A Credit Shelter Trust (CST), also known as a Bypass Trust or AB Trust, is an estate planning tool designed to help married couples maximize the use of their combined federal estate tax exemptions while preserving assets for future beneficiaries. It is created at the death of the first spouse and holds assets up to the exemption limit, ensuring these assets are protected from estate taxes upon the death of the surviving spouse.

Understanding the Federal Estate Tax Context

The federal estate tax currently allows an exemption amount that individuals can pass on tax-free to their heirs. For 2024, this exemption is $13.61 million per individual, according to the IRS. Married couples can combine their exemptions, but without proper planning, the assets can be taxed once the surviving spouse dies.

The USC tax system includes an unlimited marital deduction, allowing spouses to transfer any amount to each other tax-free at the first death. However, this can cause issues upon the second death: the surviving spouse’s estate may be large enough to exceed their personal exemption, triggering estate taxes on the combined estate.

How a Credit Shelter Trust Works

When the first spouse dies, assets up to the exemption amount are transferred into the Credit Shelter Trust. Though the surviving spouse benefits from the trust—often receiving income and limited principal access under a “health, education, maintenance, and support” (HEMS) standard—the trust assets are not included in their taxable estate. This separation means the assets pass to designated beneficiaries, such as children, free from estate taxes upon the surviving spouse’s death.

Using a hypothetical example: Sarah and John have a combined estate worth $20 million. When John dies, $13.61 million goes into the CST, protecting that portion from future estate taxes. The remaining $6.39 million is available to Sarah outright, who can use her own exemption later, minimizing the overall tax burden.

When Should You Consider a Credit Shelter Trust?

  1. Couples with estates near or exceeding the federal estate tax exemption (currently $13.61 million per person).
  2. Blended families wanting to ensure assets from the deceased spouse pass to their specific children without risk of being redirected by the surviving spouse.
  3. Individuals seeking to protect assets from creditors and future estate claims.
  4. Those desiring control over how and when beneficiaries inherit assets.

Benefits Beyond Tax Savings

While estate tax reduction is a primary goal, Credit Shelter Trusts also offer protection against creditors and divorces, maintain clear distribution instructions, and can help manage state estate taxes where exemptions may be lower.

Comparing Credit Shelter Trusts with Portability

Since 2011, federal law allows “portability,” where a surviving spouse can claim the unused estate tax exemption of the deceased spouse without establishing a trust. However, portability does not provide asset protection or control over distributions. Therefore, many estate plans combine portability with a CST to optimize benefits.

Setting Up and Funding a Credit Shelter Trust

Setting up a CST requires legal expertise. It’s typically included in wills or revocable living trusts drafted by an estate planning attorney. On the first spouse’s death, the trust is funded with assets up to the exemption amount, through proper titling and clear instructions. Regular reviews are essential to adjust for tax law changes and life events.

Common Misconceptions

  • Portability makes CSTs unnecessary: Portability lacks protective features inherent to CSTs.
  • Only for the super wealthy: CSTs can apply to moderate estates, especially with state taxes.
  • Surviving spouse loses access: The surviving spouse generally can access income and principal under conditions.
  • Too complex to establish: Professional help simplifies the process.

Related Trust Types

For those interested in understanding more about trusts, explore definitions and differences of revocable living trusts, irrevocable trusts, and testamentary trusts on FinHelp.

External Resources

For official IRS guidelines on estate taxes and exemptions, visit IRS Estate and Gift Taxes.

Establishing a Credit Shelter Trust can be a powerful component of your estate plan. Consult with qualified estate planning professionals to tailor a strategy that fits your assets, family structure, and long-term goals.