Coming Clean on Bypass Trusts

Over the years your humble blogger wrote enough newsletter articles on bypass trusts to fill a dumpster. Don't waste your federal estate tax exemption! Prevent unnecessary estate tax at the later death of your spouse!

Rarely did clients encourage us to mention the income-tax downside: Although assets left outright receive a stepped-up basis at death. assets left in trust do not. If Grandpa dies when his Apple shares, purchased at $10 each, are worth $550, Grandma can sell at that price or less without realizing taxable gain. Only additional growth would be taxable. If the shares pass in trust, everything over $10 a share will be taxable gain.

When the Bush tax cuts lowered the top tax rate on capital gain to 15%, the income tax drawback of bypass trusts seemed less important. But this year the top federal income tax rate on capital gain is back up, approaching 25%. (And, of course, the effective tax rate on gain often exceeds the listed rate.)

Fortunately, new estate tax rules allow Grandma to make use of Grandpa's unused estate-tax exemption. Bypass trusts have become unnecessary. Or have they?

According to Deborah Jacob's dispatch from "the Super Bowl of estate planning," drafters of wills and trusts have faced up to the potential income-tax cost of bypass trusts. Nevertheless, for a variety of reasons they think the trusts still have a future.

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Caution: Don't take the title of Jacob's column, "Estate Planning for the 99%," literally. Candidates for bypass trusts are the 1% (the 1% threshold is around six to eight million, depending on who you ask) or at worst the top 2%. Remember, only 5% of U.S. households have a net worth of at least $1 million.

Federal estate tax is no longer an issue in most estate planning. But estate beneficiaries still need protection from creditors and divorce lawyers. Trusts will continue to be useful.