What is a bypass trust, and do you need one?
Estate planning can take many forms, but at the end of the day, most estate plans boil down to the same purpose: maximizing the sentimental and financial value of your legacy to those you care about the most.
A bypass trust is one among a myriad of tools designed to help specific families with specific circumstances make the most of their combined fortune – especially wealthy married couples. The bypass trust is one part of a two-part trust plan, also known as the AB trust.
The goal of a bypass trust is to shield assets from estate taxes, an avoidable tax liability, later down the road.
A bypass trust, when used as part of an AB trust, allows a married spouse to ensure that their assets are transferred into a trust upon death, rather than going directly towards a beneficiary, or going through the probate process. A bypass trust also allows a married couple to utilize their combined estate tax exemption, as well as the exemptions levied onto property exchanged between spouses upon death.
This is because, when a person dies, their estate may be subject to estate taxes depending on local and federal estate tax exemption limits. If the total value of a person’s estate exceeds the exemption amount for that given year, then the surplus may be taxed at a high fixed tax rate.
A bypass trust, designed as part of an AB trust, allows married couples to minimize or even eliminate that tax liability through some clever estate planning. This involves splitting a deceased spouse’s estate into two trusts: the marital trust (A), and the bypass trust (B).
The marital trust belongs to the surviving spouse. Everything within the marital trust is transferred without an estate tax, because it is under the control of the surviving spouse, and assets transferred between spouses are tax-free.
The bypass trust is an irrevocable trust that the surviving spouse becomes a beneficiary of. Because the assets outlined in the bypass trust are not transferred to the surviving spouse, they are not tax-free – so the limit of what can be placed in a bypass trust must dictated by the current estate tax exemption rules. As long as the bypass trust is designed with these limits in mind, it will not owe an estate tax.
When the surviving spouse dies, their assets in the marital trust and the assets held in the bypass trust are passed onto the couple’s beneficiaries, without any additional estate tax liability.
When done right, a bypass trust (as part of the AB trust) allows a couple to limit or even eliminate their estate tax liability, as well as entirely bypass the probate process, another big win for individuals with large or complicated estates.
The bypass trust is designed to hold up to the limit of an individual’s estate tax exemption, and pay out income to the surviving spouse. The remainder of the first spouse’s belongings are placed in the survivor’s trust, free of state and federal estate taxes. When the surviving spouse dies, the A bypass trust is named such because it bypasses probate and the individual estate tax.
A bypass trust is less valuable if both spouses have a large amount of separate wealth and are unable to give enough of it away without incurring a significant amount of gift tax. But if one spouse is entitled to most of the wealth, a bypass trust allows the couple to utilize both of their exemptions to shelter their combined wealth for themselves and their children or grandchildren and ensure that their family can make the most of their financial fortune.
Bypass trusts have become less popular as of late, due to the rapid growth of estate tax exemption limits. But promises of a return to previous limits and harsher tax penalties on the generational wealth transfer may lead the bypass trust to a return in popularity.
Another key disadvantage is that a bypass trust can be complicated to set up. The process is quite involved, and requires the creation of two separate trusts – one revocable, and one irrevocable. In many cases, an AB trust or bypass trust calls for two managing trustees. It must also be said that the composition and funding of assets into a bypass trust is dependent on current tax laws, which are in constant flux. When the estate tax exemption laws are massively overhauled, many bypass trusts become obsolete due to the rise or drop in exemption limits. In nearly all cases, it’s worth revisiting and rewriting a bypass trust every few years.
An AB trust is uniquely designed to benefit married couples. However, trusts can be a powerful tool especially for blended families or unmarried couples living together. Wills and most other estate planning documents do not properly account for the complexities of modern blended families – nor do state intestacy succession laws.
Unmarried couples raising children together may find themselves disadvantaged should one of them die or become grievously ill. Trusts allow for a great degree of flexibility, so individuals can design the management and bequeathment of their wealth however they see fit – whether as a lump sum to an individual or group of people, or as a source of income to be paid out over the coming years.
A bypass trust, however, is more narrowly defined in its intended purpose. While your estate may benefit from a trust, it may not necessarily benefit specifically from a bypass trust.
At its core, a bypass trust exists to allow a married couple with a considerable combined financial wealth to “bypass” the federal estate tax exemption limit, and maximize the value of their estate for their family later on down the road.
Bypass trusts are worth it if the impact that both probate and the estate tax might have on your estate is substantial, and if both spouses agree to the limitations and strict nature of managing an irrevocable trust after their loved one has passed away.
Tax law changes are delicate, and can throw a wrench in your current or future plans. If you are interested in setting up or altering your existing estate plan, including a bypass trust, be sure to contact us at Werner Law to learn more.
Founded in 1975 by L. Rob Werner and serving California for over 48 years, our dedicated attorneys are available for clients, friends, and family members to receive the legal help they need and deserve. You can trust in our experience and reputation to help navigate you through your unique legal matters.
Whether you need help creating a living trust or navigating probate, our living trust law firm's compassionate team of estate planning lawyers and probate lawyers are here to help you and ready to answer your questions.
Our goal is to make your case as easy as possible for you. Hiring a lawyer can be a daunting task, but it doesn’t have to be. From the moment you contact our firm, through the final resolution of your case, our goal is to make the process easy and understandable. We cannot change the fact that probate is a long and complicated process, but through our Werner Law Firm Difference, we strive to go out of our way to keep you informed of your case through every step of the way. We are constantly refining our processes and procedures for a more streamlined and calm client experience. Our goal is to have you feel like a burden was lifted from your shoulders, and that we made the whole process an easy one
If you're dealing with a legal matter, we urge you to schedule a free initial appointment today and join the many satisfied clients who have contacted Werner Law Firm.
23 Corporate Plaza Dr., Suite 150
Newport Beach, California 92660