Navigating Trust Choices: A-B vs. Disclaimer Trusts

Living trusts are often great estate planning vehicles.

For couples, there are two basic options. One is called an “A-B” trust (also known as a formula trust), and the other is called a “Disclaimer” trust (also known as a non-formula trust). So, what’s the difference?

While both trusts are fully revocable and amendable until the first spouse dies, that is where the similarities end.

A-B Trusts

Let’s first understand how an A-B trust works.

On a first death, the A-B trust requires the estate to generally split into two sub-trusts: the “A” trust and the “B” trust. The “A” (also known as the “Survivor’s” trust) consists of roughly the survivor’s half of the estate and all their separate property. The “B” (also known as the “Bypass” or “Decedent’s” trust) holds the decedent’s half of the estate along with their separate property.

The “A” trust remains a revocable and amendable trust and the survivor can do with it whatever they desire. They can decide to change the beneficiaries of “their” trust, change the successor trustees, etc. Trust “B”, however, is irrevocable, and the surviving spouse is restricted in what they can do with the funds. The survivor cannot change who the beneficiaries are of the “B” trust, cannot change the named successor trustees, and cannot change how the funds may be used. The surviving spouse may have the right to manage the “B” trust assets, but normally only has access to the income generated from those assets, like interest and dividends. They generally cannot use the funds themselves unless they spend all of their “A” assets first. When the surviving spouse ultimately dies, the assets of the “B” trust are distributed to the heirs that were originally named in the trust that the couple wrote together.

The reason many people chose this A-B trust in the past was due to the possible benefit of estate tax savings because it splits the estate into two parts essentially doubling the amount that can pass to heirs tax free. The “B” trust can also provide some asset protection from survivor’s future creditors who will have a more difficult time reaching into that trust. Yet another reason some opt for this trust is to benefit children from a prior marriage, or to better protect separate assets so they pass to intended heirs.

The downside of this type of trust is that it can be extremely rigid, forcing the surviving spouse to go through the process of splitting the estate, as well as making it harder to “get at” the principal of the decedent’s trust. Furthermore, after the first death, the trustee of the “B” trust must file tax returns for that irrevocable trust on an annual basis (thus incurring additional tax preparation fees), account to the future beneficiaries periodically (e.g., let the kids know how the funds are used), and any income generated by that trust may be taxed at high trust tax rates (generally much higher than your individual tax rates). Also, B trust assets generally do not receive a step-up in basis at the death of the surviving spouse, so beneficiaries could potentially pay more taxes once they sell their inheritance. Altogether, these restrictions can feel like serious handcuffs on the surviving spouse.

These downsides were easy sacrifices to make when folks could enjoy large estate tax savings from A-B trusts when facing low federal estate tax exemptions. Indeed, during the 1980’s and 90’s these A-B trusts were great tax saving tools. Even today, some still choose this trust if they have “blended” families with children from prior marriages, if there is a concern that the surviving spouse remarries and there is a desire to protect estate assets for the intended heirs, or where tax concerns remain.

But tax laws have greatly changed over the last few decades, modifying the legal landscape. The current estate tax exemption is approximately $13 million dollars per person (although barring legislative action, the current rules will sunset such that in 2026 the exemption will be somewhere between $6 and $7 million dollars per person - $12 to $14 million for a couple - when adjusted for inflation). In addition, Federal legislation now allows the “porting”, or transferring, of unused exemption credits from the deceased spouse to the surviving spouse, thus essentially giving a couple the ability to double the tax credits without the need for an A-B trust. Thus, a couple can currently transfer around $26 million dollars of wealth with no estate tax, making A-B trusts less impactful or necessary for those who are unlikely to have estates that trigger high taxes.

Disclaimer Trusts

So, what is the alternative to the A-B trust? That is where disclaimer trusts come in.

Disclaimer trusts still offer some of the same protections of an A-B trust, like avoiding probate, and lowering attorney fees, etc., but they don’t force the surviving spouse to split the estate into two trusts upon the first spouse’s death. Instead, they give the survivor the option to do so if estate tax savings can be had. The legal mechanism by which the survivor does so is called a disclaimer, hence the name for this type of trust.

With disclaimer trusts, not only can the survivor choose whether to disclaim, they can choose how much they want to disclaim rather than forcing an even split of the estate, and they have up to nine months after the death of their spouse to make this decision. That gives them time to consider fluctuation in asset values, and to better assess their financial needs. If the estate is $500,000 above the estate tax exemption amount, the survivor can simply disclaim just that amount. If there is nothing to disclaim, the survivor does not have to split the estate, leaving the entirety of the estate for the surviving spouse’s use without having to jump through hoops.

The ability to decide whether to split the estate greatly reduces the administrative burdens on the survivor, reduces legal fees, eliminates the need for yearly trust return filing, and can reduce taxes since trust rates would not be applicable.

Although disclaimer trusts do not give the same level of creditor protection as A-B trusts, and they do not insulate assets for the benefit of children from a prior marriage, or protect separate assets of the first spouse to die, their flexibility generally means greater benefit to surviving spouses.

Of course, everyone’s situation is different, so if you need specific advice as to your own circumstances, speak with a trusted lawyer.