LUTZ BUSINESS INSIGHTS
Is the traditional bypass trust outdated?
justin vossen, investment adviser, principal
Many early-retirement Boomers feel comfortable that their estate plan is in order, having put their estate plan in place when they had younger children. With adult children, and the increase in the estate and gift tax exemption amounts, many feel that there is little planning to be done. However, upon review, we see plans that may need adjusting due to the recent changes in tax laws. Specifically, those plans with the AB Trust/Bypass trust structure.
How the AB trust/Bypass Trust Structure Works
With the traditional bypass trust, when the first spouse dies, the bypass trust is funded with an amount equal to the applicable exclusion amount in order to minimize federal and state estate taxes. Any remaining marital assets would transfer to the surviving spouse via a separate marital trust, typically.
Today, that amount is $11,400,000; meaning that all assets would be moved into the bypass trust if the estate is less than $11.4 million. Anything over that $11.4 million would go to the surviving spouse via the marital trust. Most folks do not have $11.4 million of assets in their name; so generally, most assets will flow to the bypass trust when trusts contain inflexible formulas for funding at death.
Assets owned by the deceased spouse receive a basis adjustment at death. However, assets placed in the bypass trust will NOT receive a second basis step at the surviving spouse’s death. This is a key worry in today’s estate planning environment. Any assets passed outright to the spouse or placed in a marital trust, WOULD receive a second step at the surviving spouse’s later death. However, the bypass trust would allow for the growth of those assets to occur outside the surviving spouse’s estate. This structure is written to use the client’s maximum estate exclusion at the first passing to primarily avoid estate tax.
Why Does/Did This Structure Make Sense?
Attorneys and planners used this bypass trust structure because estate tax avoidance was a primary concern when individuals passed away a handful of years ago. For example in 2001, the estate and gift tax exclusion was $675,000; and if you did not use that exclusion on the first death, it died with you. If you owed estate tax for amounts of assets higher than $675,000, you would have had to pay a tax of 55% on that amount. The estate tax used to be extremely punitive. Therefore, good estate planners would make sure to use the full $675,000 exemption amount at the first passing via the bypass trust. This shielded those assets and any growth from future estate taxes on the second passing.
Advantages of the Bypass Structure:
Creditor protection: This varies from state to state, so consult an attorney to understand your particular situation.
Spendthrift protection: A couple can predetermine how the surviving spouse benefits from the trust and protects the money for future generations. This also provides control of the assets for the benefit of the future generation. Also, this could shield the assets from a future spouse in case of divorce or from a comingling of assets in a mixed family situation. This could avoid the children being accidentally disinherited.
Probate: The assets in the bypass trust would avoid probate when the surviving spouse dies.
Disadvantages of the Bypass Structure:
New Laws: Today, two major things have happened, the first being the $11.4 million exclusion amount and the second was the advent of portability in 2011. Portability allows for the surviving spouse to actually “port” the amount that is unused by the first spouse which is then added to their own exclusion amount. Thus, the surviving spouse could have a $22.8 million estate and gift exclusion, as well as essentially two steps in basis if both spouses’ steps are used. The estate and gift tax percentage has also dropped to 40%, still punitive but lower than before. So, the bypass structure may no longer be needed in many cases.
Expense: Over a lifetime, the bypass trust structure is costly to create and perhaps a costly burden to administer as it requires its own tax return and administration.
Taxes: The bypass trust has a compressed (high) tax structure so careful considerations to allocations and income distribution need to be considered.
Today – What Could I Be Doing?
You need to consult your estate attorney on what is most appropriate to use in your particular situation. However, a few things should be considered:
Portability: If your assets are substantially less than the $11.4 million exemption, the portability provision has given rise to a simplified approach. This provision allows individuals to leave all of their assets to the surviving spouse and transfer their exemption to them. This allows the couple to protect $22.8 million from estate taxes without using the bypass trust planning. While this does NOT protect it from creditors or future spouses, it is a simple way to avoid the estate tax. However, keep in mind that these increased exemption amounts are due to sunset in 2026 to their pre-2018 levels.
Disclaimer Provisions: Many attorneys are drafting flexibility into plans by the use of disclaimers or “Clayton” disclaimers for federal tax planning. With this trust planning, when the first spouse dies, the surviving spouse receives the assets of the deceased spouse. At that time, the surviving spouse then has the OPPORTUNITY to make a disclaimer election. This disclaimer election would allow the assets to pass directly into a bypass or martial trust. This allows for the surviving spouse to use all or a portion of the deceased spouse’s estate exclusion amount.
Why would you want to leave the surviving spouse with a decision to make at an emotional time? The reasons to do this type of disclaimer would be to provide flexibility as the laws change over time. As mentioned, the current estate and gift exemption is scheduled to sunset at the end of 2025. Given the political climate, it may make sense to provide flexibility in the plan to do what is best at the time of the first passing.
What Should I Do?
There is not a one-size-fits-all solution for anyone with estate planning. Family dynamics, balance sheets, asset structure, and legislation continue to change as people’s lives evolve. You may not be able to achieve all of your objectives and goals with one solution, but you can get pretty close. Ultimately, creating the optimal wealth transfer plan requires an evolving strategy refined by you and your trusted advisors over time.
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ABOUT THE AUTHOR
JUSTIN VOSSEN, CFP®, NAPFA + INVESTMENT ADVISER, PRINCIPAL
Justin Vossen is an Investment Adviser and Principal at Lutz Financial. With 21+ years of relevant experience, he specializes in providing wealth management and financial planning services for high net-worth families, business owners in transition, endowments and foundations. He lives in Omaha, NE, with his wife Nicole, and children Max and Kate.
AREAS OF FOCUS
- Investment Advisory Services
- Comprehensive Financial Planning
- Business Owner Planning & Succession
- High Net Worth Families
AFFILIATIONS AND CREDENTIALS
- CERTIFIED FINANCIAL PLANNER™
- National Association of Personal Financial Advisors, Member
- Financial Planning Association, Member
- BSBA in Economics and Finance, Creighton University, Omaha, NE
- St. Augustine Indian Mission, Board Member
- Nebraska Elementary and Secondary School Finance Authority, Board Member
- St. Patrick's Church, Trustee
- Mount Michael Booster Club Board
- Lutz Gives Back, Committee Chair
- March of Dimes Nebraska, Past Board Member
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