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  • A revocable living trust holds property and other assets that you transfer to it and can be changed or rescinded during your lifetime, whereas the terms and conditions of an irrevocable trust generally cannot be altered once you create the trust. While assets in a revocable living trust avoid probate, the assets are considered part of your taxable estate.
    Also known as the "estate tax exemption equivalent amount", this is the total amount per deceased person that can be transferred to individuals free of any estate tax (there is no limit on what can be left to a spouse who is a U.S. citizen). The exemption for 2011 and 2012 is $5 million and is scheduled to change in 2013 to $1 million, unless Congress intervenes. Also, the federal estate tax exemption amount is reduced by the total of any taxable gifts made during the deceased's lifetime. In calculating the size of the deceased's taxable estate, several deductions are available that may reduce the amount of the estate subject to federal estate taxes, such as the unlimited marital and unlimited charitable estate tax deductions.
    This trust is usually funded with any amount in excess of a person's available federal estate tax exemption amount. Usually the money is left in the trust for the spouse for investment and financial management purposes, and the spouse must have the right to receive income from the trust during his or her lifetime. The surviving spouse is also granted a general power of appointment to provide him or her with the flexibility to modify the way assets will be distributed at his or her death, including naming new beneficiaries. Unlike assets in a bypass trust, the assets in a marital trust are included in the surviving spouse's taxable estate.
    A QTIP trust is a variation of the marital trust. The surviving spouse has the right to receive income from the trust while he or she is alive, then, at the spouse's death, leaves any remaining trust assets, after payment of estate taxes, to the beneficiaries the spouse designated in the trust. A QTIP trust may be especially effective when you have remarried and the intended beneficiaries after the death of your spouse's death are your children from the prior marriage.

    It is highly likely that if you are married* and have had a will prepared for you in the past by an estate planning attorney that the will includes a bypass trust (also called a "family" or "credit shelter" or "B" trust). This type of trust is designed to help your family save on estate taxes. In your will and your spouse's will, each of you directs that if you are the first spouse to die that your solely owned assets be used to fund this type of trust with up to whatever the personal estate exemption amount is at the time ($5.25 million each in 2013) . Examples of assets that were used to fund these trusts are probate assets, assets already in a revocable living trust, or assets with the proceeds of a life insurance policy or retirement account(s) in which you name the bypass trust as beneficiary.

    The bypass trust can be used to provide income to your spouse and/or other family members during the surviving spouse's lifetime. Subject to certain restrictions, you also are able to grant the trustee the power to distribute trust principal for particular needs of your spouse and/or other beneficiaries. If properly structured, the assets in the trust would not be included in your surviving spouse's estate—and would then "bypass" your spouse's taxable estate at his or her death and pass estate-tax free to the beneficiaries of the trust, even if the trust had grown significantly larger than the original exemption amount used to fund the trust at your death.

    Any amount in excess of the current federal estate tax exemption amount that is used to fund a bypass trust is usually distributed outright to the surviving spouse or is used to fund a marital trust or qualified terminable interest property (QTIP) trust.

    In the past, when a will did not include a bypass trust or when there was not sufficient solely-owned assets to fund it, the estate tax exemption of the first spouse to die is essentially wasted. Starting in 2013, however, the necessity for including a bypass trust in your will if you are married has been eliminated. The new law allows the surviving spouse to utilize the first spouse's unused estate tax exemption amount without the need to use a bypass trust, but to do so the surviving spouse must complete and file certain paperwork with the IRS after the death of the first spouse. This is referred to as a "portability" provision.

    Nevertheless, even with this law, bypass trusts can offer advantages for some investors with relatively large estates. For example, if the portability provision, rather than a bypass trust, is used, growth in the assets are not excluded from the gross estate of the surviving spouse and may run up against the estate tax exemption amount in effect when the surviving spouse dies. Or, if the surviving spouse remarries and is the survivor of that subsequent marriage, the unused exclusion from the first marriage will be lost. Also, keep in mind that for both bypass trusts and the portability strategy, any lifetime gifts you make that are taxable will decrease your estate tax exemption amount, thus decreasing the amount that can be put into a bypass trust at your death or the amount that your spouse can use under the portability strategy.

    *If you are married and you and your spouse are both US citizens. If one spouse is not a U.S. citizen, different marital deduction rules apply. Consult an estate planning attorney or tax advisor for further details.

    Copyright 2014, T. Rowe Price Investment Services, Inc., Distributor. All rights reserved.