A bypass trust is designed to allow a surviving spouse to bypass estate taxes by placing the deceased spouse’s assets in two separate trust funds, each of which is below the estate tax limit.
As of 2021, the federal estate tax carried an exemption amount of $11.7 million per individual and twice that amount — or $23.4 million — for married couples.
If an individual passes away with an estate valued at $32 million, for example, that individual’s spouse could be subject to the estate tax and face the prospect of paying 40% in taxes on that amount. However, by dividing that figure up and placing $11 million in a trust for the spouse and $21 million in a trust for other beneficiaries after the second spouse dies, the entire estate could pass to the couple’s descendants tax-free.
The catch is, the surviving spouse will have to give up some of his or her rights in order to take advantage of this benefit.
However, if used properly within the context of an overall estate plan, a bypass trust can save a couple’s heirs money by providing asset protection that allows them to avoid paying inheritance taxes.
An estate plan will also include elements like a will, durable power of attorney, and a health care directive. It will account for funeral and burial expenses and will name beneficiaries and designate an executor to oversee the distribution of assets. It’s important to have an estate planning checklist in place so you can account for everything your heirs are likely to face.
What Is a Bypass Trust?
A bypass trust is an estate planning device created by a married couple while both are living to protect their assets upon the death of the first spouse. The bypass trust provides one trust fund for the surviving spouse’s use during the rest of his or her life, and another trust fund that contains and protects assets for the couple’s heirs.
A bypass trust helps a surviving spouse bypass estate taxes by placing the deceased spouse’s assets into two separate trust funds, each of which is below the estate tax limit. The two trusts are designated as A and B. For this reason, a bypass trust is also known as an A/B trust or a credit shelter trust.
Trust A is a revocable living trust, which means the person creating the trust — the first spouse or grantor — can change (or revoke) the trust at any time. It’s a marital trust, which is left to the surviving spouse to do with as he or she pleases upon the death of the first spouse.
Trust B is an irrevocable trust, which means that under the terms of the trust, the assets placed there can’t be removed by anyone or for any reason. That includes the surviving spouse, who may be able to gain certain trust income from it — such as stock dividends — but doesn’t own the assets in the trust. That’s why it doesn’t count as income.
How Does a Bypass Trust Work?
During the surviving spouse’s lifetime, that person owns the assets in Trust A as the beneficiary, but since the amount of money he or she inherited (in our example, $11 million) is under the federal estate tax exemption threshold, no estate taxes are owed on that amount.
The assets in Trust B, meanwhile, pass on to the couple’s heirs upon the death of the surviving spouse. For this reason, Trust B is also known as a family trust. But the amount (again, say it’s $21 million) is once again beneath the estate tax exemption threshold, so the heirs, like the surviving spouse, end up owing no estate taxes.
Benefits of a Bypass Trust
A bypass trust can help you reduce your estate tax liability and avoid the probate process.
A bypass trust not only can eliminate federal estate taxes through the process described above, but it can minimize state estate taxes, too. As of 2021, a total of 17 states had estate or inheritance taxes. Estate taxes are assessed against the assets of an estate after all debts have been paid, while an inheritance tax is paid by beneficiaries on the inheritance they receive.
If you live in any of these states, it’s worthwhile to check their specific tax codes and state laws and find out whether they may affect your estate. Every state with an estate tax has one with a lower threshold than the federal exemption (although the percentage of an estate that is taxed generally isn’t as high).
In Massachusetts, for instance, an estate tax of 0.8% to 16% kicks in at $1 million, while Washington levies taxes of 10% to 20% on estates of more than $2.2 million, and in New York, there’s an estate tax of 3.06% to 16% on estates of more than $5.9 million.
Many couples also set up a bypass trust in order to avoid probate, a court process through which a decedent’s will is carried out and legally recognized.
Depending on the state in which it’s carried out and the complexity of a person’s will, probate generally takes between six months and a year to complete. During this process, an executor is appointed to take account of the estate’s assets, pay off any debts, and ensure the assets are distributed to beneficiaries according to the deceased person’s wishes.
Because it has a reputation for taking a long time, many couples may seek to avoid probate by doing things such as entering into joint tenancy agreements with heirs or opening joint bank accounts with them. Setting up a revocable or living trust, such as the “A” trust in a bypass trust setup, is another means of doing that.
A bypass trust isn’t for everyone. Most obviously, the only tax benefits it has to offer are for those with taxable estates valued at more than federal or state thresholds. There are a few potential drawbacks, as well. For instance, bypass trusts can be costly and also require maintenance.
In order to set up a bypass trust, you’ll need to employ the services of an estate planning attorney. It can be a complicated — and therefore costly — legal process.
The surviving spouse will also have to track income that’s generated by the trust for his or her tax returns.
But the biggest cost may come in the form of capital gains taxes. Although the bypass trust can help avoid estate taxes, it can actually increase the surviving spouse’s capital gains tax burden. That’s because taxes are “stepped up” to the estate’s market value at the date of the decedent’s death, erasing any capital gains.
But because the assets in Trust B never belong to the second spouse and aren’t part of the survivor’s estate, they’re not eligible for this step-up. As a result, any appreciation in value is subject to capital gains taxes.
So if the value of that second trust increased from $21 million to $24 million (hypothetically) between the deaths of the first and second spouses, the couple’s heirs would owe the IRS a capital gains tax of 20% on that $3 million — or $600,000.
Under the bypass trust system, the surviving spouse takes on responsibility for maintaining the trust, recordkeeping, and overseeing the trust’s assets. Alternatively, the survivor can pay a trustee, but that incurs additional costs.
In our example of the $32 million estate, let’s say one spouse dies without a bypass trust and leaves all assets to the surviving spouse. At a 40% tax rate, that would cost $12.8 million (assuming, for the sake of argument, that the estate has no debt). That would leave less than $20 million to pass on to any beneficiaries when the second spouse dies.
By setting up a bypass trust, however, the first $11 million would go to the spouse tax-free, and the remaining $21 million would pass to the children tax-free.
When planning your estate, you’ll want to decide whether to pass on your assets via a will or a revocable trust.
If you die without a will, known as being “intestate,” your assets will be distributed according to the laws of your state, usually to your spouse and children. By forgoing a will, you’re allowing the state to substitute its judgment for your own wishes and forfeiting your right to decide how your property is distributed upon your death.
A will, however, is not the only option. By choosing a revocable trust, you’ll be able to avoid probate and the complications that can arise if you own property in more than one state, which could require different probate processes.
Another option is an irrevocable trust, like Trust B in a bypass trust. Irrevocable trusts have the advantage of shielding assets from creditors. Remember, though, that you can’t change this kind of trust once it’s established.
Revocable trusts avoid probate and protect the grantor’s wishes if he or she becomes incapacitated. If you’re concerned about retaining control of your assets while you’re still alive, they’re an option worth exploring, but if you’re more worried about shielding your assets from creditors, an irrevocable trust could be the way to go.
As mentioned earlier, there are other alternatives, too. If you set up a joint bank account with the person you wish to have your assets after your death, that person will already have access to those funds as joint owner of the account. The same principle applies with joint tenancy: The property automatically passes to the second owner upon the death of the first.
This may, however, trigger a gift tax, and the real estate will not receive a step-up benefit upon the death of the original owner. When engaging in tax planning, it’s important to weigh any estate tax benefits against potential capital gains drawbacks.
Estate tax law can be complex, but understanding your options is key to choosing the right one. If you have a sizable estate, a bypass trust may be worth considering, but you should weigh the pros and cons of this approach — including the degree of control and responsibilities the surviving spouse will have, as well as the tax implications, before making a decision.
If you do decide on a bypass trust, you’ll want to consider how to divide the money between the two trusts. If you decide against it, you still have an array of options from which to choose, from a will to joint tenancy and joint accounts.
Consult with an estate planning attorney to help determine the course of action that’s best for you.
