We like to tell our clients that when you die, your money goes one of three places: to your descendants, to charity, or to the federal government. You have some control over the first two, and the government will take the rest.
Obviously, the truth is a little more complicated than that, but the fact remains that estate planning is a vital component of anyone’s wealth management strategy. You can’t take it with you, so it’s worth the time to decide what will happen to your money in the event of your death.
That’s where a tax bypass trust can come in handy. If you simply leave money to your descendants, it’ll be taxed at whatever the current estate tax rate is — in 2020, that’s 40 percent for any bequests over $1 million. There are gift and estate tax credits that will offset some of that tax bill, but if you have a substantial estate, it’s in your best interest to defray that tax bill as much as possible.
How a Tax Bypass Trust Works
Any person can leave their estate to their spouse in the event of their death without having to pay estate tax on those assets. However, when the second spouse dies, any assets over the exemption limit of $11.58 million per individual or $23.16 million for married couples that are left to your children will be taxed at rates up to 40 percent.
A tax bypass trust or “A/B trust” is designed to avoid that estate tax. When one spouse dies, the entire estate is divided into two separate trusts: the “A” trust and the “B” trust.
The A trust is a revocable trust (the marital trust) that belongs to the surviving spouse for them to do with as they please. The B trust is an irrevocable trust (the family trust) intended for the couple’s descendants. The surviving spouse can access that trust and gain income from it (like dividends from stocks), but they can’t spend, sell, or give away assets.
Since the surviving spouse doesn’t own the assets in the family trust, the assets in it aren’t counted in their estate when they die. By dividing your estate into two separate trusts like this, you may be able to keep the value of bequeathed assets near or below the $11.58 million mark, allowing your descendants to avoid millions in estate tax.
For example, if you leave $30 million to your children in a direct bequest in your will, they’ll pay roughly $7.4 million in taxes on that money. If you divide it up into a $10 million trust for your spouse and a $20 million trust for your children, the tax bill will go to zero, since both trusts are under the exemption limit.
Other Factors to Consider
Setting up a trust of this size isn’t a straightforward matter, so you’ll need the help of an experienced estate attorney when deciding how to divide everything up. You’ll need to decide how much of your assets will go into the A and B trust, and which kinds of assets will go where. Since the assets in the B trust are valued as of the date of the first spouse’s death and aren’t taxed until the surviving spouse dies, it makes sense to put higher appreciating assets in the B trust where they can continue to gain value over time.
The trustee will also need to obtain the fair market value of the trust’s assets as of the date of the first spouse’s death. This can be a time-consuming process, given the fluctuating value of stocks, funds, property, and other assets.
Talk to First Western Financial
If you’re ready to start taking wealth management seriously, estate planning is a major component of that process. At First Western Financial, we can take stock of your goals, priorities, and assets to come up with a plan that’s uniquely tailored to you. Get in touch today.
*This post is not intended as tax advice, consult a qualified tax advisor for your situation.
