The rise in the stock market over the past several years, teamed with the passage of the SECURE Act two years ago—as well as the scheduled 50% reduction in the size of the federal estate tax exemption four years from now—has resulted in a renewed interest in estate planning for IRA and 401(k) accounts owned by married couples. For couples owning significant IRA and 401(k) accounts, the question is whether they should now consider paying all or a portion of these to a so-called "bypass" trust for the benefit of the surviving spouse. This strategy removes the designated portion of the IRA or 401(k) proceeds from the surviving spouse's taxable estate, besides achieving certain other non-tax objectives.

Limitations Of The Spousal Portability Election
In 2013, Congress permanently passed into law what is known as the portability election for assets passing outright to the surviving spouse when the other one dies. Portability allows the survivor to use the unused federal estate tax exemption of the deceased spouse, and thus claim two estate tax exemptions.

Given the obvious beneficial aspects of this now nine-year-old law, why is there any longer a need for a married couple to consider using a bypass trust in their estate planning?

There are actually at least five reasons:

1.  The portability election will not remove appreciation in the value of the "ported" assets from the surviving spouse's taxable estate, whereas a bypass trust will remove all appreciation. 

2.  The portability election will not apply (at least for the deceased spouse’s unused estate tax exemption) if the surviving spouse remarries and the new spouse predeceases him or her, whereas the remarriage of the surviving spouse is irrelevant in the case of assets transferred to a bypass trust.

3. The portability election will not apply for federal generation-skipping transfer tax purposes, meaning the amount that could have passed to an estate and generation-skipping transfer tax-exempt bypass trust, including all appreciation in its value, could then be subject to federal transfer tax in the children's estates.

4. Using the portability election would cause the "ported" assets to be subject to potential lawsuits against the surviving spouse as well as to the potential claims of a new spouse, whereas lawsuits and claims against a surviving spouse would be avoided if a bypass trust is used. 

5.  The portability election would mean the first spouse to die would lose the ability to control where the "ported" assets pass at the surviving spouse's death, control that could have been retained had a bypass trust been used instead.

The Traditional Bypass Trust As An Alternative
Obviously, there are limitations in the spousal portability election when you compare them with "bypass trust planning," in which married couples divide their assets in some fashion so that, at the death of the first spouse, all or a portion of his or her separate assets pass to an estate tax-exempt trust for the survivor. The latter type of planning is obviously still in play since the 2013 change to the law. The question is: Are bypass trusts an appropriate receptacle for IRA and 401(k) plan proceeds given that, after the SECURE Act, these trusts are generally subject to a 10-year maximum payout rule, whereas the outright payment of IRA and 401(k) plan proceeds to a surviving spouse is entitled to spousal rollover treatment, and therefore greater income tax deferral? Furthermore, bypass trusts are generally subject to the highest federal income tax rate at levels of gross income of as low as only $13,550; they include an exemption of only $100, and do not qualify for income tax basis step-up at the surviving spouse's death.

But the judicious use of Internal Revenue Code Section 678 in the drafting of the bypass trust will generally eliminate the relevance of high trust income tax rates, as well as the minimal exemption, because under Section 678, the trust is not even taxed to the extent that the surviving spouse would otherwise be. What’s more, under the section, the estate tax-exempt bypass trust would not be reduced by the annual income taxes that are payable by the surviving spouse. This further buttresses the trust’s importance in estate planning for married couples. Finally, a so-called "conditional general testamentary power of appointment" can be included in the terms of the bypass trust, and that can sometimes result in income tax basis step-up for all or a portion of the appreciated assets in the trust at the surviving spouse's death.

Then there’s the argument that you lose some tax deferral when the IRA or 401(k) plan proceeds are paid to a bypass trust, compared to what you could defer if you paid outright to the surviving spouse. But that question has been complicated by the SECURE Act and the demise of the so-called "stretch IRA.” Beneficiaries other than a surviving spouse now have to empty the account after 10 years, which affects the tax treatment for children who inherit the proceeds at the surviving spouse's passing. The children will likely be in their highest income tax brackets when the surviving spouse passes, and now they would have to add the IRA or 401(k) plan proceeds to their peak taxable incomes over a maximum period of 10 years. So it could be that the overall income taxes to the family will be cut down if the surviving spouse intentionally chooses not to maximize the income tax deferral of the IRA and 401(k) plan proceeds after the death of the first spouse (and before the surviving spouse's death).   

The "after-tax math" will obviously be different in each estate planning situation. The estate planner will need to be cognizant of (i) the likely size of the IRA or 401(k) plan account at the death of the first spouse, as well as at the surviving spouse's passing, (ii) the likely tax situation of the surviving spouse, (iii) the likely tax situations of the couple's children after the surviving spouse's death, and (iv) the number of children who will be dividing the IRA or 401(k) proceeds at the surviving spouse's death, and therefore the amount of the proceeds each child will receive, to be taxed over 10 years. The age of the surviving spouse will also be a relevant factor. For example, if the surviving spouse is already at least age 72, the income tax deferral benefits from a spousal rollover will not be as significant as they would have been if he or she were only age 55.

It may also make overall sense in a given situation to pay a portion of the IRA or 401(k) plan proceeds to the bypass trust and a portion to the surviving spouse outright. Assuming the IRA or 401(k) plan administrator makes it available, the use of a beneficiary designation, which will allow for a full or partial disclaimer by a surviving spouse, in favor of a bypass trust would be an excellent estate planning tool here given the flexibility the technique affords, and should therefore definitely be explored.

James G. Blase, CPA, JD, LLM, is a principal at Blase & Associates LLC. For more on the estate planning techniques described in this article, see Mr. Blase's book entited Estate Planning For The SECURE Act: Strategies For Minimizing Taxes on IRAs and 401Ks, available on Amazon.