Bypass trusts: Still a viable option for wealthy families

The bypass trust is less popular today than it has been in the past. This is thanks to the increased gift and estate tax exemption ($12.06 for 2022 and $12.92 million for 2023) and a “portability” provision first made available in 2010. However, it remains a good estate planning option for wealthier families and, in fact, may enjoy a resurgence in future years. Here’s why:

How it works

As its name implies, a bypass trust (sometimes called a credit shelter trust) is designed to allow assets to bypass your spouse’s estate before others, typically children and grandchildren, inherit the property. Because the trust effectively uses the full estate tax exemption for each spouse, it may enable a married couple to transfer millions of dollars without paying any federal estate tax.

In this scenario, each spouse includes a provision in his or her will establishing a trust for the surviving spouse’s benefit and funds it with the equivalent of the deceased spouse’s basic exemption amount. Then, when the surviving spouse dies, the remaining assets go to the designated beneficiaries. If the trust is structured properly, this arrangement may avoid the federal estate tax by using the estate tax exemptions of both spouses.

Legislation intervenes

But here’s the rub: The federal gift and estate tax exemption amount has been significantly boosted since near the turn of the century when it was only $675,000. After a few gradual increases, the Tax Cuts and Jobs Act temporarily raised it to $10 million (indexed annually for inflation), for 2018 through 2025. Currently, the exemption is scheduled to revert to $5 million (also adjusted for inflation) in 2026 — unless Congress takes action.

Another factor has curtailed the estate tax benefits of a bypass trust: the portability provision initially created in the Tax Relief Act of 2010 and subsequently made permanent. Under this provision, any portion of an exemption not used by the first spouse to die becomes available to the surviving spouse’s estate. In other words, a couple now can transfer double the exemption amount — without estate taxes — no matter who the non-spouse beneficiaries are.

Option remains viable

There are still several potential reasons that you may want to include a bypass trust in your overall estate plan:

Prevent creditors from seizing assets. Assets owned individually by a surviving spouse generally become “fair game” for creditors. This can be especially bothersome to family members if a significant amount of assets is siphoned off to help pay the debts of someone who marries the surviving spouse. A bypass trust can protect the assets from the clutches of creditors.

Ensure assets pass to your children. Although the children may be named as the successor beneficiaries in the respective wills of a married couple, that could change, especially if a surviving spouse eventually remarries. There’s no guarantee that the children of the initial marriage will receive their fair share of an inheritance on the death of the surviving spouse. With a bypass trust, you can arrange for the assets to pass to your children and grandchildren, regardless of any future marriages by a surviving spouse.

Protect assets from spendthrifts. It’s possible that assets could be diluted through reckless spending by the younger generation or financial interests might be assigned to others. By including a spendthrift provision in a bypass trust, you can guard against these potential dangers, while still allowing the beneficiaries to use assets in a reasonable manner.

Grant power of appointment. Also, note that a bypass trust can provide flexibility by granting a power of appointment to a surviving spouse. Doing so can give this person legal authority to use trust assets for health care, education or other costs. As opposed to a broad general power of appointment, a limited power may permit the beneficiary to allocate only their share of the trust among classes of potential recipients.

Is the exemption sufficient?

Although the current gift and estate tax exemption is high at $12.06 million (increasing to $12.92 million in 2023), it’s scheduled to revert to $5 million in 2026 (indexed for inflation). Depending on your family’s estate planning needs, the exemption now or in 2026 may not be sufficient.

Consult with a Sol Schwartz & Associates professional to discuss the possibility of using a bypass trust or other estate planning solutions. Learn more about our trust and estate services here.  Contact us at 210.384.8000 or right here.


IRS – Frequently asked questions on estate taxes