In this blog we will discuss…
Irrevocable grantor trusts
Spousal lifetime access trusts (SLATs)
Potential benefits of using a SLAT
How an annuity could fit
Did you know that married couples can utilize spousal lifetime access trusts (SLATs) to effectively leverage the current generous lifetime gift and estate tax exclusions, which are set to expire in 2025?
Prior to the implementation of the Tax Cuts and Jobs Act of 2017 (TCJA), the federal gift and estate tax exclusion, also known as the “unified credit,” was established at $5.49 million per individual. However, as of 2023, this exclusion has increased substantially to $12.92 million per individual. It’s important to note that this historically high lifetime gift and estate tax exemption is expected to decline significantly to approximately $5.6 million (adjusted for inflation) starting in 2026 when the TCJA provisions expire.
To make the most of these temporary higher exemptions, married couples can consider utilizing a spousal lifetime access trust (SLAT), which is a specially designed irrevocable trust. By employing a SLAT, couples can maximize the benefits offered by the current exclusions before they diminish in the near future.
Irrevocable Grantor Trusts
Irrevocable grantor trusts, often recognized as a highly advantageous tool within the realm of wealth transfer, provide extensive planning possibilities. Such trusts ensure that the assets transferred by the grantor, including any future appreciation, are not considered part of the grantor’s estate for U.S. estate tax purposes. While the grantor still bears the responsibility of paying income tax liabilities, we will explore how the utilization of a tax-deferred* annuity within an irrevocable trust can help alleviate or mitigate this particular concern.
Spousal lifetime access trusts
Spousal lifetime access trusts (SLATs) provide a solution to the challenge of transferring wealth between spouses while minimizing tax implications. When assets are transferred between spouses during their lifetime or at death, they fall under the marital deduction, which means they do not trigger a taxable event according to the IRS. However, when the surviving spouse passes away, any wealth transferred to non-spouse beneficiaries beyond the applicable unified credit (currently exceeding $12.9 million in 2023) becomes subject to tax liabilities.
SLATs offer a way to extend the benefits of tax-free transfers beyond the marital relationship. These irrevocable trusts, often structured as grantor trusts, allow married individuals to utilize their lifetime gift and estate tax exemption not only for the benefit of their spouse but also for future generations. By transferring assets to a SLAT, the grantor makes a taxable gift but can apply all or a portion of the gift to the lifetime gift and estate tax exemption, effectively eliminating the tax liability. Each spouse can establish a SLAT for the other spouse’s benefit, enabling the utilization of up to $12.9 million of individual lifetime gift and estate tax exemptions (up to $25.8 million when considering both SLATs), while avoiding taxes on the transfer.
Once the transfer to a properly structured SLAT is complete, the assets are removed from the grantor’s estate for estate tax purposes, and they are also excluded from the beneficiary spouse’s estate. In addition to these estate tax advantages, a SLAT may offer the beneficiary spouse limited access to the trust assets if needed. Although the grantor loses control over the assets upon transferring them to the SLAT, this loss of control is a prerequisite for utilizing the lifetime and estate tax exemption to fund the trust.
The flexibility of a SLAT becomes apparent when the grantor spouse can request the beneficiary spouse to contact the SLAT trustee and seek a distribution. If the trustee makes a distribution to the beneficiary spouse, it can then be given to the grantor spouse, free from gift tax, as spouses can still benefit from the marital gift tax deduction. However, it’s important to note that the grantor spouse’s access to the SLAT assets relies on the willingness of the beneficiary spouse to provide such access, determining whether the grantor will realize any value from those assets.
Overall, SLATs offer an effective strategy for married couples to maximize their lifetime gift and estate tax exemptions, extend the tax benefits beyond the marital relationship, and potentially provide some indirect access to the trust assets while managing tax implications and planning for future generations.
When considering the use of a spousal lifetime access trust (SLAT), it is important to take into account various factors that can significantly impact its effectiveness. While SLATs offer numerous benefits, there are several key considerations to keep in mind:
- Divorce or death: In the event of a divorce or the beneficiary spouse’s death, the grantor spouse loses indirect access to the trust’s assets. If a divorce occurs, the beneficiary spouse will still be considered the beneficiary and continue to receive benefits from the trust. In the case of the beneficiary spouse’s death, the trust assets would be passed on to the beneficiaries named in the trust.
- Reciprocal trust doctrine: If both spouses create SLATs for the benefit of each other, it is crucial to ensure that the trusts are not too similar. The IRS may “uncross” the trusts, treating each spouse as if they created a trust for their own benefit. This would result in the inclusion of the respective trust assets in each spouse’s taxable estate at their fair market value on the date of death, including any appreciation since the assets were transferred to the SLATs.
- Grantor trusts: It is common for SLATs to be structured as grantor trusts to avoid unfavorable tax consequences. If a SLAT is structured as a nongrantor trust, the growth within the trust can be subject to high trust tax rates, reaching up to 37% once retained earnings exceed a relatively low threshold in a given tax year. To mitigate this tax burden, attorneys often recommend drafting SLATs as grantor trusts. In a grantor SLAT, the taxation responsibility falls back on the grantor, who pays taxes on the growth of the trust assets. While this arrangement may work well for some grantors, others may be concerned about the potential increase in their overall tax obligations.
However, it is worth noting that placing an annuity within a properly structured SLAT can help alleviate the tax concerns of the grantor spouse, providing a potential solution to address their specific tax situation.
How an annuity could fit
Utilizing a tax-deferred annuity within a spousal lifetime access trust (SLAT) can be a valuable strategy to minimize the overall tax impact on trust assets. This approach is applicable to both grantor and nongrantor SLATs, offering distinct benefits in each case.
For grantor SLATs, allocating a portion of the trust assets to a tax-deferred annuity can help reduce the tax liability incurred by the grantor due to the growth of the trust assets over time. By leveraging the annuity’s tax-deferred growth, the grantor can avoid immediate income tax on the investment’s appreciation.
In the case of nongrantor SLATs, allocating a portion of the trust assets to an annuity serves to shield investment growth from high trust tax rates, which can be quite burdensome. By utilizing the annuity’s tax-deferred status, the trust can potentially achieve more favorable growth without being subjected to unfavorable tax consequences.
To illustrate this concept, let’s consider the scenario of Jack and Diane, a couple with significant wealth and assets. Jack, a retired football star, intends to provide support to Diane and eventually leave an inheritance for their son, Johnny. To accomplish this, Jack decides to fund a SLAT for Diane’s benefit. Their financial professional suggests the use of a nonqualified annuity with an add-on return-of-premium death benefit that does not reduce for allowable withdrawals (usually available for an additional charge). Diane is listed as the annuitant to determine the annuity’s income and death benefit based on her life.
The tax-deferred nature of the annuity allows Jack to avoid paying income tax on the investment’s growth, unlike other taxable investments. Consequently, the annuity can experience growth without being burdened by the effects of taxation. Furthermore, in the event that Diane needs to make withdrawals after Jack’s passing, those withdrawals may be taxable to Diane at her ordinary income rate. Over a 30-year period, Diane could receive an income equivalent to 5% of the initial premium. Assuming Diane’s withdrawals do not deplete the annuity’s cash value entirely, the annuity could ultimately pay the entire initial premium to the designated beneficiary upon Diane’s passing.
By strategically incorporating a tax-deferred annuity into a properly structured SLAT, individuals like Jack and Diane can benefit from the annuity’s ability to grow without the drag of immediate taxation, providing them with potential tax advantages and enhanced financial planning opportunities.
In conclusion, utilizing spousal lifetime access trusts (SLATs) presents a valuable opportunity for married couples to optimize their use of the current generous gift and estate tax exemptions, which are set to expire by December 31, 2025. By implementing a well-structured SLAT, couples can maximize the benefits provided by the historically high exemptions available at present. Furthermore, incorporating a properly titled annuity within a SLAT can potentially offer additional advantages to enhance overall wealth management and tax planning strategies.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.
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