So, what's a QTIP trust? "QTIP" stands for qualified terminable interest property. Total legal gobbledygook, right? So forget the words. What it means is a trust that you leave for your spouse that gives him the right to all of the income and limits his right to the principal. Those limits can be total, meaning no right to principal, or minor, meaning simply limited by the HEMS standard (for health, education, maintenance and financial security) or fully available but controlled by a trustee other than your spouse.
So, why would you complicate your spouse's life by putting property in trust with some level of limitations rather than giving everything to her outright? Here are seven possible reasons:
- Creditor protection. To the extent your spouse's access to the trust funds is limited, it's protected from her creditors. For complete protection, either your spouse must have no access to principal or the access needs to be controlled by an independent trustee.
- Second spouse or gold-digger protection. If the surviving spouse owns all of your combined property in his name, it will be at risk if he becomes remarried, whether to someone he is with for decades or a late arrival in his declining years. A trust can ensure that at least a portion of your property will pass to your children and grandchildren.
- Second marriage. Or you may be in a second marriage. That's the case with a client I just met with yesterday. He wants his wife to receive all of the income from his estate and access to principal in case of an emergency, but for the remainder to pass to his sons after his wife passes away.
- Estate tax reduction. With portability, only the richest American couples—those with more than $11 million—need to be concerned with the federal estate tax. But if you're one of those, you can shelter even more by using a QTIP trust because the growth of the investments in your trust won't be taxed in your spouse's estate even if the trust and her holdings together add up to more than $11 million. More relevant, however, for Massachusetts residents where the estate tax kicks in at $1 million, you can use a QTIP trust to shelter that much, plus its growth after your death, from taxation upon your spouse's death.
- Capital gains tax reduction. This part is complicated. If you leave everything to your spouse, what you leave her will get a step-up in basis when you die and another when he dies. That's the best result for purposes of capital gains taxes and doesn't require a trust. However, if you leave $1 million in a so-called "credit shelter" trust for purposes of estate tax planning, it will not get a second step-up in basis upon your spouse's death. A QTIP trust allows you to have your cake and eat it too—estate tax protection and a step-up when the second spouse dies. I discuss this more fully in 2 Reasons Surviving Spouses Should File Federal Estate Tax Returns: Portability and Capital Gains.
- Scam protection. Seniors are increasingly becoming the targets of scams, whether being threatened with prosecution if they don't pay taxes they don't owe, importuned to send money to take care of a grandchild stranded or jailed overseas, or needing to send money to collect lottery winnings. If your spouse has limited access to the trust funds when he gets older, those funds will be protected from such scams and if he tries to gain access to them, the co-trustee will become aware of what's going on and act to prevent any additional loss of savings.
- Incapacity planning. This overlaps with scam protection. We all run the risk (or likelihood?) of losing mental acuity when we get older. This makes us targets of financial predators, but less drastically, it may mean that we stop paying bills, pay bills twice or more often, or lose track of our investments. We've often seen clients become confused and overwhelmed by simple bill payment. We've also seen them being resistant to accepting help or any loss of control. While we recommend durable powers of attorney and revocable trusts to all of our clients, leaving your assets in trust for your spouse can ensure that a co-trustee is available when needed no matter how resistant he may be to accepting help when needed.
Not all of these potential benefits of QTIP trusts will apply in every situation, but enough may be relevant to you and your spouse to take advantage of this estate planning tool.