The process of developing and maintaining a fully-fledged financial plan occurs through careful consideration and implementation of a plethora of components. One of those important components to consider is a comprehensive estate plan. A generic estate plan for an individual shall often contain fundamental elements such as a will, financial & healthcare power of attorney documentation, an advanced healthcare directive, account titling & beneficiary designation listings (and potentially other items, such as trusts). Typically, drafting the items aforementioned will produce a very thorough estate plan for the typical American. However, there are many nuances to estate planning, and it is never a one-size-fits-all approach. 

One of those nuances we’ll cover applies to married individuals (or those who plan to be married in the future) and live in a state with a state level estate tax. As of 2024, there are only 12 states with a state-level estate tax, each with varying thresholds and tax rates. While most of these states are in the Midwest or along the East Coast, Washington and Oregon also make the list! Should you find yourself within this subsect of Americans, the following information is pertinent.

In 2024, the lifetime federal estate tax exemption is $13.61 million per person. We’ll discuss this first in the context of an unmarried individual. If the unmarried individual’s estate is worth less than this amount when they die, no federal estate tax will be imposed. If their estate exceeds this federal threshold, the portion above the exemption amount is subject to federal estate tax. Depending on the value of the estate, the tax can range from 18% to 40%. 

Now, we’ll discuss this in the context of a married couple. In 2024, each spouse still has their own $13.61 million federal estate tax exemption to utilize. However, the federal exemption can effectively be doubled for a married couple ($27.22 million in 2024). This is the concept of “portability,” where if one spouse dies and does not use their full $13.61 million exemption, the surviving spouse can claim the unused portion of the deceased spouse’s exemption, allowing them to increase their own exemption amount! This means when the surviving spouse eventually passes away, they are able to defer up to $13.61 million of their own estate from federal estate tax, in addition to whatever unused exemption their deceased spouse “ported” over to them. This is an effective deferral strategy for federal estate tax that the majority of married couples can take advantage of. 

Of quick note, married couples generally do not have to worry about paying any estate tax upon the death of the first spouse. There is a provision from the IRS known as the ‘unlimited marital deduction’ which allows the first-to-die spouse to transfer an unrestricted amount of assets to their spouse upon death. This applies at the federal level which we just discussed, as well as the state level which we’ll cover below.

Now, we’ll discuss this in the context of the state level, where significant nuance exists as compared to the federal level. Since each of the aforementioned states with a state level estate tax have differing estate thresholds and tax rates, we’ll use Washington state for our explanation. There are two major differences between the federal & state levels. The first difference is that most of these states have an estate-exemption threshold that is much lower than the federal level. For example, the state-level estate exemption for a Washington resident is $2.193 million. The second difference is that not all of these states freely provide married couples with spousal portability, similar to how the federal level does. For example, Washington state does not recognize portability of any unused exemption from the first-to-die spouse. This is the critical point that is easy to overlook! Thankfully with proper estate planning, married residents in Washington can still find a way to create portability of this $2.193 million exemption and avoid unnecessary state level estate tax. This can be completed through the implementation of what is referred to as a “Bypass Trust” or “Credit Shelter Trust.” We’ll refer to this from here on out as a “B-Trust.”

What is a B-Trust?

The B-Trust is an important element that can be written into each spouse’s will to capture the power of spousal portability. In Washington, the B-Trust makes sense to implement within each spouse’s will if their net worth is in excess of $2.193 million now, or if it’s likely to ever reach this threshold in the future (Note that life insurance proceeds are generally considered as part of a couple’s net worth/estate for estate tax purposes). In effect, the B-Trust allows the surviving spouse to ‘disclaim’ or dismiss part of the first-to-die’s estate. The disclaimed assets in the B-Trust are not counted toward the surviving spouse’s estate, but can still be utilized by the surviving spouse during their lifetime however fit. The first-to-die can also write provisions within their will that the B-Trust funds can only be used for specific circumstances. While these restrictions do not have to be put in place, the first-to-die can create these provisions to ensure the assets are used within the scope of their wishes.

Case Study - John & Sue

A hypothetical case can help to illustrate the B-Trust’s usefulness. Let’s say a married couple, John & Sue, live in Washington with $5 million net worth. They have no B-Trust provisions within their wills and have each directed that their portion of the estate shall transfer to the surviving spouse. Upon the death of the surviving spouse (second-to-die), the full estate will transfer to heirs and other purposes (such as charities). Their net worth will be too low to deal with federal estate tax, but they will be subject to Washington state estate tax. John dies in 2024 with an estate of $2.5 million. If no B-Trust exists, then John’s estate will transfer to Sue as intended, but she will not retain the additional $2.193 million of exemption that John didn’t utilize (Sue doesn’t have the ability to offset twice the state exemption of $4.386 million, similar to how it works at the federal level). That means that once Sue dies, only $2.193 million of the estate can be exempted from Washington estate tax for Sue, not $4.386 million. 

This can be avoided by utilizing a B-Trust in the first-to-die’s will (John’s), which instructs for a trust to be created and filled with $2.193 million of his assets. The B-Trust is irrevocable, meaning it remains outside of Sue’s estate, but Sue can withdraw from the B-Trust however necessary during her lifetime (assuming John did not write in restrictive provisions), so it’s still accessible. This is an important strategy for Washingtonians, because it allows for the additional $2.193 million to be exempt from Washington estate taxes upon Sue’s death, which can be hundreds of thousands of dollars if no exemption is utilized.

Below is an example of what Washington estate taxes might look like for John & Sue if they did not utilize B-Trust provisions. The diagram assumes that John predeceases Sue, and that her estate grows another $100,000 before she ultimately passes as well.

Estate Flowchart - Bypass Trust Is Not Utilized

As you can see from the diagram, since no B-Trust is utilized within John’s will, Sue inherits the entirety of John’s estate, bringing her estate total to $5,000,000. She then lives a bit longer, and her estate grows from $5,000,000 to $5,100,000 before she ultimately passes away. Though she is able to utilize her $2,193,000 Washington estate tax exemption, a total of $2,907,000 is still subject to Washington estate tax.

Given Washington’s estate tax rates, Sue’s estate will owe $376,050 in estate taxes. Ignoring the costs of probate and other estate administration fees, this leaves $4,723,950 of the estate to be retained for heirs and/or other purposes ($2,193,000 of Sue’s WA exemption + $2,530,950 of estate retained after WA estate taxes are applied).

Now let’s assess a second scenario for John and Sue where all initial assumptions remain equal, but we assume that they utilize a B-Trust:

Estate Flowchart - Bypass Trust Is Utilized

As you will see from the diagram, upon John’s death, he directs for $2,193,000 of his $2,500,000 estate to be directed into a B-Trust. In effect, John & Sue are maximizing the efficacy of John’s personal Washington estate exemption. The remaining $307,000 from John’s estate is directed to Sue, to be added to her estate now valued at $2,807,000. She then lives a bit longer, and her estate grows another $100,000 to a total of $2,907,000 upon her death. From her final estate, $2,193,000 is exempt from Washington estate tax, leaving $714,000 to be subject to tax. Of this $714,000, only 10% (or $71,400) is taxable under current Washington estate rates.

Ignoring the costs of probate and other estate administration fees, this leaves $5,028,600 of the estate to be retained for heirs and/or other purposes ($2,193,000 B-Trust + $2,193,000 of Sue’s WA exemption + $642,600 of estate retained after WA estate taxes are applied).

Comparing The Scenarios

Between both scenarios, only one variable was changed: the utilization (or lack thereof) of a B-Trust.

In the first scenario, the lack of a B-Trust caused Sue’s final estate to pay $304,650 more in WA estate tax than in the second scenario. In other words, utilizing a B-Trust in the second scenario would save $304,650 from unnecessary WA estate tax. 

How Consilio Wealth Advisors Can Help

Estate planning can be confusing. If you have already drafted your wills with an estate planner, but are unsure if Bypass Trust provisions were included, we are able to review your documentation to identify if your needs are met. Should we find that this crucial element is missing, we are happy to coordinate with your estate planning attorney to ensure that your estate planning wishes are met and executed upon.

DISCLOSURES:

The information provided is for educational and informational purposes only and does not constitute investment advice or legal advice and it should not be relied on as such. Consilio Wealth is not a law firm, and our employees are not legal professionals. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

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