Protect your assets from taxes with this powerful estate planning tool.
One of the ways the federal government generates money is by collecting estate tax, which is a tax on the property you transfer upon your death. In 2006, each person whose assets in their estate are over $2 million may be subject to estate taxes. In 2001, the most recent year with available statistics, the IRS collected $20.8 billion in revenue from the estate tax.
If you are married, however, there is some good news about possibly reducing/eliminating that tax. "The federal government gives married couples tax-free property transfer credits, also known as unified or exemption credits"
, explains Derek Ferriera, CFP, CLU, ChFC, REBC, a financial planner with Lincoln Financial Advisors/Sagemark Consulting in Campbell, Calif. "A bypass trust is a very powerful tool for spouses who want to reduce/eliminate an estate tax because the trust maximizes those credits and minimizes taxes when assets are passed to the next generation."
The federal government sets ceilings on the amount of assets exempt from the estate tax ($2 million through 2008) and taxes the value of an estate that exceeds that amount (the rate in 2006 is 46%). But by doing proper planning and setting up a bypass trust, you may be able to shield some of your assets from federal estate tax and possibly also increase the value of the assets you are passing to your heirs, says Ferriera.
How a Bypass Trust Works
"Without a bypass trust, sometimes referred to as a credit shelter trust or an exemption equivalent trust, assets owned by the first spouse transfer upon death to the surviving spouse tax-free", says Ferriera. But that may simply increase the surviving spouse's estate when there is only one exemption, which could trigger an unnecessary estate tax. If assets are passed to a bypass trust, however, no estate tax would be owed on assets of $2 million or less.
A bypass trust is typically created in a living trust or a will, and the assets are then managed within the trust, says Ferriera. After the bypass trust has been funded, 'the balance of the estate is usually transferred to the surviving spouse who is a U.S. citizen either outright, or put into a Qualified Terminable Interest Property (QTIP) trust to take advantage of the unlimited marital deduction, which pays income to the surviving spouse during that individual's lifetime; the remainder typically will pass to children when the surviving spouse dies.
"When the second spouse dies, assets in the bypass trust can be transferred to whomever the first spouse decided would be the ultimate beneficiary when the trust was created", says Ferriera. Most people name their spouse the primary beneficiary and their children the secondary beneficiaries, he adds.
Funding and Accessing the Trust
"There's some strategy involved with funding the trust", explains Ferriera. Low-income, high-growth investments are best because no matter how much the assets in the trust have grown, there's no estate tax on the trust when it passes to the next generation, he says.
Ideal assets for a bypass trust include equities, such as stocks or mutual funds, exercised stock options, land that has high growth potential and rental property.
"If you have assets in a qualified retirement savings plan, such as a 401(k), consult with an accountant and your financial planner before changing the title of those assets or listing a bypass trust as a beneficiary of those assets to avoid paying unnecessary or accelerated income tax", says Ferriera.
"Since different states have different laws about property ownership and titles, you should create the trust using an estate planning attorney who's licensed in the state in which you live."
In most cases, the standard bypass trust gives the surviving spouse the right to income from the trust as well as the ability to change how the assets are invested to increase or decrease the amount of annual income that the trust generates, says Ferriera.
The trust often also gives the surviving spouse the right to use the principal to pay for health, education and maintenance costs, as well as to maintain the spouse's standard of living, he says.
Selecting the Right Trustees
"Trustees are determined when the trust or will creates the bypass trust, and most spouses name each other the primary trustees of their bypass trust", says Ferriera.
However, "we highly recommend naming a co-trustee, such as an adult child who's savvy with money to have some continuity, particularly since the original document might have been written years ago", he says.
"A good document will state that as much money as is allowed tax-free that year should be put into the bypass trust", says Ferriera. "That way you don't have to update your document every year if the exemption amount changes".
"Your financial planner will work with your estate planning attorney to design and build the right document", says Ferriera. "The incremental cost of setting up a bypass trust is minor in the big picture when you consider the inheritance protection, management continuity and tax reduction this type of trust might give you."
Talk to Your Financial Planner About:
- The tax advantages of creating a bypass trust.
- The best way to title assets for your estate.
- Estate planning for non-U.S. citizens.