What Is the Marital Deduction?
Marital Deduction Definition
A marital deduction is a deduction reducing the value of what is taxable for gift and estate tax purposes. It allows an individual to transfer some assets to his or her spouse estate and gift tax free. The IRS allows an individual to leave any amount of assets to his or her U.S. citizen spouse without taxation.
Property that passes to the surviving spouse under the marital deduction escapes taxation on the death of the first spouse, but that property then becomes part of the surviving spouse’s estate for estate tax purposes. All assets in the survivor’s estate over $5.49 million (in 2017) will be taxed. Estates above $5.49 million are taxed at 40 percent in 2017.
The marital deduction applies to property that is left outright to a spouse, in a Trust in which the spouse has the right to withdraw any or all of the property during his or her lifetime, or in a Trust for the spouse’s life under a QTIP (“Qualified Terminable Interest Property”) Trust.
Transfers That Do Not Qualify for Marital Deduction
Most gifts or transfers to a spouse, regardless of the amount, qualify for the marital deduction and pass to the spouse gift and estate tax free. Gifts that fully qualify for the marital deduction do not need to be reported on a gift tax return. Transfers to a surviving spouse at death must be reported, but are generally fully deductible on the estate tax return if an estate tax return is otherwise due.
The marital deduction is not a permanent exclusion from gift or estate taxes. Although property passing to a surviving spouse is not taxed at the death of the first spouse, it is included in the taxable estate of the surviving spouse.
Property which will not be included in the gross estate of the surviving spouse does not qualify for the marital deduction. These include the following:
- Gifts to a non-citizen spouse do not qualify for the marital deduction unless made in a special Qualified Domestic Trust (QDOT). However, such gifts qualify for an annual exclusion of $149,000 if the gifts over $14,000 (in 2017) would qualify for the marital deduction if given to a citizen spouse.
- A terminable interest (one that will end after a period of time or when a contingency occurs or fails to occur) is not deductible if the donor retained an interest or gave another interest in the same property to someone other than the spouse and that person may possess or enjoy the property before the spouse’s interest terminates.
Should You Leave Everything to Your Spouse?
Although you can leave everything you own to your spouse free of estate tax, doing so can actually increase estate tax costs at your spouse’s death. The reason for this is that each person can leave up to $5.49 million of assets to children or other non-spouse beneficiaries without any estate tax liability. By leaving everything to your spouse, you could be wasting other opportunities to utilize the $5.49 million estate tax exclusion.
- A married couple has all their assets as common property;
- The value of that common property is $10.98 million;
- The husband is the first to die and the wife dies in 2017;
- The couple has two children; and
- No gifts were ever made that exceeded the annual gift tax exclusion.
Upon the death of the husband, the husband’s estate (50 percent of the common property) is worth $5.49 million and his wife retains her 50 percent share of the common property ($5.49 million). If planned properly then neither the husband’s estate nor the wife’s estate will incur estate tax since each has an applicable exclusion amount worth $5.49 million:
- Example 1: Tax Paid – If the husband leaves all his property outright to his wife, then his wife will have an estate totaling $10.98 million. Upon her death, she will now have a $10.98 million estate subject to estate tax, but an applicable exclusion amount worth only $5.49 million. This means her estate will be subject to estate tax on the balance of $5.49 million. The tax will be $2.196.
- Example 2: Tax Not Paid – The husband left his property to a “Bypass” or “Family” Trust, which permitted his wife the right to receive all the income from the Trust during her life. Upon her death, the Trust assets are then divided between the couple’s two children and the Trust is not a part of the wife’s estate for estate tax purposes. Upon her death, her estate would be worth $5.49 million and her applicable exclusion worth $5.49 million would eliminate any estate taxes.
Dealing With Creditors and Divorce
Upon your death, you do not want your spouse’s creditors to be able to take your assets. Certainly you planned for your spouse to have these assets rather than having creditors enjoy them!
Additionally, your spouse may remarry after your death. If your spouse then divorces, that future “ex” may have legal rights to part of your estate! No doubt you did not plan on your spouse’s future “ex” getting your estate! Or what if your spouse remarried and then died? Could that new spouse take the estate?
So, what can be done? You can leave your assets to two different Trusts. The amount that you can pass free from estate tax, $5.49 million in 2017, can be put into a Family Trust. The amount over this applicable exclusion can be put in a Marital Trust that pays only income for the surviving spouse during his or her lifetime. The Marital Trust must pay all income to your spouse annually. This is also known as a Qualified Terminable Interest Property (QTIP) Trust. In addition, the QTIP Trust may be drafted to allow distributions for your spouse’s needs.
The advantage of a QTIP Trust is that the desires of the decedent spouse will control the ultimate disposition of the Trust’s assets, and the decedent’s estate retains the benefit of the marital deduction. A QTIP Trust permits the surviving spouse to receive the income during the rest of his or her life, but the principal will be distributed according to the deceased spouse’s wishes. The QTIP Trust would be included and taxed in the estate of the survivor, but this is better than having been taxed at the death of the predeceasing spouse.
As you can see, the marital deduction is a powerful and flexible tool that can yield great benefits when properly coordinated. However, careful planning, including taking into account income tax considerations and practical considerations, is necessary. Talk to a qualified estate planning attorney to determine what is best in your situation.