For decades, the bypass trust was a common staple of family estate plans. But it appeared that this tool might become a relic of days gone by after the American Taxpayer Relief Act of 2012 (ATRA) preserved the "portability" provision of the estate tax law. Because of this provision, a bypass trust no longer was needed to ensure that each spouse in a marriage could maximize his or her estate tax exemption.
Yet even today, the bypass trust remains a viable estate planning option. Consider the following background on how bypass trusts can help and four reasons why you might keep such a trust as part of your estate plan:
What Is a Bypass Trust?
A bypass trust (also called a "credit shelter trust") is established so that assets you leave to your family will bypass your spouse's estate on their way to your children. That way, the trust can use the full estate tax exemption to which each person is entitled. Without a bypass trust, some or all of the assets from the first spouse to die might go to the other spouse, and though there's usually no tax on an inheritance between spouses, the second spouse to die then would have both spouses' assets and only one individual exemption to shield that money from federal estate taxes.
Typically, each spouse might include a provision in his or her will that sets up a trust for the surviving spouse's benefit, and funds it with the equivalent of the deceased spouse's basic exemption amount (BEA). Then, when the surviving spouse dies, the remaining assets go to the kids. As long as the trust is structured properly, this arrangement may avoid estate tax by utilizing the estate tax exemptions of both spouses.
Under ATRA, the BEA is set at a generous $5 million level, subject to annual indexing for inflation. The exempt amount in 2017 is $5.49 million.
The law's so-called portability provision, established in 2010 and then permanently extended by ATRA, seems to accomplish much of what you'd create a bypass trust to do. Any part of your exemption that you don't use can be added to your spouse's exemption, letting the two of you avoid estate taxes on a total of nearly $11 million. This works no matter who dies first or how you split your assets.
Yet even though portability may eliminate one reason for establishing a bypass trust, other reasons remain. Here are four of the main considerations:
Four Protections of a Bypass Trust
1. Asset protection. Normally, assets that are owned by a surviving spouse become fair game for creditors. What can make the situation even more frustrating for family members is that assets might be siphoned off to help pay the debts of someone who marries the surviving spouse. However, a bypass trust protects the assets from the clutches of creditors, while keeping them safe from lawsuits.
2. Bloodline protection. This isn't as ominous as it sounds. You're not actually trying to preserve your family's bloodlines--you're just using a bypass trust to safeguard the interests of family members to whom you want to leave part of your estate. Although your, and your spouse's wills could name your children as "successor beneficiaries" (to inherit when both of you have died) your intentions could change, especially if the surviving spouse eventually remarries. Without a trust, there's no guarantee that the children of the initial marriage will receive their fair share of the spoils when the surviving parent dies. With a bypass trust, you can arrange for the assets to pass to your children, regardless of future marriages.
3. Spendthrift protection. Remarriage isn't the only financial concern of a married couple. Assets can be squandered through their children's free-spending ways, or the children might assign their interests in your estate to spouses or others. Including a spendthrift provision in a bypass trust can guard against these potential dangers, while still allowing the assets to be used in a reasonable manner.
4. Power of appointment. A bypass trust can provide greater flexibility by granting a power of appointment to the surviving spouse. This gives the survivor the ability to use the trust assets for his or her health, education, maintenance, or support. Rather than granting a broad "general power" of appointment, it's usually better to provide a "limited power," permitting the beneficiary to allocate only his or her share of the trust among potential recipients.
This list isn't all-inclusive. Other possible reasons for using a bypass trust include maximizing the benefits of the generation-skipping tax (GST) exemption for gifts to grandchildren (the GST exemption is not portable), accounting for state inheritance laws and taxes, creating additional protection for especially large estates that are appreciating in value, and planning for Medicaid eligibility.
With all of this in mind, you may not want to skip over the bypass trust. Consider the entire spectrum of benefits it might provide in your situation.
This article was written by a professional financial journalist for lm financial and is not intended as legal or investment advice.