Question: As a surviving spouse, most of my assets are held in my deceased husband’s bypass trust to which I am entitled to distributions of income and principal. Since I will no longer be subject to estate taxes, is there an advantage to my withdrawing as much money as possible from this trust?
Answer: The new tax law changed the landscape for dealing with estate assets. In the past, avoiding or minimizing estate taxes was the primary focus of taxpayers subject to estatetaxes upon death. With the recent, albeit temporary, increase in the Federal estate tax exemption to $11,180,000 per taxpayer, many taxpayers who previously would have been subject to estate taxes need no longer be concerned with transfer taxes. A greater emphasis is now being placed on income tax planning.
Upon a taxpayer’s death, the basis of assets in a decedent’s hands is adjusted to the fair market value of such assets as of the date of death. With the general long-term trend of asset appreciation, the adjustment generally results in an increase or step-up in the basis of the decedent’s assets as in many such cases, the fair market value of assets at death exceeds the decedent’s basis in the assets. For the beneficiary of a decedent’s estate, the increased basis in inherited assets may result in lesser gain to report and a correspondingly lower income tax to be paid when the assets are ultimately sold.
Assets in a bypass trust do not receive a step-up in basis. A bypass trust is created to permit a decedent’s surviving spouse to access trust funds as needed during the spouse’s continuing lifetime but without causing the trusts assets to be subject to estate taxes on the spouse’s subsequent demise. From a planning perspective, surviving spouses were in the past usually advised to retain in bypass trusts as many of the trust assets as possible so as not to cause estate taxation of such assets on the spouse’s death. With estate tax rates historically higher than income tax rates, minimizing estate taxes generally took precedence over withdrawing trust assets to achieve a higher income tax basis.
With the increase in the Federal estate tax exemption, there is one less reason to retain assets in a bypass trust as estate taxes will no longer come into play for many individuals. In the right circumstances, a better strategy is to distribute bypass trust assets to the surviving spouse so the spouse’s beneficiaries will receive a step-up in basis in the distributed assets on the spouse’s death.
Before embarking on a plan of maximizing the distribution of by-pass trust assets, other factors should be considered. Distributions should only be made if they are permitted under the terms of the governing trust instrument so the trustee is not violating the trustee’s fiduciary duty to all of the trust beneficiaries. The impact must also be considered from a State perspective. While only a minority of states impose estate taxes, retaining assets in a bypass trust may be beneficial if you reside in one of those states. Advantages may also result from retaining assets in trust from a creditor protection standpoint. The income tax benefits will be realized only with assets which have appreciated in value; an asset whose income tax basis is less than fair market value might better be left in a bypass trust to avoid a decrease in the asset’s basis upon the surviving spouse’s death. Finally, keep in mind that the recent increase in the Federal estate tax exemption will sunset in 2025 and the amount of the exemption after that date is uncertain.
Your situation is a common one as conventional wisdom has changed with respect to bypass trust assets held for the benefit of surviving spouses. In the right circumstances, distributing assets out of a bypass trust can provide a meaningful savings in income taxes for your beneficiaries upon your demise.
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