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The bypass trust, also called a credit shelter trust, remains an underappreciated way of structuring your legacy. This type of trust has declined in some popularity due to restructuring of the tax code, which made it less important for specific situations. But what many don’t know is that four huge benefits remain! Under what circumstances might a bypass trust be an optimal choice?

A bypass trust serves four core purposes:

1. To reduce or avoid estate taxes
2. To protect assets from creditors
3. To avoid changes to beneficiaries
4. To leave income available to the surviving spouse

While these can be a bit complicated to understand, I will help break this down into its components so that you can see the picture of how beneficial it can truly be.

Reducing Taxation Through a Bypass Trust

As of 2024, estate taxes are incurred for any assets above the $13.61 million mark. Keep in mind, this threshold is $13.61 million per individual. So for a married couple, they could technically pass double that amount tax-free to their beneficiaries. This limit is usually adjusted for inflation over the years.

But hold on. In the absence of a trust, this exemption amount can be significantly reduced when one spouse passes away!

Consider an example: let’s name our clients Jared and Colleen. For simplicity, let’s assume each owns $12 million in assets. Jared sadly passes away, leaving Colleen to live another ten years afterward.

Through a rule called “portability,” Colleen will actually inherit the remaining exemption amount from Jared to use when her time of passing comes. Let’s say he leaves all assets to Colleen, and has not used any of his exemption through gifts or inheritance left to non-spouse beneficiaries. She maintains the full $27.22 million exemption when passing assets to future beneficiaries.

For more on portability, Forbes has an excellent article you can read here: What Spouses Need To Know About Portability Of The Estate Tax Exemption (forbes.com)

But there are two things to beware!

1. The portability exemption that she inherited from Jared does not increase for inflation. Only her half does. So if she passes away ten years later, and the exemption amount increases around 2% each year (just an estimate), then she personally now has an exemption of about $16.59 million while Jared’s exemption remains at $13.61 million.
2. Her $24 million of assets over ten years could have grown significantly higher! If we assume even a 5% average growth rate and an annual withdrawal of $150,000 for living expenses, it could have grown to approximately $40 million!

The problem with these two combined events is that with only approximately $30 million in exemption, compared with $40 million of assets, Colleen’s beneficiaries are facing a tax bill on nearly $10 million of her estate! And the effective tax rate, as of 2024, is approximating 40%, or $4 million to Uncle Sam!

This is where a bypass trust can make a world of difference.

Bypass Trust Saves the Day!

If your net worth is above the estate tax exemption amount, a bypass trust may be accompanied by a marital trust. This two-trust split is also referred to as an A-B Trust.

If your net worth is below the estate tax threshold, then only a bypass trust is created at death.

The marital trust is owned and in full control by the surviving spouse.

The bypass trust will bypass the spouse in terms of unlimited access to principal, but it will allow him or her to receive income and/or principal to a limited degree as long as the spouse lives. After the surviving spouse also passes away, it will pass to the specified beneficiaries at that time.

What’s the advantage?

The estate is only subject to the estate tax threshold at the time of the original spouse’s passing. That means, if Jared passed away after setting up a bypass trust, he could allow his $12 million to flow into the bypass trust. If he has more than the estate tax threshold at his death, he could alternatively direct that threshold amount ($13.61 million in 2024) into a bypass trust and the rest into a martial trust.

Let’s say he leaves $2 million to the marital trust and $10 million to the bypass trust, just to give Colleen more flexibility with the $2 million. Since $10 million is below the $13.61 million threshold, it goes tax-free to the bypass trust. Because of the tax-free nature of spousal inheritance, the other $2 million to Colleen through the marital trust also is tax-free.

Colleen does not have access to the lump sum $10 million, but depending on the directions of the trust, she can take cash from it under certain circumstances. Usually, dividends and interest from the bypass trust are allowed. The 5-by-5 power is also a common feature, meaning the surviving spouse is allowed up to the lesser of $5,000 or 5% of the principal in any given year.

Over the next ten years, this $10 million might be close to $16 million even at a 5% rate of return, or $25 million at a 10% rate. Regardless of what the estate tax threshold is at that time, the entirety of the bypass trust will go to the beneficiaries tax-free after Colleen’s death.

Imagine $25 million going tax-free versus being taxed nearly 40% on anything over the threshold, which could easily be around $16-17 million in ten years’ time. A 40% tax on $9 million is $3.6 million!

Important Details to Know

In order to take advantage of the portability rule, the surviving spouse must file a Form 706 – Estate Tax Return within nine months of the death. Make sure that you do not elect to opt out of the portability option!

Note that the surviving spouse only inherits the unused portion of the estate tax exemption. So, for example, if Jared had previously gifted $3 million to his children, and designated another $3 million to go to them at his death, he will have then already used up $6 million of his estate tax exemption. Assuming a $13.61 million limit, then his DSUE (Deceased Spouse Unused Exemption) is only $7.61 million which gets added to Colleen’s exemption.

A bypass trust is not entirely tax-free to the beneficiaries. The cost basis does not “step up” when the surviving spouse dies. That means, if the value of the assets were $10 million when Jared passed, but $25 million when Colleen passed, then there exists $15 million of unrealized capital gains that will be taxed upon sale. The silver lining is that capital gains tax, as of 2024, is far less than the estate tax (20% capital gains tax at the high end, versus 40% estate tax).

The current estate tax exclusion is scheduled to reduce significantly at the end of 2025. This could cause the bypass trust to become more relevant in future years.

Other Reasons to Use a Bypass Trust

If you’re like most of us, you’re probably thinking, “That’s all great about the tax savings, but my net worth is no where near that threshold. Why would I use a bypass trust unless I were ultra-high net worth?”

As mentioned above, there are three other benefits of a bypass trust.

A bypass trust protects the money from creditors.

That means that if, for some reason, creditors come after the surviving spouse, they cannot access the bypass trust assets. These are not technically part of his or her estate or net worth, because the funds cannot be accessed in lump sum.

Let’s say the net worth of this couple is closer to $2 million together. Maybe they have children that they would like to ensure get an inheritance, but they also want to make sure that an unexpected long-term care stay for Colleen doesn’t run the children’s inheritance down to zero. They might use a bypass trust to put some away (say $500k) so that it cannot be accessed and will not count as part of Colleen’s available net worth in determining eligibility for financial medical assistance or if creditors were to ever pursue compensation.

A bypass trust avoids changes to beneficiaries.

Maybe Jared and Colleen have children from previous marriages that they want to ensure get some of the inheritance. A bypass trust’s beneficiaries cannot be changed once the trust grantor (Jared) passes away. Because of this, he can rest assured that the beneficiaries will definitely get the inheritance even if that happens many years after he is gone.

A bypass trust still provides some assistance to the surviving spouse.

Typically, one wouldn’t want to leave the entire inheritance in a bypass trust; after all, the surviving spouse needs plenty to live comfortably. But assuming that this has been properly thought through, one additional benefit of the bypass trust is that the spouse is allowed to withdraw cash within certain limitations, usually income produced and a small amount of principal (the 5-by-5 power).

This generally leads to an incentive for investing in high income assets such as bonds or dividend paying stocks, unless the surviving spouse cares more about the growth for the beneficiaries’ sake than for the income available to him or herself.

Conclusion

As you can see, the bypass trust serves very specific functions which apply to some, but certainly not all, situations.

A bypass trust might be a good fit if:

• You are an ultra-high-net-worth individual that is likely to surpass the estate tax threshold.
• You want to ensure that a certain amount of inheritance is available to certain non-spouse beneficiaries, such as children, even if the surviving spouse lives many years afterward.
• You want the peace of mind knowing that the beneficiaries are “set in stone,” so to speak, and cannot be changed.

If any of these describe your situation, you might consider discussing this option with an attorney who can delve into the details and provide customized professional advice for your situation. It can make a tremendous difference to the intended beneficiaries and provides an opportunity you likely won’t want to bypass (pun definitely intended)!