An estate plan for a couple
sometimes includes trusts designed to minimize taxes, by "sheltering"
assets from estate tax payable when the second person dies. The
plan is that assets of the first spouse to die "bypass" the second
spouse and instead, go into a trust. If your combined assets
(house, retirement, savings, etc.) are now (2024) approaching $6-7
million, OR if you own real estate in a high-tax state like
Massachusetts, you may need a bypass plan.
Why? What's old is new again! Or may be new. Estate
tax exemption hikes made these plans unnecessary, but these hikes are
due to expire in 2026.
It's true that the 2024 federal estate tax exemption is $13.16 million
(potentially double that if a federal estate tax return is filed when
the first spouse dies and the second doesn't remarry -- this is called
"portability"). And even in
Connecticut, the exemption is the same as the federal exemption,
although with no "portability" to double it. (Other states
may have much lower cutoffs -- $2 M for Massachusetts -- and that will
affect you if you own ANY real estate there.) But the federal law "sunsets" in
2025, bringing back an
inflation-adjusted amount from 2010. In 2026, it seems
increasingly likely that the exemptions will be $6-7
million (maybe a bit more due to inflation) at both state and federal
levels. At the federal level, the excess will be taxed at
40% after a deduction for any state taxes; at the state level, 12%.
So, fast forward to 2026, and keep in mind
that if you aren't spending your savings and if they are in the stock
market, it's likely they will increase in value. If a Connecticut
couple's COMBINED assets in 2026 are
UNDER the federal exemption amount, let's say $6 million, no tax will
be due when either dies, period. (Don't
get me started on the probate fee, up to
0.5%, max $40,000...)
AND if the surviving spouse remembers to file a federal estate tax
return when the first spouse dies, AND ALSO doesn't remarry, there will
be no federal tax when the second one dies either. But suppose
they have $8 million and both die and that federal tax return isn't
filed. If
one dies and then the other and
the
first person leaves everything to the spouse, no tax will be due at the
first spouse's death, but will be at the second, because assets that
pass to
your surviving spouse will be taxed as part of that spouse's estate on
that spouse's death. Tax will be due on
the excess over $6 -- combined federal and state tax of something just
under 52%! Even if no federal tax is due, a 12% CT tax will be
due -- 12% x $8 million minus $6 million = $240,000. That
tax is paid out of the estate or if there is no "estate" (no
probate), by the people who get the money: your family. (NO tax is due
on amounts you leave to charity!)
Example: It's 2026. Ozzie
has $4
million. Harriet has $4 million of her own. Ozzie dies
leaving his $4 million to Harriet. Harriet, grief-stricken, dies
a year later. She has $8 million -- her $4 M plus what she got
from Ozzie. On her death, the $8 million generates about $240,000
in
Connecticut estate tax (roughly 12% x $2 million) PLUS if she did not
file the federal estate tax return, about $704,000
in federal estate tax (40% x $2 million less the CT tax)
One way to show this is a kind of math equation:
OZZIE $4M + HARRIET
$4M = HARRIET $8M
HARRIET $8M = FAMILY $7,520,000 + TAX $948,000
This problem could have been solved if
Ozzie's estate plan (will and/or trust) included a "bypass trust" AND
he had assets in his sole name or the name of his own separate trust,
that could be used to fund the bypass trust. His $4 million would have
gone into the trust for Harriet so that when she died, the Bypass Trust
would have owned $4 million and she, Harriet, would still have owned
only $4 million. Trusts aren't people and don't die, so no more tax on
the Bypass Trust assets. Harriet would have had her own $4
million only
-- no tax there either. So if Ozzie and Harriet paid their lawyer
$3,500 -$6,000 for this plan, they saved nearly a million in taxes!
Pretty good deal Even if it is only compared to $240,000!!
So here is the solution:
OZZIE
$4M + HARRIET
$4M = BYPASS $4M + HARRIET $4M
BYPASS $4M + HARRIET $4M = FAMILY $8M
Problems?
(1) ALL trusts have certain complications, including (and as we
lawyers say, but not limited to) having to file special trust tax
returns each year, high tax brackets for income that is retained in the
trust and all capital gains earned by the trust, plus a 3.8% net
investment income tax on top of the high tax if income is retained,
having to deal with a trustee OR remember to dot the i's and cross the
t's if serving as trustee and beneficiary at the same time, and just
the sheer bother of having to understand what the trust document says
and means and consult lawyers and accountants. CLICK for my article about
what it means to be the beneficiary of a Bypass Trust rather than
inheriting your spouse's estate outright. Sometimes, it's just not
worth it to save taxes. That said, you could set the thing up and
leave it to the surviving spouse to decide whether or not it should
actually be carried out, by doing a "disclaimer" plan. The spouse
decides within 9 months of the first spouse's death and if disclaimed,
assets are then held in the Bypass Trust (called a Disclaimer Trust).
(2) Whether this makes any sense may depend on your assets! As noted -- to "bypass"
Harriet, Ozzie's assets have to get
into the Bypass Trust when Ozzie dies. If Ozzie's $4 million
consisted of his 401(k), this would have created complications.
The trust would have had to draw down on the 401(k) over 10 years at
best, most likely accelerating income tax and as a result, due
to compressed tax brackets, resulting a high tax hit -- maybe 40% if
the money had to stay in trust. Since traditional IRAs, 401ks,
403bs etc. are "pre-tax,"
estate tax can be pocket change compared with the INCOME TAX that is
due on every dollar that comes OUT of the IRA, 401k and so forth.
It's usually preferable to leave these assets to the surviving spouse,
period. (IF there are minor children or disabled beneficiaries
that can also work, but it is complicated.)
(3) What if Ozzie and Harriet's $8 million consists of appreciated
stock in a company that they started with $1 but which seems to double
in value every few years? The stock that would go into Ozzie's
Bypass Trust would also "bypass" the so-called "step-up in basis" (ask
Google) on Harriet's later death -- that is, any GAIN in value after
Ozzie died would be subject to capital gains tax if it went into the
Bypass Trust as compared with zero gain if the family inherited it
directly from Harriet. This could also be a problem if Harriet
lives for many years after Ozzie's death and doesn't remember to keep
diversifying the assets and they build up untaxed gains. Still --
possibly 20% or so of capital
gains tax may not be a big deal compared with the estate tax- it
depends.
What are
some Alternatives? If you don't like
the idea of the Bypass Trust, you have alternatives: (1) spend the
extra money
during lifetime! (2) give it away each year in amounts that don't
exceed $18,000 per donor, per donee (2024 number), or qualify for the "med/ed"
exclusion, so you don't die with more than the estate tax exemption;
(3) leave something
to the children when the first spouse dies, or alternatively, the
surviving spouse can decide (within 9 months of first spouse's
death) to "disclaim" assets that will then pass to the children
directly; (4) give the excess to charity; or (5) if you feel sure your
spouse will do the federal estate tax return to take advantage of
"portability," don't worry
about the Connecticut estate tax -- what's $240,000 or whatever in tax
when you are
leaving $8 million to your children anyway. Actually there may be
a few other
tricks -
consult a qualified estate planning attorney!
Note:
When
it comes to
the Bypass Trust, there may be as many variations as there are
lawyers. Even the name comes in different flavors. Some
lawyers call
this type of estate plan an "A/B" plan, which means that the "A" part
bypasses the surviving spouse and the "B" goes to a different kind of
trust for the surviving spouse, and/or passes outright. Some call
it a
"credit shelter" plan. In some plans, the "marital" share
(non-bypassing) goes outright to the spouse and everything else is held
in trust. In community property states, there may be a
"Decedent's"
trust and a "Survivor's" Trust. The "Decedent's" community
property
half will bypass the survivor. So: if you see any of these
terms you
can feel pretty sure it is a "bypass" plan and the resulting trust is a
"bypass" trust.
WARNING
-- these
trusts do NOT help avoid paying for long-term care expenses and
qualifying for Medicaid. I assume that if you have more than $6
million, you can definitely afford to pay some of this for long-term
care and/or
purchase long-term care insurance and you will have more options if you
just keep your money -- but you should know that if your
surviving spouse is the beneficiary of a Bypass Trust, the Connecticut
Department of
Social Services will treat the trust as fully available to meet your
spouse's long-term care expenses - -the whole amount will in most cases
have to be
consumed before the beneficiary can qualify for Title 19.
CAUTION:
EVERYTHING I JUST WROTE HAS EXCEPTIONS AND FINE POINTS
AND MAY CHANGE AT THE WHIM OF CONGRESS, THE STATE LEGISLATURE,
ETC. THIS IS A VERY GENERALIZED EXPLANATION. IT IS ABSOLUTELY
ESSENTIAL THAT YOU MEET WITH YOUR OWN ATTORNEY AND PROVIDE YOUR
ATTORNEY WITH FULL INFORMATION ABOUT WHAT YOU OWN AND THE WAY IT IS
TITLED -- AND THAT YOU FOLLOW YOUR ATTORNEY'S INSTRUCTIONS!
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