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After New Tax Law, Do You Still Need A Bypass Trust?

At long last, the 2010 Tax Relief Act brings some clarity to estate planning. But the law will be in effect only through 2012, and the future beyond then remains cloudy. So it’s important to assess your situation carefully before making changes to your plan. For instance, though provisions of the new law might suggest bypass trusts are no longer needed, junking yours now may not be the wisest move.

During the past 10 years, the estate tax landscape has been constantly shifting. Beginning in 2001, key changes were gradually phased in. The exempt amount that an individual’s estate could shield from taxation grew from $1 million to $3.5 million in 2009, while the top estate tax rate decreased from 55% to 45%. Comparable changes also took effect for the generation-skipping tax (GST), and the gift tax and estate tax systems, formerly unified, each got its own rules, with the lifetime exemption from gift tax staying at $1 million. Meanwhile, the tax treatment of inherited assets was also revised. Though there was no estate tax in 2010, heirs who received stock or other securities that year faced steeper capital gains taxes when the assets were sold.

Under the new law, passed late in 2010, the estate tax exemption jumps to $5 million for 2011 and 2012 (indexed for inflation in 2012), while the top estate tax rate drops to 35%. And now an individual’s exemption is “portable,” meaning that a surviving spouse can use any amount left over after the first spouse’s death. That means a married couple can together shield a total of $10 million from estate taxes. And the rules on inherited assets have reverted to their pre-2010 form, allowing heirs to “step up” the cost basis of securities to their value on the day of death. Finally, the new law reunifies the estate and gift tax systems and coordinates those changes with the GST.

The overall impact of the new rules is to reduce the tax burden of transferring assets from one generation to the next. In particular, the higher exemptions and the portability feature mean that much larger amounts can go to heirs without complication or penalty.

But does that mean that one of the most commonly used estate planning vehicles, the bypass trust, is no longer needed? With a bypass trust, there’s a provision in each spouse’s will to fund the trust using the estate tax exemption. So, for example, if a husband died in 2009, $3.5 million (then the maximum exempt amount) could go into the trust, thus “bypassing” the wife’s estate. And though income from the trust could go to support the wife, most of the assets would ultimately pass to the couple’s children or other beneficiaries without estate taxes. When the wife died, her exemption could then also be used to send estate tax-free assets to the couple’s heirs. Without such a trust, the husband’s assets would have gone to the wife—spouses can generally inherit an unlimited amount from each other without taxes—but when she died, there would be only her exemption to reduce the tax liability of the larger estate. The husband’s exemption would have been wasted.

Under the new tax law, such maneuvering may no longer be necessary. Now, the maximum exemption is a generous $5 million, and the portability provision means that the first spouse’s exemption won’t be wasted, even if the surviving spouse inherits directly. The total amount a couple together can shield from estate tax is $10 million—period.

Yet even now, there could be reasons to keep a bypass trust. Though one benefit of a trust is to minimize taxes, it may also control how assets are distributed—keeping a spendthrift spouse from burning through the money, for example, or providing protection from creditors. Also, the GST exemptions for a couple aren’t portable, so a bypass trust may be needed to maximize gifts to grandchildren. What’s more, there’s no guarantee that today’s estate rules will continue after 2012. When the current law expires, its replacement could reduce the amount of the exemption or end portability, restoring much of the old rationale for establishing a bypass trust.

If you already have a bypass trust, you may want to check the language in the trust documents to make sure the new tax law doesn’t lead to unintended consequences—for example, by sending too much of your combined estate into the trust and shortchanging the surviving spouse. Or you may decide to create a trust now, because of its non-tax benefits. We can work with your attorney to help determine what works best in your situation.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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