What Is a Marital Deduction and How Does It Work?

The marital deduction is a provision in U.S. federal estate and gift tax law that permits an individual to transfer an unlimited amount of assets to their spouse without incurring federal transfer taxes, applying to both lifetime gifts and transfers made at death. Its primary purpose is to defer federal estate and gift taxes on assets transferred between spouses.

This mechanism treats married couples as a single economic unit for transfer tax purposes. By allowing assets to pass tax-free, the marital deduction helps preserve family wealth and ensures the surviving spouse has access to combined resources without immediate tax burdens.

Fundamentals of the Marital Deduction

The concept of the “unlimited” marital deduction signifies that there is no cap on the value of assets that can be transferred between legally recognized spouses free from federal gift or estate tax. This deferral means that while the first spouse’s estate may not pay tax on assets transferred to the survivor, those assets will be included in the surviving spouse’s taxable estate upon their death. The tax is imposed when the assets are transferred to a third party or when the surviving spouse passes away.

A spouse can gift an unlimited amount of property to their U.S. citizen spouse during their lifetime without incurring gift tax. Assets bequeathed through a will or other means at death to a surviving spouse also qualify for this deduction.

Qualifying for the Marital Deduction

For a transfer to qualify for the marital deduction, the transfer must be to a legally recognized spouse who is a U.S. citizen. Different rules apply if the recipient spouse is not a U.S. citizen. The property transferred must pass “outright” to the surviving spouse, meaning they receive full ownership and control.

The property transferred must also be includible in the transferor’s gross estate for estate tax purposes or constitute a completed gift. Many types of assets can qualify, including cash, real estate, stocks, bonds, and personal property. These assets can be transferred through various means, such as an outright bequest in a will, direct beneficiary designations, or joint ownership with rights of survivorship.

Understanding Terminable Interests

A significant limitation to the marital deduction involves “terminable interests,” which are interests in property that will terminate or fail upon the lapse of time or the occurrence or non-occurrence of an event or contingency. These interests do not qualify for the marital deduction because the property might eventually pass to someone other than the surviving spouse or their estate, without being subject to estate tax in the surviving spouse’s estate. The rule aims to ensure that property receiving the marital deduction is eventually subject to U.S. transfer tax.

There are specific exceptions to the terminable interest rule that permit the marital deduction.

Qualified Terminable Interest Property (QTIP) Trust

A QTIP trust allows the grantor to provide for their surviving spouse by ensuring they receive all income from the trust at least annually for life, while controlling the ultimate disposition of assets after the surviving spouse’s death. To qualify, no one can appoint any property to someone other than the spouse during the surviving spouse’s lifetime, and the executor must make an election on the estate tax return. This structure is often used in blended families to provide for a current spouse while preserving the principal for children from a previous marriage.

Power of Appointment Trust

The surviving spouse must be entitled to all income from the trust at least annually and possess an unlimited power to appoint the trust assets to themselves or their estate. This general power of appointment ensures that the assets will be included in the surviving spouse’s estate, satisfying the intent of the marital deduction.

Estate Trust

This exception requires the property to eventually pass to the surviving spouse’s estate. Unlike other trusts, the surviving spouse in an estate trust need not receive all income during their lifetime, making it suitable for non-income-producing assets.

Marital Deduction for Non-Citizen Spouses

When the surviving spouse is not a U.S. citizen, the unlimited marital deduction generally does not apply. This restriction exists to prevent assets from escaping U.S. estate tax entirely if the non-citizen spouse were to move the assets out of the country before their death. Without special planning, transfers to a non-citizen spouse are subject to gift or estate tax if they exceed the annual gift tax exclusion amount, which is $185,000 for 2024 for gifts to a non-citizen spouse.

To address this, the Qualified Domestic Trust (QDOT) serves as the primary mechanism to qualify for the marital deduction. A QDOT allows a U.S. citizen spouse to transfer assets to a non-citizen spouse without immediate federal gift and estate tax, deferring the tax until distributions of principal are made from the QDOT or upon the non-citizen spouse’s death. Key requirements for a QDOT include having at least one trustee who is a U.S. citizen or a domestic corporation, and the trust must be structured to ensure the collection of estate tax on distributions and upon the death of the non-citizen spouse.

For example, if the QDOT holds over $2 million, a U.S. bank must serve as trustee, or the U.S. individual trustee must provide a bond or letter of credit equal to 65% of the trust’s value. Distributions of income from a QDOT are tax-free, but principal distributions are subject to estate tax unless for hardship reasons.