Here's the problem. You and your spouse have an estate, including life insurance, worth $1.3 million. It may grow to $5 million or more by the year 2011 (yes, there's a reason for these numbers). If you die first, you want your spouse to be financially secure. You also want to pass on as much of your estate as possible to your children once your spouse dies. Your spouse will inherit your entire estate tax free upon your death. But when your spouse dies, at least half of the estate, perhaps more, will face steep estate taxes. What to do? 

        Here's a possible solution: the credit-shelter trust. Sometimes called a family trust or a bypass trust, the credit-shelter trust is one of the most fundamental and effective ways to save estate taxes. 

        To understand how it works, let's quickly review the federal unified gift and estate tax system. Each person can pass on a certain amount of their estate through lifetime gifts or at death free of federal gift and estate taxes. That exemption amount is $5 million in 2011.  Of course, married couples can pass on their entire estate (even if it's worth zillions) free of tax to their spouse, but that merely postpones the taxes. For example, let's say you die in 2011 (sorry about that). Your estate-$5 million goes to your spouse, whose estate also is worth $ 5 million, free of estate tax. However, your spouse unexpectedly dies a short time later, leaving a total estate of $10 million. The first $5 million (the surviving spouse's estate tax exemption amount) would pass tax free to your children. However, the second $5 million would be taxed-to the tune of over $2,100,000.  In essence, you wasted your $5 million estate tax credit. 

        A credit-shelter trust, however, could keep that extra  $5 million from being taxed. You and your spouse each write a will that creates a credit-shelter trust upon your death. If you die first, the trust is funded with assets from your estate equal to $5 million (or whatever the maximum exemption amount is in the year of your death). The will stipulates that all trust income goes to support your spouse, but the trust assets go to your children upon your spouse's death. 

        Again, for the sake of simplicity, let's say your spouse dies later in 2011. Your spouse passes on tax-free to the children his or her exemption amount of $5 million.  In addition, the remaining $5 million in assets in your credit-shelter trust also pass to your children tax free. Thus, the entire $10 million estate is passed on tax-free, saving you over $2.1 million in taxes. 

        Even more tax savings can occur if your spouse doesn't consume some or all of the income produced by the trust assets. Let's say the assets in the credit-shelter trust grow to $5 million before your spouse dies. All $5 million passes free of estate tax to your children, not merely the $5 that originally went in at your death in 2011. 

        A good estate planning attorney should be able to draft this relatively common type of trust. However, there are a couple of things you should watch out for. First, a credit-shelter trust can be funded only with assets owned solely by the person who establishes the trust. If all your property is jointly owned with your spouse at your death, the property could go to your surviving spouse, not the trust. This isn't a problem in community property states, but in others you may have to retitle assets. It's also possible to put into the trust document language that property up to the exemption amount you want to put into the trust be treated as tenancy by entirety or tenants in common (for someone other than your spouse). 

        The other issue to watch out for is naming a trustee. It's common to name the surviving spouse as the trustee, but this can present problems if the spouse is also named as the income beneficiary. If insufficient restrictions are imposed the trust assets could end up being treated as part of the surviving spouse's estate, essentially negating the entire purpose of establishing the credit-shelter trust.