Should I use an AB Trust? Pros and Cons
We all learned our ABCs as kids, and the nice thing about the alphabet is that it never changes. This is not the case for the ABCs of estate planning - where things can and do change often, especially with structures such as AB Trusts. What was once the correct estate planning technique for a client can suddenly become the wrong technique for that same client if estate tax laws change.
What is an AB Trust?
An AB trust is an estate planning strategy used by married couples to pass as much of their estate to their heirs free of estate taxes as possible. Here’s how it works.
At the death of the first spouse the estate is split into two trusts, an A trust also known as a survivor trust and a B trust also known as a bypass trust. Assets put into the A trust for the surviving spouse incur no estate taxes at the first spouse’s death, but they will be included in the surviving spouse’s estate at his or her death.
Assets that are put into the B bypass trust will not be subject to estate taxes at the first spouse’s death as long as the value of the assets placed in the trust is equal to or less than the amount a deceased spouse is allowed to pass estate tax free. This amount is known as the estate tax exemption amount. At the death of the surviving spouse, B trust assets will escape estate taxes and pass to the beneficiaries free of estate taxes no matter how large the B trust assets are. B Trust assets can also be used by the surviving spouse during their lifetime for their health, maintenance and welfare.
See the diagram below which illustrates how an AB trust works.
Source: Advisys, Inc.
This is a high-level explanation and cannot be interpreted as advice specific to any one person. For recommendations that apply to your personal situation, consult with an attorney.
AB Trust tax law changes do happen
It’s important to stay apprised of changes in estate and tax law because they could alter the efficacy of your AB Trust.
An estate tax law change occurred in 2011 when federal law was changed so that the amount each person could pass estate tax free to their heirs jumped to $5,000,000 and was indexed to inflation. On January 1, 2018, it jumped again from $5,490,000 to $11,180,000. Because this amount is indexed to inflation, the current exemption amount in 2022 is $12,060,000 per individual and $24,120,000 per couple. These changes in the law immediately made certain AB trust planning the wrong estate planning strategy for some people where it had previously been the correct strategy for many years.
Do you know if you have a mandatory AB trust provision in your estate planning documents?
If you do, you should review the reasons for having it, and make sure the reasoning still applies today in light of the recent estate tax law changes. Again, see the AB trust diagram above for a refresher on how AB trusts work.
A lot of AB trust planning was done simply and solely as a technique to maximize the amount of money you could pass on to your heirs free of estate tax. When the estate tax exemption amount was only $2,000,000 per person in 2006 through 2008, an AB trust arrangement was necessary just for spouses to pass $4,000,000 to heirs free of estate tax.
The estate tax exemption is now $12,060,000 per person and surviving spouses are allowed the “unused” portion of this amount (referred to as “portability”). A married couple can now pass an estate worth $24,120,000 estate tax free without having an AB trust provision in their estate planning documents.
Are there still reasons to use AB trusts even if the value of your estate is unlikely to ever exceed $24,120,000 as a married couple or $12,060,000 as an individual?
Yes, absolutely.
Reasons to continue using AB trusts
Here are some reasons to continue using AB trusts even if your estate’s value is below $24,120,000 as a married couple or $12,060,000 as an individual.
To avoid future estate tax: If you think your estate may someday be larger than $24,120,000 as a married couple or 12,060,000 as an individual plus the inflation rate, you should consider using a B trust. This is because growth in B trust assets is not subject to estate tax at the second death; however, it is subject to capital gain tax.
Protection against creditors: B trust assets are protected from future creditors.
Long-term care protection: B trust assets are not considered available resources for purposes of determining Medicaid eligibility. However, B trust assets could still be subject to a lawsuit to provide for the needs of the surviving spouse.
To retain control over assets: B trusts protect the decedent’s heirs in the event the surviving spouse gets remarried.
To transfer assets to grandchildren: Couples who want to take advantage of passing on assets to their grandchildren still need AB trusts in order to use their generation-skipping exemptions.
Planning for state estate tax: Currently there is no California estate tax, but there are many states that have some form of estate or inheritance tax. If you plan to move to a state that has estate or inheritance tax, a B trust could still be a relevant tool.
And most importantly remember that the current estate tax law sunsets at the end of 2025 which means the exemption amounts will drop by roughly 50% to $12,000,000 for a married couple and $6,000,000 for an individual. For many, this fact alone is enough reason to continue using B trusts in their estate planning.
As you can see, there are legitimate reasons for using B trusts besides reducing federal estate taxes. That stated, there are also many reasons why you may not want to be forced to split your estate into two trusts when the first spouse dies.
Reasons to discontinue using AB Trusts
Here are some reasons you may want to discontinue using AB trusts.
None of the benefits listed above appeal to you or pertain to you.
More legal and accounting costs: AB trust estate planning is more expensive and there are ongoing tax preparation fees for B trusts.
More administrative work: The Trustee is responsible for the annual accounting of the B trust.
Higher potential capital gains taxes at the Second Death: B trust assets do not receive a second step-up in basis at the death of the surviving spouse.
What should you do?
First, look to see if you have an AB trust provision in your estate planning documents (frequently the B trust is referred to as a “bypass” trust). Second, review how AB trusts work so that you thoroughly understand them. Third, sit down and review the main reasons you decided to use the AB trust estate planning strategy in the first place.
Try to weigh the pros and cons of using AB trust planning to make the best choice for your personal circumstances. Along with your estate planning attorney, we can help you think through your situation and decide on the best course of action. Finally, and most importantly, work with your estate planning attorney to make the necessary changes to your documents in light of this review.
B trusts are still a very valuable planning tool, but they certainly are not for everybody — especially now that an estate of $24,120,000 can be passed estate tax free by a married couple and $12,060,000 can be passed by an individual. Even if the estate tax law sunsets at the end of 2025, estates of roughly $12,000,000 for married couples and $6,000,000 for individuals can be passed onto the next generation completed free of federal estate taxes.
We are a financial advisory firm in La Jolla, California. If you are experiencing questions related to your wealth and you are looking for financial advice, please contact us.
Sources
Is An AB Trust Right For You? Trust & Will. https://trustandwill.com/learn/ab-trust
Footnotes
2 – Trust may be irrevocable if it is a general power of appointment trust or an estate trust.
3 – For 2022, the applicable exclusion amount is $12,060,000. In 2021, the applicable exclusion amount was $11,700,000.
Jim Freeman, CFP®
Lead Advisor, Partner
Jim oversees both the financial planning and investment management divisions for the firm.
After working in the financial services industry for several years, Jim was inspired to start his own Fee-Only firm in 1991 to eliminate conflicts of interests with his clients. Since that time, he has been named on numerous occasions by Robb Report Worth Magazine as one of the top Wealth Advisors in the United States.
Jim holds a BA in Psychology from Point Loma Nazarene University and also holds the CERTIFIED FINANCIAL PLANNER™ designation. He is a member of the National Association of Personal Financial Advisors (NAPFA) and the Financial Planning Association (FPA).
In his free time he enjoys cycling, running, going to the gym, reading, traveling, and spending time with his wife and kids as well as extended family and friends.