An estate planning technique that was very popular some years ago is still present in many people’s wills, especially if they haven’t reviewed their estate plan in a while. But this technique – called a “bypass trust” – might now actually increase taxes rather than decrease them for many people, as a result of changes in the law in the last few years. If you haven’t reviewed your estate plan recently, now is a good time.
Not long ago, the federal estate tax affected even relatively small estates, and it was a big problem. One solution was to provide that, when the first spouse died, many assets would go into a trust. The trust would take care of the surviving spouse, and when he or she died, the assets would go to the children. The assets in the trust would escape, or “bypass,” the estate tax.
Now, however, the federal estate tax only affects estates worth well over $5 million (and, if handled properly, couples worth more than $10 million). So in the vast majority of cases, these bypass trusts are no longer necessary.
And in fact, they might be a bad idea.
For example, if the surviving spouse’s assets are tied up in the trust, the spouse might not have control over how they’re invested and distributed. The trust might be required to file accountings and tax forms, which can be expensive and burdensome. And if the trust generates income that isn’t passed on to the spouse right away, under current law it might be taxed at a much higher tax rate than if it wasn’t in the trust.
Yet another problem is that a bypass trust can cause a family to pay higher capital gains taxes. When the first spouse dies, if the surviving spouse inherits the assets outright, he or she gets a “step-up” in basis, meaning the spouse’s basis for capital gains purposes is the value as of the date of death. But if the assets go into a trust, there’s no step-up, and the basis is the value at the time of the original purchase. This difference can cause a big tax bite.
Bypass trusts aren’t always bad – they can be useful for avoiding state estate taxes (Massachusetts filing threshold is $1 Million) and they sometimes serve other purposes that aren’t tax-related. But if you have a bypass trust in an older will, it’s worth having it reviewed and having your estate plan brought up-to-date.