A Bypass Trust is a legal document that allows married couples to pass along assets from one spouse to the other when one passes away in order to avoid estate taxes. When one of the spouses dies, the estate’s remaining assets are split into two different trusts. It is split into a marital trust (for the surviving spouse) and a bypass trust (for the family members).
A marital trust is revocable, whereas a bypass trust is irrevocable. The surviving spouse has complete control over the A trust. They can sell, give away or spend as they wish. The surviving spouse doesn’t own the assets in the “B” trust. But they do have access to it and can collect income from it (cannot touch the principal however). Once the surviving spouse passes away, the remaining assets from the marital trust are transferred to the bypass trust.
How Does A Bypass Trust Work?
In order to know how a bypass trust works, you must understand what the difference is between its two parts. The “AB Trust” consists of both the marital trust and the bypass trust. They act as vehicles to pass along assets, but in a different manner.
How A Bypass Trust Works
You can pass your assets on to your surviving spouse tax free upon your death. This is called the “Marital Deduction”, which allows transfer of assets from one spouse to the other without estate taxes. The caveat is that once the surviving spouse dies, the heirs could be saddled with those estate taxes (if they reach that threshold limit).
This is why a bypass trust would be critical, so that you can work around that estate tax limit by dividing the assets into the two trusts, if your estate is valuable enough to reach that federal exemption amount.
What Is An “A” Trust?
The “A” Trust, also known as the “Marital Trust”, is a revocable trust used by married couples. It would typically hold the primary checking and savings accounts as well as their primary residence for the married couple.
With an “A” trust, the surviving spouse is usually the trustee as well so that they can have immediate access to the assets. Since the spouse is typically the trustee, they can spend, sell or move assets as they see fit without having to go through any probate process.
What Is A “B” Trust?
The “B” Trust, also known as “Credit Shelter Trust” or “Bypass Trust”, is an irrevocable trust that is typically reserved for the remaining amount that you would like to go to your children, or other familial beneficiaries. This type of trust is used up to the estate tax exemption usually, as to avoid paying the federal and state estate taxes.
The heirs receive the principal amount that is passed into the trust upon the death of both of the spouses. Up until that point, the surviving spouse can collect income off of the investments within this trust.
The surviving spouse can also act as the trustee of the “B” trust, or they can hire someone to do so for them. The trustee is responsible for dividing the assets appropriately into each of the two separate trusts, as well as managing the account as detailed in the trust.
Why Use A Bypass Trust?
You should use a bypass trust if you are an affluent married couple with significant assets. This trust can help minimize both federal and state estate taxes. With a “B” trust, there is a federal exemption amount that will not be hit by the federal estate tax. For 2020, the limit is $11.58M, and for married couples it is doubled.
Obviously, if you do not reach this threshold with the family’s assets, then you will not have to pay federal taxes. Most people don’t need to worry about this amount, as it is mainly for very wealthy families. If you have more than this exemption amount in your estate and would like to avoid the tax, dividing the amount into the two trusts can shelter your assets.
Pros and Cons Of A Bypass Trust
If you are a married person with a large net worth and children that you intend to leave an inheritance to — a bypass trust should be considered. The benefits should be weighed against the disadvantages though when deciding if you should proceed with establishing a bypass trust.
Pros of A Bypass Trust
The main advantages that accompany a bypass trust come with sheltering your estate from the potential tax liabilities. Some of the other pros for this type of trust include:
- Assets that are held within the “A” trust or “Marital Trust” are not subjected to federal or state estate taxes. Surviving spouses can provide credit shelter benefits to their heirs or beneficiaries
- Assets held within a “B” trust or “Bypass Trust” are able to avoid the probate process (as with any trust)
- Can ensure that you pass your assets on to a beneficiary of your choosing. If you or your spouse have children from a prior marriage, you can make sure the inheritance is passed along to the heir(s) of your choosing
Cons of A Bypass Trust
The main cons of this type of trust depends on which vantage point you have. If you are the surviving spouse you may have more decisions to make, and potentially some limited access. Some of the other cons for this type of trust include:
- Costly and time consuming to establish and also require ongoing maintenance
- Surviving spouse is trustee by default. If they choose to designate someone else as trustee there are fees associated with them
- Surviving spouse doesn’t have access to the irrevocable bypass trust part, only the marital trust
- State estate taxes may still apply, depending upon which state you live in
Final Thoughts: Start Planning Your Estate
The bypass trust is useful for married couples with a large or very valuable estate. This could be a good tool for avoiding costly taxes when passing on your estate to your heirs. If you aren’t abundantly wealthy, this type of trust may not be for you.
Depending on the federal and state estate tax rules, you could completely avoid the estate taxes, or at the very least minimize them greatly. If you do not have a large amount of assets however, the marital trust may not allow for much to be placed into the bypass trust. It may not be as useful with a lower amount. When deciding how to plan your estate and if a bypass trust is applicable for your family, you should consider working with a financial advisor.