So, you’ve left all of your assets to your spouse...

At first glance, leaving all of your wealth to your spouse may seem like a simple, effective estate planning strategy. After all, the unlimited marital deduction exempts all transfers between spouses from gift and estate taxes (provided the recipient spouse is a U.S. citizen). Plus, it ensures that your spouse is provided for. But leaving everything to your spouse is a potentially costly mistake that can cause you to waste your federal estate tax exemption and dramatically reduce your children's inheritances.

imageA better approach is to contribute some or all of your assets to a bypass trust that provides income to your spouse for life, but preserves the principal for your children. For example, John is married to Anita, and he has an estate worth $7 million. John dies in 2009, when the exemption amount is $3.5 million and the top estate tax rate is 45%. John's will calls for all of his assets to go to Anita. The marital deduction shields his estate from estate tax, but his exemption goes unused.

If Anita dies later in 2009, her exemption will protect $3.5 million in assets from estate taxes, but the remaining $3.5 million will be taxable, reducing the amount available for their children by nearly $1.6 million.

John could have avoided this result by leaving $3.5 million to Anita outright and placing the other $3.5 million in a bypass trust. The trust provides Anita with income and on her death leaves the principal to their children.

The assets Anita receives outright are protected against estate taxes first by the marital deduction and later by Anita's $3.5 million exemption. The funds in the bypass trust are shielded from tax by John's exemption and are never included in Anita's estate. Thus, John and Anita's children will receive the entire $7 million, estate tax free.

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