A Qualified Terminable Interest Property (QTIP) trust is an estate planning tool that enables a grantor (i.e. the trust’s creator) of a blended family to take care of their surviving spouse while retaining full control over the distribution of their assets, even after their surviving spouse passes away.
In this article, you’ll be given a comprehensive understanding of how QTIP trusts work, why they’re beneficial to members of blended families, and how you can create one of your own to protect you and your loved ones.
Table of Contents
- 1 Estate Planning for Second Marriages and Blended Families
- 2 What is a QTIP Trust?
- 3 What is a QTIP Trust Used For?
- 4 QTIP Trust Requirements
- 5 QTIP Trust Advantages
- 6 QTIP Trust Disadvantages
- 7 QTIP Trust vs Marital Trust
- 8 Variations of QTIP Trusts
- 9 Does a QTIP Trust File a Tax Return?
- 10 How to Set Up A QTIP Trust
- 11 How CWO Can Help You Further
- 12 Download our 2023 Financial Planning Guide
Estate Planning for Second Marriages and Blended Families
Estate planning can be more complex for those in second (or later) marriages and blended families. That’s because there are often multiple sets of beneficiaries with differing interests and needs.
As a result, it’s important to examine the estate planning tools at your disposal, and understand which offers the features you need to keep you and your loved ones secure. If you’ve re-married, and are part of a blended family with children from a previous marriage, it may be worth looking into a QTIP trust.
What is a QTIP Trust?
A Qualified Terminable Interest Property (QTIP) trust is an irrevocable trust that allows you to provide financial support to your surviving spouse while maintaining control over the ultimate distribution of the trust’s assets.
A QTIP trust’s income, and sometimes principal, is paid out to your surviving spouse to provide financial support for the duration of their lifetime. After your surviving spouse dies, the remaining balance within the trust is paid out to your designated beneficiaries.
What is a QTIP Trust Used For?
QTIP trusts are commonly used in estate planning to provide financial support to a surviving spouse while preserving assets for chosen beneficiaries and managing tax implications. This type of trust is often utilized in second marriages or to provide for children from a previous marriage.
By utilizing a QTIP trust, you can ensure that your assets are managed and distributed in accordance with your wishes, providing peace of mind to both you and your loved ones.
Your surviving spouse never has power over the principal assets inside your QTIP trust, which keeps them bound to your chosen beneficiaries even if your surviving spouse passes away or chooses to remarry.
In addition to providing the surviving spouse with a source of funds, QTIP trusts can also help minimize applicable gift and estate taxes. The income from the trust assets that provides for the surviving spouse qualifies for the marital deduction, which means that the trust’s value is not taxed after the first spouse’s death. Instead, the trust’s assets become taxable after the surviving spouse’s death.
QTIP Trust Requirements
To establish a QTIP trust, certain requirements must be met. Review the following rules that must be abided by to ensure the validity of your QTIP trust:
- Your QTIP trust must distribute all its income to your surviving spouse.
- Your spousal beneficiary is required to be a U.S. citizen.
- You can have no other beneficiaries until your surviving spouse passes away.
- Your surviving spouse must be provided with an income at least once each year.
- The surviving spouse possesses the authority to compel the trust’s fund manager to transform non-income producing assets into revenue-generating assets.
QTIP Trust Advantages
Control Over Where Everything Goes: With a QTIP trust, you have the power to determine the final recipients of your assets. Upon the passing of both you and your spouse, the assets in the trust will be distributed according to your specifications, regardless of any actions taken by your surviving spouse. This allows you to ensure that your assets will be passed on to your desired secondary beneficiaries, which may include children from other marriages.
Security For All Assets and Income: A QTIP trust offers comprehensive protection for all assets and income. As your surviving spouse grows older, they may lose the capacity to make prudent financial decisions. But by establishing a QTIP trust, you can specify how income or principal should be distributed and utilized, protecting your assets for your chosen beneficiaries. Your assets will be shielded from thieves, accidental signings, creditors, and mistakes owed to cognitive decline.
Step-Up In Basis: The step-up in basis for QTIP (Qualified Terminable Interest Property) trusts The step-up in basis for QTIP trusts is a tax benefit that occurs upon the death of a spouse (both first and surviving). When either spouse passes away, the assets held in a QTIP trust may receive a “step-up” in their tax basis to their fair market value. This means that the cost basis of the assets in the trust is adjusted to their current value, which can reduce or eliminate any capital gains taxes that may be owed if the assets are sold at some point in the future.
The step-up in basis is a valuable feature of QTIP trusts because it can help to minimize the overall tax burden on the assets in the trust, which ultimately benefits the surviving spouse and any other beneficiaries of the trust. Additionally, the step-up in basis can help to ensure that the assets in the trust are distributed in the most tax-efficient manner possible.
QTIP Trust Disadvantages
Potential Arguments: One major issue with a QTIP trust is the potential for disagreements amongst blended family members. Your surviving spouse beneficiary will have no control over the principal assets in the trust, and your beneficiaries may include children from previous marriages. Disputes over taxes, investment choices, and the trust’s management may all arise depending on the relationship between your beneficiaries and the level of financial security each has outside the distributions of the trust.
Limited Allocations: A QTIP trust requires that the surviving spouse be the only beneficiary during their lifetime. This means your surviving spouse cannot directly allocate the trust’s income or principal across multiple generations.
Potential Income Tax Liability: In federal income tax terms, a QTIP trust is considered a “simple trust” because it must make all income distributions at least annually. Keep in mind that even though simple trusts must distribute all their income, they may still be subject to income taxes.
It’s important to note that the definition of income is determined by the trust’s governing documents and relevant state law, which may not include all taxable income. For instance, while capital gains are considered taxable income, they may be treated as part of the trust’s principal rather than income under state law and as a result, are not distributed as income.
These differences in what’s considered income can result in taxable income being trapped in your QTIP trust. Although simple trusts typically build up less taxable income than their complex trust counterparts, they may still face potential income tax liability.
Potential Estate Tax Liability: One purpose of utilizing a QTIP trust is to potentially secure a step-up in basis after the surviving spouse dies. From there, it is usually hoped that the surviving spouse’s gift and estate tax exemption amount will cover any estate taxes owed. However, there is always the possibility that this estimate may be incorrect due to unexpected growth of the spouse’s or the trust’s assets or there’s a change in estate tax law that lowers the exemption.
Please note, the Tax Cuts and Jobs Act is set to expire at the end of 2025. As a result, starting in 2026, the federal gift and estate tax exemption will be returning to its pre-2018 level ($5,000,000 for individuals) with adjustments for inflation. So unless legislation changes, potential estate tax liability for QTIP trust may come at a much lower threshold in the near future.
QTIP Trust vs Marital Trust
QTIP Trusts and Marital Trusts operate similarly in many ways. Both are unalterable trusts that name the surviving spouse as the sole beneficiary for the duration of their lifetime.
However, the key difference between the two is the extent of control exercised by the grantor of a QTIP trust, even beyond their lifetime.
By granting your spouse the income from the trust but restricting their access to the principal, you have the ability to dictate the use of the funds and limit the amount that can be withdrawn.
Variations of QTIP Trusts
Clayton QTIP Trusts
The Clayton election permits the selection of a QTIP trust or Bypass trust (or both) upon the death of the first spouse. This gives your trustee more time to decide what assets are best suited to each trust type based on the current economic and tax landscape. While the surviving spouse can be the trustee of these trusts, a different trustee can be selected in cases of blended families or if the surviving spouse requires creditor protection.
A key difference between a bypass trust and a QTIP trusts rests with how each is taxed. A bypass trust has the benefit of excluding the initial funding amount and any growth from federal estate tax for both spouses. But, the downside is that the assets and their growth are not included in the second spouse’s taxable estate, which means that the children could inherit assets with built-in appreciation and may have to pay capital gains tax if they sell them.
However, with a QTIP trust, assets are included in the surviving spouse’s taxable estate. That means they can receive a second step-up in basis before passing to beneficiaries after the second spouse dies. This reduces the tax burden on beneficiaries should they choose to sell the assets they receive. Additionally, QTIP trust’s provide the grantor with control over how their assets are distributed even after their passing.
Ultimately, whether or not a QTIP trust or Bypass trust (or both) is right for you will depend on your specific estate size, exclusion amounts, and individual estate planning objectives.
Reverse QTIP Marital Trust
A reverse QTIP election ensures that both spouses’ generation-skipping transfer tax (GSTT) exemptions are utilized. The election treats the QTIP property as belonging to the first spouse to pass away for GSTT purposes. Without this election, only the surviving spouse’s GSTT exemption would be available, causing the predeceased spouse’s unused exemption to be lost.
Reverse QTIP elections are generally used when the value of an estate being transferred to grandchildren (or other beneficiaries of a generation removed) exceeds the GSTT exemption of the surviving spouse. Please note, however, to take advantage of this election you must adhere to the proper IRS filing requirements.
Does a QTIP Trust File a Tax Return?
Yes, a QTIP trust is required to file a tax return if it has income during the tax year. For federal income tax purposes, the trust is classified as a simple trust and is therefore required to distribute all income at a minimum of an annual basis.
As a result, the trust must file a tax return (Form 1041) to report the income and any tax liabilities. The trust may also face estate and/or state taxes, depending on the state and the specifics of the trust agreement. You’ll want to consult with a tax professional to determine the tax obligations of a QTIP trust and ensure that it is in compliance with all tax laws.
How to Set Up A QTIP Trust
Step 1) Identify the Purpose of the QTIP trust: The primary purpose of a QTIP trust is to provide income to the surviving spouse while ensuring that the remaining assets pass to the intended beneficiaries at the surviving spouse’s death.
Step 2) Choose the Property to Fund the QTIP Trust: Decide what assets will be placed in the QTIP trust, such as cash, stocks, bonds, real estate, or other property.
Step 3) Name the Trustee: Choose an individual or institution to act as the trustee of the QTIP trust. The trustee is the one responsible for taking ownership of the trust, managing it, and making sure its terms are properly executed.
Step 4) Name the Beneficiaries: Identify the individuals or entities that will receive the benefits of the QTIP trust, including the surviving spouse and the remainder beneficiaries.
Step 5) Determine the Distribution Terms: Specify the terms for distribution of income from the trust to the surviving spouse, including the frequency and amount of distributions.
Step 6) Provide for the Remainder Beneficiaries: Specify the conditions under which the remaining assets will be distributed to the remainder beneficiaries, such as the surviving spouse’s death or the occurrence of a specified event.
Step 7) Consider Tax Implications: It’s essential to consult with a tax expert to ensure the QTIP trust’s tax efficiency during its formation.
Step 8) Prepare the Trust Document: Have an attorney draft the QTIP trust agreement, detailing its specific provisions and guidelines.
Step 9) Fund the Trust: Transfer the assets to the appointed trustee for safekeeping and management within the trust.
Step 10) Make the QTIP Election: File a QTIP election with the IRS to ensure that the QTIP trust qualifies for the marital deduction.
How CWO Can Help You Further
At CW O’Conner it’s a privilege to help our clients keep their legacies in tact. And the primary way we’re able to help is ensuring you have the right estate plan in place.
Depending on your unique marital and family situation, it may be worth looking into a qualified terminable interest property (QTIP) trust. They’re a powerful tool that’s able to look after both your spouse, and your children from previous marriages from a financial standpoint.
As a team, we’ll help figure out the terms, assets, and variations within your QTIP trust that make the most sense. We’ll also be able to work with your attorney and tax planning professional, or provide ones of our own. Our vetted network of industry professionals can point you in the right direction for all your estate planning needs.
If you’re ready to establish a QTIP trust, or have further questions on whether or not one may be right for you, please don’t hesitate to reach out. You can call us directly at 770-368-9919, or fill out a contact card, and we’ll reach out to you.
The opinions and analysis expressed herein are based on C.W. O’Conner Wealth Advisors, Inc. research and professional experience and are expressed as of the date of this report. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice.