A bypass trust, also known as an AB trust or credit shelter trust, is an estate planning strategy for married couples that can help them reduce or avoid federal estate tax. When one spouse dies, their assets will 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 up to the estate tax exemption. Upon the death of the surviving spouse, these assets will transfer to the beneficiaries and bypass any estate tax liability.
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 — $12.06 million in 2022, or $24.12 million for a married couple. Nonetheless, there are some instances in which a bypass trust can benefit you, such as when there are children from a previous marriage.
Bypass trust is also called a credit shelter trust since it shields assets up to the estate tax exemption amount.
The bypass trust works in conjunction with a marital trust that holds a surviving spouse’s assets.
The estate tax exemption is $12.06 million in 2022.
Most people don’t need a bypass trust and can benefit from regular family trust instead.
How a bypass trust works
Let's say that the value of a couple's estate exceeds the federal estate tax exemption. 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 for a tax-free transfer of assets between spouses.
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However, the estate taxes may be due once the second spouse dies. Without a proper estate plan, the surviving spouse’s estate most likely consists of everything their deceased spouse owned, which could put them over the estate tax exemption. This will ultimately decrease the money left for future beneficiaries, likely their children.
To avoid estate tax, you can have your assets transferred to a bypass trust, and when your spouse dies these trust assets are distributed to the final beneficiaries.
By using a bypass trust, you can divide your assets between two trusts, so their values are below the federal estate tax exemption. That's why a bypass trust is sometimes referred to as an AB trust, since it’s comprised two separate trusts — the A and the B.
The A trust
The "A trust" is referred to as a marital trust or survivor's trust since it holds assets for the use of the surviving spouse. The trust is typically revocable, and the surviving spouse acts as the trustee, with the right to change it and use and spend the assets as they wish.
The B trust
The "B trust" is an irrevocable trust that primarily holds all the other assets up to the estate tax exemption, which is why it's sometimes referred to as a credit shelter trust or decedent's trust.
If a married couple were planning today, then the B trust should hold assets under $12.06 million in assets. The final beneficiaries of a bypass trust are typically the couple's future heirs, like their children, but a surviving spouse might be able to receive unearned trust income.
When the second spouse dies, the assets in a bypass trust avoid probate and pass on to the final beneficiaries. They are shielded from estate taxes because the B trust is irrevocable and can't be changed or terminated, except under narrow circumstances defined by state law. The assets are owned by the trust and do not belong to any person.
You should talk to 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.
Can a surviving spouse be the trustee of a bypass trust?
The surviving spouse may act as trustee of the B trust of the 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. As the trustee, they will file bypass trust taxes separately).
The surviving spouse may be able to receive the bypass trust income to use for certain expenses — 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 their individual tax return.)
Who benefits from a bypass trust?
You don't need a bypass trust if you're not worried about paying estate taxes; it's harder to go over the estate tax exemption, which has been set high under today’s tax law.
Additionally, the passing of another tax law in 2012 allowed for portability, which meant that married couples could pool their federal exemption together (to a collective $24.12 million in 2022) minus any part of the exemption that was used during the deceased spouse's lifetime.
However, the law is subject to change — the exemption amount will sunset after 2025 without additional actions from Congress — and a bypass trust can still offer other benefits of an irrevocable trust, like asset protection. If you or a spouse have children from a previous marriage, a bypass trust can also help ensure that the inheritance passes to the beneficiaries 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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