A bypass trust, also known as a credit shelter trust or an AB trust, is a strategic estate planning instrument designed primarily for married couples. It helps minimize federal and state estate taxes while ensuring that wealth transfers occur according to the couple’s wishes after both spouses have passed away. By keeping assets outside of the surviving spouse’s taxable estate, the bypass trust preserves the deceased spouse’s estate tax exemption and protects the assets from unnecessary taxation, creditors, or claims from new spouses.
How Does a Bypass Trust Work?
When the first spouse dies, their will or living trust directs assets—up to the amount of their federal estate tax exemption—into the bypass trust. These assets are no longer part of the surviving spouse’s estate, yet the surviving spouse can still benefit from the trust income or principal under certain conditions, typically for health, education, maintenance, and support (HEMS). This arrangement allows the assets to grow shielded from estate taxes upon the surviving spouse’s death, and eventually, the remaining assets pass directly to the designated beneficiaries, often children or other heirs.
Historical Context and the Role of Portability
Traditionally, bypass trusts helped avoid the “use it or lose it” issue under U.S. estate tax laws, where each spouse had a separate exemption amount. Before 2011, if the first spouse left all assets to the surviving spouse, the deceased spouse’s estate tax exemption was lost, potentially leading to a higher tax bill when the second spouse died.
However, the introduction of “portability” via the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 allowed the surviving spouse to claim any unused federal estate tax exclusion of the deceased spouse. While portability simplified estate tax planning for many couples, bypass trusts remain relevant, especially for managing state estate taxes, blended families, asset protection, and control over inheritance distributions.
Who Should Consider a Bypass Trust?
Bypass trusts can benefit:
- High-net-worth couples facing federal and state estate taxes exceeding exemption limits.
- Blended families where protecting children’s inheritance from previous marriages is a priority.
- Couples concerned about creditor protection or potential divorce.
- Those wanting to control the final distribution of assets beyond the surviving spouse’s lifetime.
- Residents of states with estate taxes that have lower exemption thresholds than federal limits.
Advantages and Limitations
Advantages:
- Utilizes both spouses’ federal estate tax exemptions effectively.
- Protects assets from creditors and divorce settlements.
- Ensures inheritance intentions are followed.
- Provides income and support to the surviving spouse without adding to their taxable estate.
Limitations:
- Adds complexity and administration costs to estate plans.
- Assets in the trust receive a step-up in basis only at the first spouse’s death, which may result in higher capital gains taxes for heirs upon sale.
- The surviving spouse has limited control over trust assets.
Best Practices for Using a Bypass Trust
- Regularly review your estate plan with an attorney, especially after major life events or tax law changes.
- Ensure proper funding by transferring assets into the trust after the first spouse’s death.
- Select a trustworthy and competent trustee to administer the trust.
- Clearly understand trust terms and beneficiary rights to avoid disputes.
- Consult with an estate planning professional to decide if a bypass trust or portability fits your needs best.
Common Misconceptions
- Bypass trusts are obsolete: They remain critical for various situations, especially for blended families and state-level estate tax planning.
- Surviving spouse has no access to trust funds: Most trusts provide for the surviving spouse’s income and support.
- Only for the super-rich: Even moderate estates can benefit, particularly for protecting family inheritances or managing state taxes.
Frequently Asked Questions
Can a bypass trust be changed after the first spouse dies? No, it is generally irrevocable.
What if the surviving spouse remarries? Assets in the bypass trust are typically protected from claims by a new spouse or divorce.
Do I need one if my estate is below the exemption limit? Possibly for asset protection or state taxes, but not always for federal estate tax purposes due to portability.
Are there downsides? Complexity, costs, and limited control by the surviving spouse.
For more information about estate tax strategies, see our Estate Tax Planning guide.
Authoritative External Resource
- Internal Revenue Service: Estate Tax (IRS.gov)
Bypass trusts remain a valuable estate planning tool for securing your financial legacy and minimizing tax liability. Working with a qualified estate planning attorney ensures your bypass trust meets your unique family and financial needs.