Should an AB Trust Be Part of Your Estate Plan?

AB trusts are an increasingly uncommon albeit valuable type of living trust, specialized for wealth preservation, tax avoidance, and long-term financial planning. At its core, an AB trust requires a married couple to file a two-part trust scheme that utilizes the individual tax exemption limits to create a tax-free inheritance for their ultimate beneficiaries. AB trusts are not always helpful, nor are they always worth making. But when they do come into use, they can mean the difference between leaving behind a fortune and leaving behind a mess.

Double Taxation of a Married Couple

An AB trust is a living trust built to avoid double taxation upon death in married couples. Let's presume a married couple with substantial wealth goes about their lives without an estate plan. When the first spouse dies, a considerable amount of their wealth passes onto the surviving spouse.

This includes community property and the third or half of a decedent spouse's individual property that usually passes to a surviving spouse in intestacy. Depending on state and federal tax laws at the time and the total size of the estate, the wealth passing onto the surviving spouse may be subject to estate taxes. The tax rate for both federal and state estate taxes is considerable, meaning the inheritance may be subject to a significant financial blow.

Fast forward. At this point, the surviving spouse is on their deathbed. Whether they remarried or did not is irrelevant – one way or the other, the wealth they have accumulated through their lifetime – including their former spouse's assets – will be subject to another round of estate taxes, even though the principal inheritance was already taxed with estate taxes years prior.

How an AB Trust Works

An AB trust bypasses the double taxation of inheritance passed between spouses by segmenting the estate, limiting the estate's value, and cleverly utilizing existing tax law benefits to minimize the tax impact of passing away. It works a little bit something like this.

Let's take our earlier example of a married couple. This time, they set up an AB trust. This is a joint trust, meaning no matter who dies first, their portion of the scheme will be transformed into trust A. The process of setting up an AB trust begins with the equal distribution of wealth between both spouses.

The spouses share their wealth and split it up, so each of them funds an equal amount of assets into their respective halves of the joint trust, later becoming trusts A and B, respectively. Trust A is an irrevocable living trust. This means it cannot be amended, and anything funded into it remains with the trust until the trust is adequately resolved and distributed among its beneficiaries.

As an irrevocable trust, anything funded into trust A is untouchable by estate taxes. The first spouse's entire remaining estate tax exemption can be transferred to the surviving spouse. Trust A is created upon the first spouse's death and funded with whatever they contributed to the joint trust.

The beneficiaries of trust A are the pair's children and grandchildren. The surviving spouse cannot touch the contents of trust A, but the trust pays out a regular income based on the increased valuation of assets within the trust or passive income earned by the assets within the trust, such as rental properties.

Meanwhile, the surviving spouse carries on with their life, continuing to amend and fund their portion of the trust, now trust B. This is a revocable living trust. However, because the surviving spouse received their spouse's tax exemption in addition to their own, they are unlikely to owe any estate taxes on the contents of trust B.

When they die, trust B and trust A are dissolved by their respective trustees and distributed among the original beneficiaries of the joint trust. Because the first half of the plan avoided estate taxes entirely, and the second half benefited from the estate tax exemption limit of two individuals, the process allows a sizeable inheritance to avoid federal estate taxes entirely.

Who Needs an AB Trust?

Currently, very few people need an AB trust. This is mainly because the 2017 Tax Cuts and Jobs Act heavily increased the lifetime exemption for estate taxes to a whopping $12.06 million per taxpayer as of 2022. Unless the total value of your combined estate approaches that number, an AB trust may be excessive.

However, estate tax exemptions can be changed. The alterations made to the estate tax exemption are temporary and, unless written into law before 2026, may revert to pre-2017 levels. If you expect to live past 2026, you will want to prepare for the worst.

Consider discussing your estate planning options with a professional tax attorney and consider how you might want to alter or adjust your plan for a lower individual estate tax exemption. Tax law as a whole is complex and ever-changing. That is why it is essential to keep an eye on significant changes and consider how they might affect your estate planning strategy.

Do not neglect to update your estate plan from time to time. Most estate planning professionals recommend their clients review and revise their plan every few years or immediately after a significant, life-changing event, including (but not limited to):

• Large inheritances
• Death in the family
• Birth
• Marriage
• Divorce

Incorporating an AB Trust Into Your Estate Plan

Ideally, an AB trust will comprise one small part of a larger estate plan. For example, while your AB trust helps you and your spouse avoid the impact of a devastating estate tax, especially after years of eating into your estate tax exemption limit, the trust may not address the rest of your estate – such as who gets the house after you both pass, who manages the business, and to whom will you bequeath any investment properties or assets.

Trusts also cannot name guardians for any minor children or dependents. While they can be helpful both in life and death, trusts won't help answer any healthcare or financial questions your loved ones might have if you are incapacitated, physically or mentally. An estate plan should be coherent from top-to-bottom, and any revision to the plan must be made holistically. Ask your tax advisor and estate planning professional if you have any questions.