AB Trusts: Tax-Saving Trusts for Married Couples

An AB trust (also called a marital trust or credit shelter trust) is a two-part trust that married couples use to maximize their federal estate tax exemptions, potentially saving hundreds of thousands of dollars in taxes. In simple terms, when one spouse dies, the trust splits into two: Trust A (the marital trust) for the surviving spouse, and Trust B (the credit shelter trust) that locks in the deceased spouse’s estate tax exemption. This framework is particularly valuable for couples with estates that exceed the federal exemption amount, which is $12.92 million per individual in 2023 (but may change annually). By understanding and implementing this framework, you can protect your assets for your heirs and maximize the wealth you pass on.

Introduction to the Framework

The AB trust is a framework—a mental model—for estate planning that relies on the concept of tax exemptions. When one spouse passes away, their estate is subject to federal estate tax if it exceeds the exemption limit. However, thanks to the unlimited marital deduction, assets left to a surviving spouse are generally exempt from estate tax at the first death. The problem? If you leave everything outright to your spouse, you waste the deceased spouse's exemption—assets pass to the surviving spouse, and then at their death, only the surviving spouse's exemption applies, potentially pushing more of the estate into taxable territory.

The AB trust solves this by splitting the estate into two parts at the first death:

• Trust A (Marital Trust): Holds assets that benefit the surviving spouse and qualify for the unlimited marital deduction. These assets defer estate tax until the second spouse dies.
• Trust B (Credit Shelter Trust): Holds assets up to the deceased spouse’s estate tax exemption amount. These assets are not subject to estate tax at the first death and are also sheltered from estate tax at the second death, because they are not included in the surviving spouse’s estate.

This framework is a powerful tax-saving tool for couples with estates that exceed the exemption, but it also has practical benefits like asset protection and control over distribution.

Why This Framework Works

This framework works because it leverages two tax principles: the unlimited marital deduction and the estate tax exemption. The unlimited marital deduction allows assets to pass to a spouse without immediate estate tax, but it doesn't eliminate the tax—it defers it. The credit shelter trust, conversely, effectively uses the deceased spouse’s exemption to the fullest, removing that amount from the taxable estate permanently.

Let’s illustrate with hypothetical numbers. Suppose a married couple, Alex and Jordan, have a combined estate of $20 million in 2023. Without an AB trust, if Alex dies and leaves everything to Jordan, no estate tax is due at Alex’s death thanks to the marital deduction. But at Jordan’s death, the entire $20 million (assuming it hasn’t been spent) is part of Jordan’s estate. Jordan has an exemption of $12.92 million, so the taxable amount is about $7.08 million, which at a 40% top tax rate results in an estate tax bill of roughly $2.8 million.

With an AB trust, at Alex’s death, up to $12.92 million is placed in Trust B (the credit shelter trust) and $7.08 million in Trust A (the marital trust). At Jordan’s death, only Trust A is included in Jordan’s estate, which is $7.08 million—under Jordan’s exemption—so no estate tax is due. Total tax savings: $2.8 million. That is why the framework works: it avoids wasting the first spouse’s exemption.

The framework also works because it provides control. The deceased spouse can specify in the trust how assets are invested and distributed to the surviving spouse and eventually to children or other beneficiaries. This is particularly valuable in second marriages or when there are children from previous relationships.

The Framework Steps

Step 1: Determine If an AB Trust Is Right for Your Estate

An AB trust isn't for everyone. It's most beneficial if your combined estate is likely to exceed the federal estate tax exemption at either death. Because the exemption is high—$12.92 million per person in 2023—most couples won't owe federal estate tax. But if you live in a state with its own estate tax or inheritance tax, the threshold may be lower, making the AB trust useful. Also, if you have a large life insurance policy, retirement accounts, or real estate that could appreciate, you might cross the threshold. Review your assets and estimate their value to decide if you need this strategy.

Step 2: Understand the Two Trusts That Form the AB Trust

• Trust A: Marital Trust – This trust holds assets that pass to the surviving spouse and qualifies for the unlimited marital deduction. It can be structured in different ways, such as a general power of appointment trust or a qualified terminal interest property (QTIP) trust. The surviving spouse receives income and perhaps principal for health, education, maintenance, or support, but they don't control the remaining assets outright.
• Trust B: Credit Shelter Trust – This trust holds assets equal to the deceased spouse’s estate tax exemption amount. The surviving spouse can receive income from this trust, and sometimes principal, but the assets are not part of the surviving spouse’s estate. This trust is designed to avoid estate tax at the second death and to preserve assets for children or other beneficiaries.

Step 3: Draft the Trust Agreement

You need a legal document that establishes the AB trust. This is a complex legal document that should be drafted by an attorney or through a reliable online service. The document must clearly define how assets are divided into the two trusts, who the trustees are, how distributions are made, and who the beneficiaries are. It should also include provisions for what happens if the surviving spouse remarries, how the trusts handle income and principal, and what happens when the surviving spouse dies.

Step 4: Fund the Trust with Appropriate Assets

An AB trust only works if you actually transfer assets into it. This is called “funding” the trust. You need to retitle assets—such as real estate, bank accounts, investment accounts, and life insurance policies—into the name of the trust. Failure to fund the trust defeats its purpose. Work with your financial advisor and attorney to ensure all assets are properly assigned.

Step 5: Manage the Trust After the First Death

When the first spouse dies, the trustee (often the surviving spouse) takes over administration. The trustee must divide the assets into the two trusts according to the trust document and, if necessary, allocate assets to maximize tax benefits. The trustee will also need to obtain a tax ID number for the trusts, file tax returns, and manage investments. The surviving spouse can usually receive income from both trusts, but the terms may differ.

Step 6: Plan for the Second Death and Distribution

At the surviving spouse’s death, the marital trust assets are included in his or her estate, and the credit shelter trust assets pass to the remainder beneficiaries (e.g., children). The trustee must distribute the assets according to the trust terms. The executor of the estate will handle probate for any assets not in trusts. The key is that the credit shelter trust avoids estate tax entirely, which is the main benefit.

How to Apply It

Applying the AB trust framework involves making strategic decisions early. First, decide whether you need an AB trust by analyzing your net worth. If your estate is likely to exceed the exemption (federal or state), consider creating an AB trust as part of your overall estate plan. You can create one through a lawyer or through online estate planning platforms that offer trust templates. However, because of the legal complexity, it's wise to consult a professional to ensure it's drafted correctly.

Next, coordinate your beneficiary designations. Life insurance policies, retirement accounts, and payable-on-death accounts should name the trust as beneficiary, not your spouse directly, to ensure assets flow into the trust. Also, coordinate with your will—a pour-over will can transfer any missed assets into the trust at death.

Finally, review your plan regularly. The federal exemption changes with inflation and new tax laws, so you may need to adjust your strategy. For example, if the exemption increases, you might want to make full use of portability (if applicable) rather than use an AB trust. Portability allows the surviving spouse to use the deceased spouse’s unused exemption, but it doesn't protect against future estate growth or state taxes. The AB trust locks in the exemption amount at the first death, which is more protective.

Examples/Case Studies

Case Study 1: The High-Net-Worth Couple

Consider David and Sarah, a couple in their late 50s with a combined estate of $15 million. In 2023, the federal exemption is $12.92 million per person. If they don't plan, at the first death, the entire estate goes to the survivor, so no tax is due. At the second death, the entire $15 million is taxable. With the exemption of $12.92 million, the taxable amount is $2.08 million, resulting in a tax of about $832,000.

With an AB trust, at David’s death, $12.92 million is placed in the credit shelter trust, and $2.08 million in the marital trust. At Sarah’s death, only the marital trust is taxed, but it's under her exemption, so no tax is due. They save $832,000. This example illustrates the direct tax savings.

Case Study 2: The Second Marriage

Jack and Jill are in a second marriage, each with children from previous marriages. They want to ensure that their biological children inherit their assets, but also provide for each other. Without an AB trust, if Jack dies and leaves everything to Jill, Jack’s children might be disinherited if Jill changes her estate plan later. An AB trust solves this: at Jack’s death, his assets go into Trust B (credit shelter trust), with income to Jill for life, and then the principal goes to Jack’s children. Jill’s own assets remain in her estate and can pass to her children. This ensures both spouses are cared for and their intended beneficiaries receive the inheritance.

Common Mistakes to Avoid

• Not funding the trust: A trust is worthless if assets aren't titled in its name. Remember to retitle all eligible assets.
• Using an AB trust when you don't need one: If your estate is well under the exemption, the complexity may not be worth it. Consider simpler options like a living trust basics.
• Ignoring state estate taxes: Some states have much lower exemptions (e.g., Massachusetts at $1 million). An AB trust can save state tax even if federal tax isn't an issue.
• Making the surviving spouse the sole trustee of the credit shelter trust: This could cause the assets to be included in their estate if they have too much control. Limit their control to income and limited principal for their health, education, maintenance, or support.
• Failing to coordinate with retirement accounts and life insurance: These assets may have their own beneficiary designations; ensure they align with the trust.
• Not updating the plan after tax law changes: The SECURE Act and other laws can affect distribution requirements. Review your plan periodically.

Templates/Tools

While creating an AB trust requires personalized legal documents, you can use worksheets to organize your assets and decisions. Here’s a basic template:

AB Trust Planning Worksheet

Also, consider using online estate planning platforms that offer trust templates; many offer free preliminary tools, like those from our platform, which can guide you through the process. You can learn more about how to set up a trust and how to choose between revocable vs. irrevocable trusts.

How an AB Trust Fits Into Your Overall Estate Plan

An AB trust is one tool in a broader estate plan. It works well alongside a will and other trusts. For most couples, a simple will and a revocable living trust may suffice, but when tax savings are significant, an AB trust becomes essential. It's also worth considering charitable giving: if you're charitably inclined, you might set up a charitable trust, which can provide income to your spouse and then leave assets to a nonprofit, potentially saving even more in taxes. To explore this, see our guide on charitable trusts.

Conclusion and Next Steps

The AB trust framework is a time-tested strategy for married couples who want to save on estate taxes, protect assets, and control the distribution of their wealth. By dividing assets into a marital trust and a credit shelter trust, you can maximize your estate tax exemption and potentially save hundreds of thousands of dollars. However, it's not a one-size-fits-all solution. You need to evaluate your estate size, consider state tax laws, and coordinate with all your beneficiary designations.

As a next step, estimate your net worth and determine if your estate is close to or exceeds the current exemption. If so, consult a qualified estate planning attorney to discuss drafting an AB trust. Alternatively, you can start with our free online tools to gauge your needs. Remember, the key to a successful estate plan is regular review and adjustment. Take action today to secure your legacy and provide for your loved ones.

For a deeper dive into asset protection, read our comprehensive guide on trusts and asset protection.