Mike and Betty came to the office to discuss their estate planning. They have been happily married for over thirty years, and have both contributed significantly to their retirement plans. Their house, like seemingly every house in and around Mt. Airy, has appreciated significantly. Mike and Betty have a total estate of just about $2 million.

Mike reports that he and Betty were not initially concerned with taxes. "We heard that the amount we can pass estate-tax-free has gone up to $1.5 million, and will increase to $2 million next year. But when we read this column last month, we realized that we would pay Maryland estate tax when Betty dies. It sounded like a lot of money."

"That’s right," their attorney replied, "when the second of you dies, the tax will be nearly one hundred thousand dollars."

Mike pondered, "While that’s ‘only’ five percent of our estate, we don’t want to pay a hundred grand to the government. That’s not ‘chump change’!" Betty nodded concurrence.

Their attorney agreed. "Let’s look at how to make that tax go away. The problem comes when you give the survivor everything. Because each of you can pass $1 million free of both federal and Maryland estate tax, you only pay taxes if the last one to die has more than that. If the survivor could have access to the million-dollar exemption of the first spouse to die, and use it for her needs, but didn’t actually own it, she would be provided for, but there would be no tax."

Mike and Betty looked interested. The attorney quickly sketched two boxes on the whiteboard, labeled one "MT" – "Mike’s Trust" – and one "BT" – "Betty’s Trust." He wrote "$1M" in each box, to represent putting that sum in each trust.

"What if we put half of your assets in Mike’s Trust, and half in Betty’s Trust. When Mike dies – assuming he died first – then there would be $1 million in his trust. It wouldn’t generate either federal or Maryland estate tax liability. Betty could use the money in the trust until she dies – but she wouldn’t actually own it, just control it.

"When she died, Mike’s trust wouldn’t require payment of tax, because his trust had already passed over the tax threshold. Betty’s trust also would pass to the kids tax-free, because it wasn’t over the threshold, either."

"What happens if our estate grows," Mike asked. "Is the state exemption increasing like the federal one?"

Their attorney shook his head. "The state legislature has already decided not to do that. It’s not likely that the Maryland exemption will grow in the future.

"Let’s say your estate grows to $3 million. It would still be exempt from federal estate tax if we used the trusts. If we didn’t, though, the federal estate tax this year would be just over $700,000. The Maryland estate tax without the trusts would be over $180,000. So the total tax burden would be almost $900,000."

He changed the sum in the boxes to "$1.5M." "To avoid this, you would again put half in each trust. When Mike dies first, there would be no federal estate tax, because his trust is under the $1.5 million federal estate tax threshold. But because his trust has more than the $1.0 million state threshold, you would have to choose whether to pay about $65,000 in Maryland estate tax when he died, or defer that tax until Betty died by transferring the $500,000 excess to her upon Mike’s death.

"If you did that, there would be no Maryland estate tax on Mike’s death, but on Betty’s death there would be a Maryland estate tax of $100,000, and a federal estate tax of $225,000, if she died in 2005 – but if she lived into 2006 or later, there would be no federal estate tax at all until the federal exemption goes back to $1.0 million in 2011. The estate planning community doesn’t believe that the exemption will ever be reduced to that number, but it could happen.

"Interestingly, the Maryland estate tax at Betty’s death with the $500,000 added to her trust is less than what it would be if each of you had $1.5 million in your trusts – $100,000 vs. $130,000. So it makes financial sense to leave the $500,000 in Mike’s trust when he dies, rather than giving it to Betty, as long as she can stomach paying taxes then. Some folks think ‘the best tax is a tax paid later,’ and would rather wait to make the payment."

Mike considers this information. "I think we want to do the tax planning. But about half our estate is in our IRAs and retirement plans from work, and three-quarters of a million is in our house. Can we put our IRAs in our trusts?"