There is no greater vehicle for protecting generational wealth than a well-crafted estate plan. To that end, there's no reason to sacrifice complete access to today's assets for a tax shelter in the distant future. With the help of a Bypass Trust, married couples can provide income for their spouses today and protect assets from the costly probate process in the future.
Understanding what a Bypass Trust is and how it works is essential in securing your financial future. As a result, we've developed this guide to tell you everything you need to know about these accounts, including:
What is a Bypass Trust?
Otherwise known as a Residual Trust, a Bypass Trust is one of the many types of Trusts created when one spouse in a Joint Trust passes away. When each person in the relationship agrees to create a Bypass Trust (or any other sub-trusts), it will be created when one passes away. That's not to say a Joint Trust turns into a Bypass Trust when one person dies, but rather that a Bypass Trust can be added to the original terms of the Joint Trust.
Sometimes referred to as a Credit Shelter Trust, Residual Trust, or Family Trust, a Bypass Trust helps couples minimize liabilities on future estate taxes. Instead of passing directly to the surviving spouse, the assets of the individual who passed away will be placed in an irrevocable trust account. In doing so, the account will receive the decedent's assets (depending on the terms of the original Trust).
The surviving spouse may benefit from the Trust's assets indirectly, meaning they may be entitled to income generated from the assets in the Residual Trust. However, the irrevocable nature of Residual Trusts significantly limits control of the account. The surviving spouse may collect income but won't own the assets outright. As a result, Residual Trusts can help reduce the estate tax liability of the surviving spouse when they die because the assets held in the account are not considered part of their estate.
What is the purpose of a Bypass Trust?
The purpose of a Bypass Trust, or one part of an AB Trust, is to minimize a couple's tax liability during the estate planning process. In doing so, the new account receives the assets of the first spouse that passes away — up to the estate tax exemption limit. As an irrevocable Trust, the new account grants the surviving spouse little control. In return for the limited access, the assets bypass costly estate taxes.
During their lifetime, the surviving spouse may be allowed to draw upon income generated from the account. Still, the real purpose of a Bypass Trust comes into play when the second spouse passes away. At the time of the second spouse's death, assets won't be included in the taxable estate. As a result, the assets may be passed on to named beneficiaries without incurring significant estate taxes.
How a Bypass Trust works
As its name suggests, a Bypass Trust places the deceased spouse's assets in a trust account and allows them to bypass the surviving spouse and costly estate taxes. More specifically, however, a Bypass Trust works by following these steps:
To establish a Bypass Trust, each person in a Joint Trust must agree to include it in terms of the original Trust documents. The terms must state a Bypass Trust will be created upon the passing of the first spouse.
While both spouses are alive, the Joint Trust will remain intact. However, once the first spouse passes away, the Bypass Trust will be created. The deceased spouse's assets (or the amount specified in the original Trust) will be transferred into the Bypass Trust (usually maxing out at the estate tax exemption limit).
The surviving spouse's assets (or those over the estate tax exemption limit) are generally transferred to a Survivor's Trust.
The Bypass Trust becomes irrevocable, even if the original Joint Trust was revocable. As a result, the surviving spouse has very little control over the assets in the Bypass Trust.
Outside of providing limited income in certain situations, the Bypass Trust bypasses the surviving spouse. When the surviving spouse passes away, the Trust passes the assets to its named beneficiaries.
True to its name, the Bypass Trust will allow the assets in its account to bypass estate taxes (up to the exemption limit).
Since the assets in the Bypass Trust aren't part of the taxable estate, the couple's estate tax liability can be reduced and preserve capital for beneficiaries.
Bypass Trust advantages
The advantages of using a Bypass Trust include, but are not limited to:
Save on estate taxes: The assets held in a Residual Trust are not included in the estate's value (up to a certain amount). When the assets transfer to a beneficiary, capital is preserved because they are not subject to an estate tax.
Asset protection: Assets in a Residual Trust are protected from creditors and lawsuits, ultimately keeping them safe from litigious activities that may threaten their value.
Creator control: While the surviving spouse won't be able to control the Residual Trust due to its irrevocable nature, the original creator can rest assured the assets will be used for their intended purposes.
Bypass probate: Assets in a Residual Trust can bypass the lengthy and costly probate process. Since the Trust dictates how the assets get distributed, there's no need to rely on a probate court.
Privacy: Residual Trust terms are private, unlike a Will.
Bypass Trust disadvantages
The disadvantages of using a Bypass Trust include, but are not limited to:
Loss of control: Once created, Bypass Trusts are irrevocable and can't be changed. Consequently, ownership of the account transfers from the creators to the Trust itself.
Complexity: The nature of a Bypass Trust is complex. Those looking to set one up should consult a professional before taking the first step.
Expensive: The legal fees, accounting fees, and other costs associated with creating and maintaining a Bypass Trust can add up.
Tax implications: While Bypass Trusts minimize estate taxes, their income may be subject to income taxes.
What is an example of a Bypass Trust?
Let's say, for example, a couple has a combined estate valued at more than $10 million they wish to leave to their children. Their priority is to ensure that assets are distributed to beneficiaries as they intend and with minimal estate taxes cutting into the account's value. To do so, the couple sets up a Residual Trust with the help of a qualified professional.
When one of the two inevitably passes away, their assets are transferred into the Bypass Trust per the terms of the original Joint Trust agreement. Since the new account is irrevocable, the surviving spouse has very little control over the assets in the Bypass Trust. Throughout the surviving spouse's life, they may be able to generate income from the assets in the Bypass Trust, but that's about it.
When the surviving spouse dies, however, the assets in the Bypass Trust won't be subject to probate or estate taxes, which can help reduce their overall estate tax liability. The beneficiaries are then set to receive more capital relative to the amount sheltered from additional taxes and costs.
Bypass Trust vs. Survivor's Trust
A Bypass Trust is created if one spouse in a Joint Trust passes away. Subsequently, the deceased spouse's assets are transferred into the irrevocable Bypass Trust, where the surviving spouse has little control. A Survivor's Trust, on the other hand, is where the surviving spouse's assets are sent when the first spouse passes away.
Unlike a Bypass Trust, however, a Survivor's Trust is revocable and entirely changeable. The surviving spouse is free to do whatever they like with the assets in a Survivor's Trust. That said, Survivor's Trust assets are not extended the same tax advantages as their Bypass counterparts.
To learn more about the differences between Bypass Trusts and Survivor’s Trusts, be sure to check out our full guide here.
Bypass Trust vs. Marital Trust
The most significant difference between a Bypass Trust and Marital Trust is how each deals with estate taxes. While a Bypass Trust allows the surviving spouse to protect assets from estate taxes (up to the estate tax exemption amount), a Marital Trust may simultaneously defer taxes and provide for the surviving spouse.
Does a Bypass Trust file a tax return?
A Bypass Trust does not file a tax return. If for nothing else, assets in the account do not figure into the surviving spouse's estate. That said, any income the surviving spouse generates from the assets in the account will be subject to personal income taxes.
How to set up a Bypass Trust
A Bypass Trust can be an invaluable estate planning tool. Set up correctly, a Bypass Trust can shelter wealth for generations and provide the ultimate peace of mind for its creators. That said, it's not enough to throw some terms together. Instead, you need to consult a qualified estate planning attorney to determine if a Bypass Trust is the right option for you and your loved ones.
Here at Trust & Will, we keep things simple. You can create a fully customizable, state-specific estate plan from the comfort of your own home in just 20 minutes. Take our free quiz to see where you should get started, or compare our other estate planning and settlement options today!
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