A credit shelter trust, also known as a bypass trust, allows married couples to exclude from estate tax assets above the limits allowed for individuals. As of 2012, the basic amount excluded from estate tax was $5.12 million, so couples with high net worth can potentially protect $10.24 million. The provision for a credit shelter trust is set up in either a revocable living trust or a will, and does not actually exist until after the death of one of the spouses.
How It Works
After the first spouse dies, funds equaling the permitted exclusion are put into the credit shelter trust. The surviving spouse receives trust income and, depending on the trust's provisions, may access the principal. After the second spouse dies, the trust's assets are distributed to beneficiaries as per the trust's directions. Assets in the trust at the time of the second spouse's death are not included as part of the decedent's taxable estate.
A credit shelter trust protects assets beyond the lifetime of the surviving spouse. Assets in the trust are not subject to estate tax, even if these assets grow considerably. For example, if the original credit shelter trust is funded at the $5.12 million exclusion limit after the death of the first spouse, and grows to $7.12 million by the time the second spouse dies, that additional $2 million is still free of estate tax, even though it is now over the original exclusion.
Why It Matters
Because there is an unlimited marital deduction, assets left to a spouse are not subject to estate tax even if exceeding the exclusion, if that person is a U.S. citizen. The problems with estate tax begin at the death of the second spouse, if there is no credit shelter trust. Without it, estate assets exceeding $5.12 million are subject to a 35-percent federal tax. Individual states might also impose estate taxes, sometimes on estates worth less than $5.12 million, so even if the second spouse's estate does not exceed federal limits, it might exceed state exclusion limits for taxes. For example, several states, including Hawaii, Illinois and Delaware, impose estate tax on estates worth less than the amount excluded federally. For that reason, a credit shelter trust might be funded even if the assets are less than the permitted federal exclusion to avoid the estate taxes in a particular state.
Certain assets do not need to be included in a credit shelter trust. Individual retirement accounts can be left to a surviving spouse without incurring estate tax. Since estate laws are subject to change, keep abreast of new laws pertaining to this issue and consult your estate planner for the way new regulations may affect you.
A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including PocketSense, Financial Advisor, Sapling, nj.com and The Nest.