Bryan Strike, CFP®, CPA/PFS has a great article in the latest issue of the Journal of Financial Planning entitled, “Should Planners Bypass the Bypass Trust?”
I’m going to summarize the article here in order to explain why you might want to have a bypass trust even after the unified credit changes for estate planning in 2013. Read the full article for more information after reading this summary.
Using a bypass trust, when the husband dies first, $5.25 million of investments can get a step up in cost basis and be put in a bypass trust. The wife can (normally) use those assets or at least the income and the children ultimately inherit the assets after the wife passes away.
Without a bypass trust, the new unified credit rules say that when the wife is the second to die there is a unified credit of $10.5 million and everything gets a step up in cost basis when she dies. The husband’s amount which is excluded from estate taxes is said to be portable and can be used by the wife’s estate when she dies.
Normally there is little difference between these two options. But here are some of the subtle differences:
Remarriage: If the wife remarries and it then widowed again, the unused exclusion from the first decedent spouse is wasted. It would have been better to have gotten a $5.25 million exclusion from husband #1 and another $5.25 million exclusion from husband #2 before getting the final $5.25 million exclusion from the wife passing away. Using the first husband’s exclusion allows $15.75 million to avoid the 40% estate tax.
Marrying a string of dying men is one method of avoiding estate taxes.
If after the first husband dies without setting up a bypass trust the wife is considering remarrying there is another approach which she can take. She can gift up to $5.25 million any time before her second husband dies. The “temporary regulations” are currently interpreted as any taxable gifting made by the surviving spouse will first use the unused exclusion from the most recently deceased spouse. On the one hand $5.25 million more avoids estate taxes. On the other hand, money in a bypass trust is easier to use if needed than money which has been gifted.
Protection from creditors and lawsuits: A bypass trust can protect asset. Since the trust was created and funded by the late husband, its provisions can protect the wife better from creditors and lawsuits. The protection gained this way varies from state to state.
Transfers two or more generations: Portability of the deceased husband’s $5.25 million applies only to the estate exclusion. A trust is required to allow the wife to benefit from the husband’s assets and still leave those assets to the grandchildren.
Preventing accidental inheritance: The wife’s remarriage changes her default inheritance while a trust keeps that inheritance clearly defined.
Professional management, spendthrift provisions, and avoiding probate: These can all be benefits of having a trust.
Growth outside of the estate: If the husband puts $5.25 million in a bypass trust it can grow to $22 million before the wife dies and still avoid estate taxes.
Details on each of these benefits to using a bypass trust are important and found in the original article.
The use of a bypass trust can also provide some downsides including…
Costs: It can cost a couple of thousand dollars to set up a bypass trust.
Limited access: A bypass trust can limit a spouse’s ability to spend from the trust. I’ve seen trust which are very restrictive and trusts which give a spouse much freedom to spend the assets.
Trusts are taxed more severely: Trust income tax brackets are compressed and reach the higher tax brackets relatively quickly. Most surviving spouses have the income from the trust distributed to them each year which alleviates this problem. This does, however, reduce some of the benefits of leaving the growth in the trust. It leaves the unrealized capital gains but does not leave the interest and dividends.
Potential capital gains problem for the heirs: For amounts lower than the estate planning limits, capital gains growth would be better in the surviving wife’s assets. Capital gains there would get a step up in cost basis upon her death. Capital gains in a deceased husband’s bypass trust would have already received a step up in cost basis upon his death. any subsequent gains would have to be paid when the ultimate heirs decided to sell.
The new unified credit changes for estate planning in 2013 have once again changed when you should have provisions for a bypass trust.