Financial Advice for Retirement, Social Security, IRAs and Estate Planning

Everything You Need to Know About Estate Planning Bypass Trusts & Irrevocable Trusts

Published on: Dec 22 2017
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Many observers think two popular Estate Planning kinds of trusts will no longer be needed.

They’re wrong… in fact, these two trusts are as valuable as ever!

Benefits that once were considered ancillary now are important to many estates. Though no longer created primarily for estate tax reduction, these two trusts can be essential to reaching other estate planning goals.

The Bypass Trust 

Also called the A/B trust, credit shelter trust and other names, the bypass trust primarily was used to ensure maximum use of the federal estate tax exemption.

Under the old standard estate plan for married couples, after the first spouse passed, part of the estate equal to the estate tax exempt amount would be directed to the bypass trust. The rest of the estate would pass to the surviving spouse.

The surviving spouse would receive all the income from the trust and distributions of principal as necessary. After the surviving spouse passed, the trust would be distributed to the children or other named beneficiaries.

The result was no federal estate taxes on the estate of the first spouse to pass away, and full use of the first spouse’s lifetime tax exemption.

Today’s higher lifetime exemption, and the portability of the exemption from one spouse to another, keep most estates tax free without a bypass trust. But the trust has other important uses.

The bypass trust delivers control and certainty over the eventual disposition of assets.

You know that part of the estate first will support your surviving spouse, and then will go to your children, or whomever else you designate as beneficiaries.

These factors can be especially important when one or both spouses had a previous marriage with children, or if the surviving spouse remarries.

The bypass trust also prevents someone else from influencing your surviving spouse to distribute the assets in a different way.

The trust also lets you determine how the wealth is distributed to your children, or other beneficiaries, after your spouse passes away.

You can have it all distributed to them in a lump sum. Or the trustee can retain most of the property for a period of years, and distribute income or other amounts each year until a final distribution occurs. (There is a wide range of possible distribution strategies.)

Asset protection is another advantage of the bypass trust.

The assets in the trust will be protected from creditors of the surviving spouse and the children as long as the assets remain in the trust.

The trust also protects the assets from being taken by a spouse of one of your children in a divorce.

Creating a trust allows you to determine the initial trustee, and at least the process for selecting any successor trustee.

That lets you influence the investment policy and reduces the odds an unscrupulous or incompetent individual will gain control of the assets and either mismanage or embezzle them.

The bypass trust also ensures that the estate tax exemption amount of the first spouse to pass away isn’t wasted.

The portability of the lifetime estate and gift tax exclusion from one spouse to another isn’t guaranteed. The estate executor could make a paperwork mistake that loses the exemption of the first spouse to pass.

A bypass trust can provide family income tax savings when the trust generates significant income each year, and the beneficiaries have incomes or other income-generating assets.

Then, the trustee can coordinate investments, income and distributions to reduce the family’s overall tax burden.

For this to work, the trustee must be fairly sophisticated, and have wide discretion over the investment strategy and annual distributions.

The Irrevocable Trust 

When an estate might be taxable, a common tax reduction strategy is to remove assets from the estate during the owner’s lifetime, especially assets that are likely to appreciate.

One way to do that without giving beneficiaries full control is to put the assets in an irrevocable trust.

The irrevocable trust still provides a range of benefits, even for nontaxable estates.

Of course, the tax reduction benefits still exist for estates that are approaching the taxable level, or when your state is one of the few that has estate or inheritance taxes, especially when the threshold for taxation is low.

Just like the bypass trust, the irrevocable trust protects assets from creditors, lawsuits and divorcing spouses. The level of protection depends on state law.

As with the bypass trust, the irrevocable trust allows you to set the ultimate distribution of the income and assets to the beneficiaries.

Plus, the trustee can offer professional investment management, and insulate the assets from poor decisions of beneficiaries.

You also should know that irrevocable trusts aren’t as inflexible as in the past.

In many states, there are ways to modify an irrevocable trust without a court order.

For example, in many states an irrevocable trust can be modified by unanimous agreement of a living grantor, all the fiduciaries (trustees) and all the beneficiaries.

You also can include a provision in the trust that allows the trustee to move the trust’s situs, or residence, to another state. That can be helpful, because state taxes and trust laws change.

Some states allow a process known as decanting.

When decanting is allowed by state law and in the trust agreement, the assets can be transferred to a new irrevocable trust with some different terms.

This essentially allows you to rewrite an irrevocable trust, within limits, if your circumstances or the laws change.

Of course, there are disadvantages to both Types of Trusts.

There is the cost of creating them, and the trustee might have to be paid out of trust income and assets.

The trust also will be a separate taxpayer. It needs a taxpayer identification number and must file its own income tax return.

Trusts reach the highest income tax bracket at much lower income levels than individual taxpayers, so careful tax planning might be needed to avoid high taxes on trust income.

Also, when someone inherits assets through a trust, the basis of assets isn’t increased to fair market value as it is when assets are inherited through the estate.

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