Do you still need a bypass trust?

Recent changes have eroded some of the estate tax benefits of bypass trusts. And, if President Trump gets his way, the federal estate tax could be completely repealed.

Strategy: Don’t junk these trusts just yet. Although the need for bypass trusts may have diminished, and future savings are in doubt, these arrangements could still make sense.

Take a look at the big picture before you make any rash decisions.  

Here’s the whole story: In the past, well-to-do individuals often reduced their exposure to federal estate tax liability by combining two fundamental tax breaks.

1. Unlimited marital deduction: Any transfer between spouses, whether it is made during one’s lifetime or upon death, is completely exempt from estate and gift taxes.

2. Estate tax exemption: Transfers to a nonspouse beneficiary may be sheltered by the estate tax exemption. Under current law, the effective exemption amount is $5 million (indexed to $5.49 million for 2017).

Thus, by leaving your entire estate to your spouse or vice versa, you’re wasting the exemption of the first spouse to die. Upon the death of the surviving spouse, assets valued above the available exemption amount are subject to estate tax.

The bypass trust was created to avoid this result. Typically, the trust was funded with assets equal to the estate tax exemption amount available at death. A surviving spouse could be a beneficiary of the bypass trust. As long as the trust was properly drafted, the value of the assets were included in the deceased spouse’s estate and sheltered by that person’s exemption.

However, the “portability” provision mitigates the tax-saving reason for a bypass trust. Under this provision, the estate of a surviving spouse can elect to use any remaining exemption of the deceased spouse.

Thus, bypass trusts don’t pack the same estate tax-saving punch. And estate tax repeal would render this issue moot. But a bypass trust may still be viable for these nontax reasons.

  • Assets in the trust are generally protected from creditors; if they pursue a surviving spouse, the assets remain intact for the family.
  • Your kids might otherwise squander money they inherit. By including a spendthrift provision in a bypass trust, you can guard against wild spending sprees, while still allowing the assets to be used in a reasonable manner.
  • With a bypass trust, you can protect against assets being directed to a person, or persons, whom you do not wish to benefit.
  • A wealthy individual may still use a bypass trust to arrange for assets to eventually pass to your children. This could be particularly important for a second marriage.
  • A bypass trust can provide additional flexibility by granting a power of appointment to the surviving spouse. This gives the spouse the ability to invade trust assets for his or her health, education, maintenance or support.

Tip: Meet with an estate planning pro to determine the best course of action.