This type of trust is best for very affluent couples or people with stepchildren.
A bypass trust may be referred to as a credit shelter trust or AB trust.
To avoid estate tax, someone can have their assets transferred to a bypass trust when they die, and when their surviving spouse dies the assets transfer to the final beneficiary
The estate tax exemption for 2020 is $11.58 milion and will be $11.7 million in 2021
A bypass trust is an estate planning strategy for married couples. When one spouse dies, their last will and testament instructs that all assets to be divided between two trusts, referred to as the A trust and the B trust. One trust holds assets for the surviving spouse, and the other trust holds an inheritance for beneficiaries, including any high value assets which would be subject to the estate tax. Upon the death of the surviving spouse, these assets will transfer to the beneficiaries and bypass any estate tax liability. The bypass trust is also known as a credit shelter trust or AB trust.
Most people don’t have to worry about the estate tax, since you’re only taxed if your estate is valued over a very high amount — $11.58 million in 2020, but going up to $11.7 million in 2021. Nonetheless, there are some instances in which a bypass trust can benefit you, such as when there are children from a previous marriage. We’ll discuss how a bypass trust works, the potential tax benefits, and who might benefit from them.
Let’s say that a couple’s estate exceeds the estate tax exemption ($11.58 million in 2020 or $11.7 million in 2021). When a spouse dies, the estate can transfer to the surviving spouse without any estate tax being paid, thanks to the marital deduction, which allows these (tax-free) transfer of assets between spouses.
However, in this example, the estate will have to pay the estate tax once the surviving spouse dies. This will ultimately decrease the money left for future beneficiaries, likely their children. (The vast majority of estates — more than 99% — are not subject to the estate tax because they weren’t valued high enough.)
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By using a bypass trust, you can divide the assets between two trusts, so their values are below the federal estate tax exemption. Typically, the will provides instructions for the creation of these trusts (called testamentary trusts) upon the death of the first spouse.
Bypass or AB trusts are split into two trusts.
The “A trust” holds assets for the use of the surviving spouse. For example, the A trust might hold the couple’s primary residence and savings or checking account. The “A trust” is sometimes referred to as the marital trust or survivor’s trust.
The surviving spouse is typically the trustee to this revocable living trust. They possess the right to change it and use and spend the assets as they wish.
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The “B trust” primarily holds all the other assets up to the estate tax exclusion. If a married couple were planning today, then it should be under $11.58 million in assets (or $11.7 million for 2021). The beneficiaries of the B trust are typically the couple’s future heirs, like their children, but a surviving spouse might be able to receive some of the assets (more on this later).
For example, a husband might instruct the transfer of a vintage car, real estate property, money for college tuition into the B trust for future use by his children and have any unearned income from investments distributed to the wife.
Sometimes the the B trust is called the bypass trust or credit shelter trust or decendent’s trust.
When the surviving spouse dies, assets in the B trust bypass probate and pass along to the children. They are shielded from estate taxes. This is because the B trust is irrevocable, which means it can’t be changed or terminated, except under narrow circumstances defined by state law. The assets of this type of trust do not belong to any person, but to the trust itself. It even has its own tax identification number. The trustee files the tax return for the bypass trust and manages the assets.
You might talk with an estate planning attorney to draft the terms of the trust document, since it should use certain language so it properly operates as a bypass trust according to IRS tax law.
Learn more about the different types of trusts.
The surviving spouse may act as trustee of a bypass trust and often does. Remember that when the surviving spouse acts as trustee, they do not own the trust assets and cannot use them for their own personal benefit. (The bypass trust property does not figure into the surviving spouse’s income tax return).
However, as trustee, the surviving spouse may be able to receive the bypass trust’s income to use strictly for health, education, maintenance, and support — in accordance with IRS tax code. (The money from this distribution would be considered income and must be filed on the tax return.)
A bypass trust isn’t as helpful as it used to be because of the more lenient tax laws that advantage those with large amounts of wealth. It’s harder to go over the estate tax exemption because it has been set so high. Additionally, the passing of another tax law in 2012 allowed for portability, which means that a husband and wife can increase their federal exemption to a collective $23.16 million, minus any part of the exemption that was used during the deceased spouse’s lifetime.
On the other hand, the law is always subject to change and a bypass trust still offers some benefits, like asset protection. If you or a spouse have children from a previous marriage, a bypass trust can help ensure that the inheritance passes to the beneficiary of your choosing. (For example, you might want the assets to go to your child and not the surviving spouse's stepchild or new partner.)
If you aren’t fabulously wealthy or don’t have any children from another marriage, then it might not make much financial sense to set up a bypass trust, which might be tedious to open and operate.
You can still get tax advantages and benefits like creditor protection from a basic irrevocable trust, which, like a bypass trust, may reduce your taxable estate. As mentioned, irrevocable trust assets aren’t claimed on your tax return (if they properly operate and aren’t counted as “grantor trusts” in the eyes of the IRS) so instead of being taxed at your income tax rates, they will be subject to the tax brackets for estate and trusts. The taxes will be paid out of the trust assets by the trustee. Consult with financial advisors like a tax accountant for more information.
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Elissa Suh is a personal finance editor at Policygenius in New York City. She has researched and written extensively about finance and insurance since 2019, with an emphasis in esate planning and mortgages. Her writing has been cited by MarketWatch, CNBC, and Betterment.
Elissa has a B.A. in Film Studies from Barnard College.
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