Balancing Your Estate Plan With Bypass Trusts

For decades, the bypass trust was a popular estate planning tool for wealthy couples who wished to take full advantage of the federal estate tax exemption and bequeath more of their wealth to successive generations. However, recent changes to estate tax laws have made bypass trusts unnecessary for many. Individuals may now exempt $5.43 million from estate taxes in 2015, but grants surviving spouses a “portability exemption” that allows the total amount shielded to rise to over $10 million per couple.

New Exemption Eliminates Need for Many — for Now

The lower the estate tax threshold, the more popular bypass trusts became. A married taxpayer may bequeath an unlimited amount of assets to a spouse without triggering federal estate taxes — a practice known as the unlimited marital deduction. A missed opportunity arises when a surviving spouse inherits these assets and subsequently dies with an estate that is worth more than the amount of the federal estate tax exemption for couples. As that amount is now $10.9 million, fewer couples will have a need for this type of trust to shelter their assets.

However, there are currently a number of states — including New York, Ohio, and Minnesota — that impose their own estate taxes separate from the federal government. Residents of these states may find that a bypass trust still has benefits. The trust also may make sense for a remarried individual who wishes to pass along select assets to children from an earlier marriage.

How Bypass Trusts Work

Couples often establish bypass trusts within the framework of a living trust that determines legal ownership of the couple’s assets. Estate planning experts typically recommend “titling” or assigning assets so that each spouse maintains a bypass trust with assets that are worth close to the value of the current estate tax exemption. Because the couple has limited control over these assets, they typically are those that the couple does not intend to use during their lifetimes.

Upon the death of the spouse who dies first, the surviving spouse inherits the decedent’s assets that are not part of the decedent’s bypass trust. Because of the unlimited marital deduction, there is no immediate estate tax liability for these assets. The surviving spouse is the beneficiary of the decedent’s bypass trust, which will not be included in the surviving spouse’s estate. The assets used to fund the decedent’s bypass trust thus “bypass” the estate tax that otherwise would have been assessed upon the death of the surviving spouse. Under certain circumstances, the surviving spouse may have limited access to the assets held by the trust. When the surviving spouse dies, the couple’s heirs become beneficiaries of both bypass trusts.

Regularly Monitor Its Funding

If you do decide to establish a bypass trust, it’s important to review your estate plan periodically to make sure the value of the assets placed in the trusts approximates the current federal estate tax exemption. For example, if you fund a bypass trust with stock that subsequently drops in value, you may need to title additional assets to the trust to achieve the maximum estate planning benefit.

Determining which asset should be placed in bypass trusts is critical in achieving the maximum benefit from them. Certain types of assets, such as retirement accounts and jointly owned property, do not qualify for the federal estate tax exemption. Therefore there is no tax benefit in including them in a bypass trust. Assets that couples often place in bypass trusts include mutual funds, securities, and real estate.

Trusts are complex, so be sure to consult an experienced estate planning attorney if you and your spouse want to include them within your estate plan. Your tax advisor and financial professional can help you navigate the options and formulate a plan that fits your needs.

The information in this article is not intended to be tax advice and should not be treated as such. You should consult with your tax advisor to discuss your personal situation before making any decisions.

Points to Remember

1. Bypass trusts are designed to enable a couple to maximize use of the federal estate tax exemption and bequeath more wealth to heirs.
2. Estate planning experts often recommend that each spouse maintain a bypass trust with legacy assets whose value approximates the current federal estate tax exemption.
3. The couple’s heirs ultimately become beneficiaries of the bypass trusts. Because the assets within the trusts are not subject to the federal estate tax, the corresponding exemption can be applied to other family assets.
4. Because certain assets, such as employer-sponsored retirement plans and jointly owned property, do not qualify for the federal estate tax exemption, there is no tax benefit in including them in a bypass trust.
5. Qualified tax and insurance professionals can help you understand the federal and state tax implications of a life insurance donation.
6. If the amount of the federal estate tax exemption has increased or the assets within bypass trusts have declined in value, additional assets may need to be titled to the trusts for maximum tax benefit.

LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.