doing the right thing and setting up separate trusts from the beginning.

2: REMOVE ASSETS FROM YOUR ESTATE USING IRREVOCABLE TRUSTS

Irrevocable trusts cause a lot of confusion, so I’ll try to keep this brief and straightforward (your attorney will walk you through the more complex details that are relevant to your specific situation) - the basic idea is that if done properly you can transfer your assets to a trust in a way where those assets (and the future appreciation on those assets) is not considered part of your estate for estate tax purposes.

Understanding this, I have some clients who consider taking advantage of the historically high federal estate tax exemption (about 13.6 million at the time of this writing) by transferring that value of those assets to an irrevocable trust (usually a spousal lifetime access trust, also known as a SLAT) before 2026.

Put differently, if you want to lock in the higher exemption amount now before the law changes, then you can do that - but it requires you to give up direct control of those assets for the rest of your lifetime - that’s the risk in doing this type of planning. Some savvy estate planner will tell you about “escape hatches” or ways to retain certain powers that would reduce the risk of something going wrong, but it’s still an area to tread lightly in.

The good news is that there are trusts, particularly ILITs (which stands for irrevocable life insurance trusts) that have become relatively common for clients with high net worths or those who need additional liquidity in their estate (for example, business owners). The idea is simple, if you have an insurance policy in your name individually then those insurance proceeds would be part of your estate for estate tax purposes and therefore be taxed accordingly. However, if you transfer that policy to an irrevocable trusts that is set up properly, then after three years (or immediately if that policy is purchased in trust) the life insurance policies would not be part of your estate. 

To be fair, these trusts do require having a good trustee (not you) to make sure the trust is funded properly, that withdrawal notices are sent to beneficiaries each year, and the premiums are paid in a timely manner, but if you have that trusted friend, family member, or advisor who can serve as a trustee, then these trusts are great at removing an asset from your estate under current tax law.

The third type of trust you may hear about when talking about irrevocable trusts and freezing assets is the grantor retained annuity trust (GRAT) - the basic idea is that you put an investment or business into the trust that you expect to grow at a fairly high rate. The IRS publishes something called the AFR (applicable federal rate) and whatever appreciation occurs above that rate is removed from your estate after the term of the GRAT. There have been talks about whether this is a trust that will continue to be allowed, but the only risk for clients when using this trust is paying the fees to set it up (either you exceed the hurdle rate or you don’t). Whatever doesn’t exceed the hurdle rate passes back to the owner and they can just rinse and repeat this process (which is why you sometimes hear the term rolling GRATs used for clients who pursue this strategy over a long period of time).

Questions or concerns? Would you like me to review your current trust or create a new one for you? Click then link below to schedule a call with me today.

I’m always happy to help!