A trust is a fiduciary legal agreement that allows a third party, or trustee, to hold assets on behalf of a beneficiary or beneficiaries. Trusts can be arranged in many ways and specify exactly how and when the assets pass to the beneficiaries.
Property of any sort may be held in a trust. Trusts are usually created by a will, an insurance policy, a retirement plan, or an annuity through drafting a trust instrument or another contract.
Trusts are often favored in estate planning because they do not go through the probate system. That system can take a year or more to complete, and all that time, the beneficiaries are waiting for the will to be approved and finalized and are governed by the terms under which the trust was created. Avoiding probate is often one of a trustor’s goals in setting up the trust.
Further, trusts are also favored because they provide tax benefits and help protect assets.
What is a QTIP Trust?
A Qualified Terminable Interest Property Trust (“QTIP Trust”) is a popular trust used to avoid various estate taxes. A QTIP trust is irrevocable – it cannot be altered once made. A QTIP trust allows an individual, called the trustor, to leave assets for a surviving spouse and determine how the trust’s assets will be split up after the surviving spouse dies.
A QTIP trust provides income for a surviving spouse for the rest of their life. Upon the spouse’s death, the assets go to additional beneficiaries named by the deceased. In other words, the trustor’s spouse will have the income from the trust assets during their lifetime, but then all of the assets are passed along to someone else, often the trustor’s children from a previous marriage.
QTIP trusts are often used in second marriage situations and to maximize estate and generation-skipping tax or estate tax planning flexibility. A QTIP trust will preserve the surviving spouse’s marital deduction while avoiding costly estate taxes.
A QTIP trust has two important benefits:
- The QTIP trust allows you to attach conditions on your property rather than simply leaving it to your spouse outright. This is especially useful if you’re on your second marriage and want to provide for both your current spouse and also your children from a previous marriage after you pass away and
- When one spouse dies, it lets the surviving spouse decide how much of the deceased spouse’s property should be held in trust to maximize estate tax savings. This helps combat the ever-changing field of estate taxes.
Benefits of a QTIP
While QTIPs are similar to another trust called a “marital trust,” QTIP trusts provide benefits in certain situations.
- You control where the assets end up: You control who your assets pass to after you and your spouse die. This means that no matter what your spouse does after you pass on, any assets left in the trust are passed on to the secondary beneficiaries of your choice. These could be your children, grandchildren, or children from a previous marriage. If you have no relatives to whom you would like to leave the trust assets, you can pick a friend or even a charity.
- QTIPs protect all assets and income: As your spouse ages, they may become unable to make sound financial decisions. Your orders concerning how income or principal is distributed and used protect the assets for all beneficiaries you name. Scammers or thieves cannot access your assets, nor can they be accidentally signed away or used in ways you didn’t intend for them to be used.
What Are the Benefits of Putting My IRA in a Trust?
Without the QTIP trust, a deceased spouse’s Individual Retirement Account (IRA) funds would become immediately available to the surviving spouse. Some people do not want their spouse to control the IRA completely. They may believe that their spouse is not financially sophisticated enough to manage the IRA directly, or they may wish that the funds be available to their children after the surviving spouse has died.
How Can I Avoid Estate Taxes for My IRA Through QTIP Trusts?
Using a QTIP trust, your IRA does not go directly to your surviving spouse right after your death – instead it goes into the trust. In that way, the IRA and the trust meet the special qualifications of the Tax Code for the estate tax marital deduction. When those requirements are unmet, the IRA will become a taxable asset for estate tax purposes.
The easiest way to avoid the estate tax and to qualify for the estate tax marital deductions is by creating a Qualified Terminable Interest Property trust. Some basic requirements must be met to form a QTIP trust. If these conditions are satisfied, the estate of the first spouse to die can claim a marital deduction for the value of the property in the QTIP trust. They are:
- The property of the trust must pass to the surviving spouse from the deceased spouse.
- The surviving spouse must be entitled to all of the income from the property for the rest of their life, and the income must be distributed at least once a year.
- No one, including the spouse, may have the power to appoint any part of the principal to anyone other than the spouse during the spouse’s life.
The third requirement is the most beneficial because it means that for federal tax purposes, the property of the trust is considered part of the surviving spouse’s estate and, thus, is not subject to the estate tax on the decedent spouse’s estate. This means the trust property assets will be protected from the federal gift and estate tax.
What is Considered Income for QTIP Distribution?
In general, income is more than it seems in the context of trusts. For calculating how much money a surviving spouse is entitled to, trust “income” means any income produced by investments combined with a fixed percentage of the annual value of the principal assets.
However, in 1997, Congress passed the Revised Uniform Principal and Income Act (UPIA) and the Prudent Investor Act, which many states have since adopted. The Acts include the power to adjust receipts between the income and the principal. In turn, the IRS has modified its consideration of “income” to the benefit of the beneficiary when it comes to tax season.
However, not all states have adopted the Acts, and despite the IRS’s so far unsuccessful attempts to clarify the rules, it is important to learn your local state’s rules.
Should I Hire an Attorney If I Want to Create a QTIP Trust?
As can be seen, forming a trust as a QTIP trust is an excellent way to avoid costly estate and federal gift taxes and to allow you to control who gets the property after your death and even after your spouse’s death.
The laws surrounding any tax-related issue are ever-changing, vary by state, and can be extremely confusing. Thus, it may be best to consult and hire a qualified and experienced trust attorney near you to ensure your QTIP trust is formed properly. Missed deadlines or improper formation of a QTIP trust can cost the trust thousands of dollars or lose the marital deduction for your estate.