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.