According to some people, the bypass trust (sometimes referred to as a credit shelter trust) has gone the way of the dodo bird in the current estate tax environment. However, this “dinosaur” of a technique for married couples is far from extinct. In fact, it may return to prominence as a scheduled estate tax law change looms in the near future. (See “Prepare for a potentially lower exemption” below.)

Taking the bypass route

As the name implies, a bypass trust allows the trust’s funds to bypass your spouse’s estate and go straight to the trust’s beneficiaries, such as your children. Because the trust effectively uses the full federal gift and estate tax exemption for each spouse, it may enable a married couple to transfer millions of dollars estate-tax-free.

Typically, each spouse includes a provision in his or her will that sets up a bypass trust for the surviving spouse’s benefit, and funds it with the equivalent of the deceased spouse’s exemption amount. The exemption amount is the amount that’s sheltered from estate tax in addition to the marital deduction for transfers between spouses.

When the first spouse dies, the assets are transferred to the trust. After the surviving spouse dies, the remaining assets go to the beneficiaries. If the trust is properly structured, this arrangement could avoid estate tax by using the estate tax exemptions of both spouses. That was often the primary motive behind bypass trusts.

A brief history lesson

Estate tax planning took a dramatic turn in 2001 when the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) became law. Previously, the estate tax exemption amount was a relatively paltry $675,000. The EGTRRA gradually raised it from $1 million to $3.5 million. Under EGTRRA, the estate tax was completely repealed — but for 2010 only — before it returned in 2011 with a $1 million exemption.

A subsequent tax law allowed for the “portability” of the unused exemption amount of the first spouse to die. In other words, if there was a $1 million exemption amount remaining in the estate of the spouse who died, that amount could be added to the estate tax exemption of the surviving spouse. This essentially doubled the exemption amount for some families. Accordingly, the need for using a bypass trust for estate tax purposes was reduced.

In addition, the exemption amount was hiked to $5 million and ultimately preserved until the Tax Cuts and Jobs Act (TCJA). And that’s when things really got interesting.

For starters, the TCJA doubled the $5 million exemption to $10 million, and added inflation indexing through 2025. The exemption amount for 2024 is $13.61 million. Thus, the maximum current tax shelter for a couple is a staggering $27.22 million. Only the wealthiest of families would exceed this amount.

Other benefits

Nevertheless, there are several other reasons why you might consider a bypass trust. Normally, assets that are owned individually by a surviving spouse are fair game for creditors. To add insult to injury for other family members, assets might be siphoned off to help pay the debts of someone who marries the surviving spouse. However, a bypass trust protects the assets from the clutches of creditors, while protecting them from lawsuits.

If children are named as 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 inheritance after the surviving spouse dies. With a bypass trust, you can guarantee assets pass to your children, regardless of any future marriages.

Furthermore, assets can be squandered through irrational spending by beneficiaries. If this is a concern, consider adding a spendthrift provision to your bypass trust. It can guard against frivolous spending while allowing the assets to be used in a reasonable manner.

A bypass trust can also provide flexibility by granting a power of appointment to the surviving spouse. This gives the surviving spouse the ability to access trust assets for specific reasons, such as health care or education-related expenses. Instead of granting a broad, “general power” of appointment, consider using a “limited power” of appointment. Here, the person holding the power of appointment can give assets to a select group of people who’ve specifically been identified by the deceased.

Finally, some states impose state estate tax with a lower estate tax exemption amount than the federal exemption. A bypass trust may be a viable solution for minimizing state tax.

Right for your plan?

Does a bypass trust make sense for your estate plan? It depends on your personal situation. Although the current record-high federal gift and estate tax exemption amount may make a bypass trust less useful, these arrangements can still serve a useful purpose for many married couples. After all, the estate tax “certainty” under current law is only temporary. Therefore, the benefits of a bypass trust should be valuable for years to come.

Sidebar:   Prepare for a potentially lower exemption

Under the Tax Cuts and Jobs Act, the federal gift and estate tax exemption is scheduled to revert to $5 million, indexed for inflation, after 2025. If this becomes reality after 2025, a bypass trust will become more relevant for a greater number of families.

Of course, Congress could act before then, by extending or preserving the higher exemption amount or otherwise modifying the estate tax laws. Much depends on the outcomes of the elections this fall.

Best approach: Develop an estate plan based on current laws that’s flexible enough to accommodate changes.