Due to the relatively generous estate and gift tax provisions included in the American Taxpayer Relief Act (ATRA), estate planning is easier than it was before. However, it can still be tricky, especially if your spouse isn’t a U.S. citizen.
Strategy: Use some ingenuity. For instance, you might use a special trust to shift income to your noncitizen spouse. Alternatively, you might rely on other tax law provisions to minimize the potential damage.
Here’s the whole story: The two main estate tax breaks for married couples are the unlimited marital deduction and the federal estate exemption. As the name implies, there is no estate or gift tax due on any transfer between eligible spouses. Under ATRA, the estate tax exemption can effectively shelter transfers of up to $5 million (indexed to $5.25 million for 2013 and $5.34 million for 2014) to nonspouse beneficiaries. The same tax shelter is available for lifetime transfers, but such gifts reduce the available estate tax shelter.
However, if your spouse is not a U.S. citizen, the unlimited marital deduction privilege doesn’t apply. Instead, you must use the estate tax exemption ($5.25 million for 2013 and $5.34 million for 2014) to cover assets transferred to your noncitizen spouse at death. Furthermore, the lifetime gift tax exemption for gifts to a noncitizen spouse is limited to $143,000 for 2013 and $145,000 for 2014.
To avoid dire results, you might establish a QDOT (qualified domestic trust) and name your spouse as beneficiary of the trust. As a result, your spouse can receive income free of estate tax. At least one trustee of the QDOT must be a U.S. citizen or a domestic corporation.
Caveat: Any principal withdrawn from a QDOT by your noncitizen spouse is taxed as if it were removed from your taxable estate. This can push your estate into a higher tax bracket. Also, there are certain limitations on investments made by QDOTs. Therefore, you may decide to shift more assets into the name of the noncitizen spouse, subject to the limit for the lifetime gift tax exemption.
Another possibility is to have your spouse become a U.S. citizen if he or she is inclined to do so. A QDOT may be structured so that it ceases to be effective when your spouse formally obtains citizenship.
Tip: If you are the noncitizen spouse, you can petition a court to set up a QDOT if your spouse predeceases you.