What if a bypass trust is never funded? And 4 Other Things You Should Know About Your New Bypass Trust
I’ve spent the past 20+ years working with financially successful families, and one of the things that almost all of them have in common is an irrevocable trust.
To be clear: for the sole purpose of avoiding probate, 100% of the families I’ve worked with have had a revocable living trust (RLT). But, an irrevocable trust is quite different.
Most people have heard of a simple RLT, but according to former accountant and tax legend Bob Keebler, there are 29 other types of trusts! And, since oftentimes the same trust will have multiple names (i.e. a Bypass trust is also known as a Family trust), I am sure you can find articles that count more than 30 kinds.
For today, I want to talk about Bypass trusts (aka Family trusts) and the 5 most common questions we get about them.
For a married couple with children, most RLTs have 3 parts:
What happens when both spouses are alive (usually nothing from a trust perspective)
What happens when one spouse dies (the purpose of today’s article)
What happens when both spouses die
After RLTs are created, signed, and funded, it’s normal for many years go by before they are looked at again. More often than not, the next time they’re reviewed is when a spouse dies (typically the husband dies first) and the wife is sitting down with her Attorney or Advisor to find out what happens next.
At that point, the spouse is surprised (and sometimes upset) to learn that their RLT says: “At first death, place ½ of the estate in a survivor’s trust and the other ½ in a Bypass (or Family) trust.” So, what does that mean?
The Attorney or Advisor then explains that:
A new trust is going to be created.
That new trust will be irrevocable.
Assets equal to 50% of the value of the estate will need to be retitled into this new irrevocable trust.
This new trust will have a separate tax return.
Distributions from the trust (i.e. accessing the money that was “yours” before your spouse died) will be subject to the terms of the trust, and may be restricted.
Before you call your Attorney and demand that they revise your RLT (if both spouses are still alive, this can be done very easily), there are benefits to this kind of trust design.
For today’s purpose I will not explain all pros and cons of a bypass trust, but I will write a follow up blog post on that subject. Email me: rob@swrpteam.com and I will send it to you. What I will provide today are answers to the 5 most common questions I get when a spouse first learns that they will now have a Bypass trust in their life.
1) Do I really have to fund my bypass trust at 1st death?
Technically yes. However, I once had an attorney say that if: 1) it was a first marriage; 2) all kids were from that marriage; 3) everyone alive agreed to sign a waiver, that the surviving spouse could decide NOT to fund the bypass trust. I am sure that many of the estate planning attorneys reading this are not going to like that answer, and I’m not saying it was the right thing for the attorney to do. But, they did it, and the mom’s still alive, the kids are all still doing well, and 100% of the estate remains in the survivor’s trust.
Given that, let’s look at an example of how a bypass trust gets funded when the first spouse dies. In our example, assume that dad died first and the assets in the estate were as follows:
His IRA was worth $1.5M and his wife was named as primary beneficiary
The house was paid off and was worth $2M, and was held in their RLT as community property
The Schwab / Fidelity brokerage account was worth $2M, and was held in their RLT as community property
The IRA passes directly to the wife, and there are no estate planning decisions to be made (unless she disclaims the asset, a different subject for a different day 😊).
The attorney says the wife has to fund the bypass trust with 50% of the remaining 2 assets, which leaves 3 options:
Put 50% of the house in the bypass trust and 50% in the survivor’s trust, and do the same for the brokerage account.
Put 100% of the house or the brokerage account in the survivor’s trust and 100% in the bypass trust.
Put a promissory note in the bypass trust for $2M (at the applicable interest rate) that says it will be repaid in full when the surviving spouse dies.
Over my 20+ years of working with families in this situation, I have seen all three of these occur. I’ve also seen many attorneys tell the surviving spouse: “This decision has legal ramifications, tax ramifications, and investment ramifications, so find an Advisor that can help you think through this and let me know what you decide to do.”
2) What do you mean our Revocable Living Trust says to create 2 (or even 3) trusts when my spouse dies?
RLTs were initially written in a manner that created 2 (or even 3) trusts as first death for estate tax reasons. However, the estate tax rules have changed so much that even for very successful families, this is often no longer needed. But, if you haven’t updated your trust in a while, you may find that this is how yours is still written.
To describe the 3 trusts I am referring to, we will use the terms A, B, and C trust to describe what typically happens at first death:
A trust = the survivor’s trust
B trust = the bypass/family trust
C trust = the marital (sometimes referred to as a QTIP) trust
Each of these trusts has different rules for income distributions from the trust, separate tax returns, and different levels of authority granted to the beneficiaries. One of the decisions you will need to make is which assets go in which trusts. And, you will need to live with this decision potentially for many years, so make sure you have a Wealth Advisor that has experience in this area.
Again, this may sound overly complicated and potentially unnecessary, but there are tax and non-tax reasons for this structure. While I will write about this in more detail in the next blog post (email me rob@swrpteam.com to access it), for now let’s say that these trusts cannot and should not be dismissed as in some cases, the pros outweigh the cons.
3) What is Portability?
At the risk of upsetting estate planning attorneys, I am going to grossly oversimplify a fairly complicated subject.
When someone dies, the IRS has rules that state how much money that person can leave behind before their estate is subject to taxation. The current amount for 2026 is $15M, and the tax rate on any amount above that is 40%. The $15M is known as a “lifetime exemption amount.”
Portability is a concept that allows a surviving spouse, who presumably inherits money from her late husband (without any estate tax, even if over $15M thanks to the “unlimited marital deduction”), to add his unused lifetime exemption amount (let’s say it’s the full $15M) to her lifetime exemption amount. This allows a married couple to benefit from the full $30M deduction ($15M per person) even if their deaths are many years apart.
One of the decisions you will have to make is whether to file a portability election. And because this impact could save or cost your family thousands of dollars, make sure you have a Wealth Advisor that has experience in this area.
4) Why is there a separate tax return?
An irrevocable trust will have its own tax ID number, which in turn will mean a separate tax return (Form 1041 as opposed to Form 1040, which you use when filing your personal tax return).
To further complicate things, an irrevocable trust will be subject to more punitive tax rates than an individual. So, income tax planning becomes more important and more fruitful once someone dies and the surviving spouse now has 2 tax returns to contend with.
You also have issues like the step-up in basis, which occurs at death, and can result in assets being sold without capital gains taxes or rentals being re-depreciated all over again even if they had already been depreciated down to $0.
Once again, while the complexity of it all can seem overwhelming, there are potential benefits to understand.
One of the things that makes irrevocable trust tax returns unique is that you have 65 days after the year ends to make several decisions that impact the prior year’s tax returns. The full name for this provision is called IRC 663(b), and it’s a rule that “allows trustees of complex trusts and estates to treat distributions made within the first 65 days of a new tax year as if they were made on December 31 of the previous year. This enables trusts to avoid high tax rates by shifting income to beneficiaries.”
Decisions made here could save or cost your family thousands of dollars, so make sure you have a Wealth Advisor that has experience in this area.
5) Can’t I just amend all of this?
If you and your spouse are both still alive and in a position to make decisions (i.e. no one is experiencing diminished mental capacity), then yes, you can amend your RLT now and leave everything in 1 trust as first death. And, this may be the right thing for you to do.
We’ve had many clients make this exact amendment to their revocable living trust because they are in a position where the benefits of the myriad trusts that will come up after the first spouse dies are not worth it given their goals.
Before you come to this same conclusion, I would highly recommend sitting down with a Wealth Advisor who understands investments, tax planning, and estate planning, because you need to factor in all three when making these decisions.
If you or someone you love is seeking this kind of advice around wealth and complexity, please send me an email at rob@swrpteam.com.
Our specialty is helping successful families navigate wealth and all the complexity that comes with it. We want to continue to write about the topics that are most important and interesting to readers like you – so if you have questions or blog article ideas, please reach out to us and let us know: rob@swrpteam.com
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