The rise in the stock market over the past several years, teamed with the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act two years ago and 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 individual retirement account (IRA) and Internal Revenue Code Section 401k accounts (401k accounts) owned by married couples. Married couples owning significant IRA and/or 401k accounts, as well as other assets, need to decide whether to consider paying all or a portion of the IRA and/or 401k proceeds to a bypass trust for the benefit of the surviving spouse to remove the designated portion of the IRA or 401k proceeds from the surviving spouse’s taxable estate, as well as to achieve certain other non-tax objectives.
Limitations of the Spousal Portability Election
In 2013, Congress permanently passed into law what’s known as the portability election for assets passing outright to a surviving spouse at the first spouse to die's death. Portability allows a surviving spouse to use the unused federal estate tax exemption of the deceased spouse, thus claiming two federal estate tax exemptions. Given the beneficial aspects of this now 9-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 at least five reasons:
- The portability election won’t remove appreciation in the value of the “ported” assets from the surviving spouse's taxable estate, whereas a bypass trust will remove all appreciation.
- The portability election won’t apply (at least as to the first spouse to die’s estate tax unused exemption) if the surviving spouse remarries and the new spouse predeceases the surviving spouse, whereas remarriage of the surviving spouse is irrelevant in the case of assets transferred to a bypass trust;
- The portability election won’t apply for federal generation-skipping transfer (GST) tax purposes, meaning that the amount that could have passed to an estate and GST tax-exempt bypass trust, including all appreciation in the value of the same, will now potentially be subject to federal transfer tax in the children's estates;
- Using the portability election will 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 will be avoided if a bypass trust is used; and
- Using the portability election will result in the first spouse to die losing the ability to control when the “ported” assets pass at the surviving spouse’s death, control which could have been retained had a bypass trust been used instead.
In states that impose a separate estate or other transfer tax, there may be a sixth reason if state law doesn’t afford a portability election similar to federal law.
Traditional Bypass Trust as an Alternative
In light of the above-described limitations of the spousal portability election when compared to bypass trust planning, whereby married couples divide their assets in some fashion so that, at the death of the first spouse to die, all or a portion of their separate assets pass to an estate tax-exempt trust for the survivor, the latter type of planning is still in play after 2013. The question is: are bypass trusts an appropriate receptacle for IRA and 401k 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 401k plan proceeds to a surviving spouse is entitled to spousal rollover treatment and, therefore, potentially greater income tax deferral? Bypass trusts are also thought to: (1) be subject to the highest federal income tax rate at levels of gross income of as low as only $13,550, (2) include an exemption of only $100, and (3) not qualify for income tax basis step-up at the surviving spouse's death.
It’s a simple matter to dispatch with the last issues mentioned. Judicious use of IRC 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 the trust isn’t even taxed to the extent the surviving spouse is taxed instead under Section 678. What’s more, using Section 678 will cause the estate tax-exempt bypass trust to be unreduced by the annual income taxes that are payable by the surviving spouse, thereby further enhancing the importance of the bypass trust in estate planning for married couples. (For more information on the use of Section 678 to avoid the high income tax rates on complex trusts (including electing small business trusts), see Jim Blase, 6-7-8: Estate Planning with Section 678 of the Internal Revenue Code (2022)). Although a full discussion of the topic is beyond the scope of this article, a conditional general testamentary power of appointment (POA) may be included in the non-IRA portion of the bypass trust, which inclusion can often result in full or partial income tax basis step-up for all or a portion of the appreciated assets in the trust at the surviving spouse’s death. If income tax basis step-up is also desired for the IRA portion of the trust, full or partial income tax basis step-up at the surviving spouse’s passing may be achieved by intentionally triggering the so-called “Delaware Tax Trap.”
As far as the loss of greater income tax deferral when IRA or 401k plan proceeds are paid to a bypass trust versus outright to the surviving spouse, the question becomes whether having the surviving spouse maximize income tax deferral on the IRA or 401k proceeds always makes economic sense after the SECURE Act, given the demise of so-called “stretch IRA” treatment to the children at the surviving spouse’s passing. Observing that the children will likely be in their highest income tax brackets when the surviving spouse passes and will now need to add the IRA or 401k plan proceeds to their peak taxable incomes over a maximum period of 10 years, it could actually turn out to be that, by intentionally choosing not to maximize income tax deferral of the IRA and 401k plan proceeds after the death of the first spouse-to-die and before the surviving spouse’s passing, overall income taxes to the family will be reduced.
The after-tax math will be different in each estate-planning situation. The estate planner will need to be cognizant of: (1) the likely size of the IRA or 401k plan account at the first spouse-to-die's death as well as at the surviving spouse’s passing, (2) the likely tax situation of the surviving spouse, both income tax and estate tax, (3) the likely income tax situations of the couple’s children after the surviving spouse’s death, and (4) the number of children who’ll be dividing the IRA or 401k plan proceeds at the surviving spouse’s death and, therefore, the amount of IRA or 401k plan proceeds each child will receive, to be taxed to each of them over 10 years. The age of the surviving spouse will also be a relevant factor. For example, if the surviving spouse will already be at least age 72 when the first spouse passes, the income tax deferral benefits from a spousal rollover won’t be as significant as they would have been if the surviving spouse was only age 55. It may also make overall sense in a given situation to pay a portion of the IRA or 401k plan proceeds to the bypass trust and a portion to the surviving spouse outright.
Use of Disclaimer Beneficiary Designation
Assuming the IRA or 401k plan administrator makes it available, use of a beneficiary designation that 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, due to the flexibility the technique affords, and should therefore definitely be explored. Here’s one sample primary beneficiary designation for the husband’s IRA and/or 401k accounts, when a full or partial disclaimer may be anticipated:
"JANE DOE, provided, however, that to the extent JANE DOE shall disclaim any portion of the benefits, (i) the disclaimed portion shall be distributed to JANE DOE, or her successors in trust, trustee of the trust established under the DOE FAMILY TRUST AGREEMENT dated __________, 2022, as amended, to be further divided and/or distributed if and as said trustee directs, and (ii) for the purposes of interpreting the provisions of the aforesaid trust agreement, JANE DOE shall not be treated as having predeceased JOHN DOE.
Because the surviving spouse may not retain a testamentary limited or conditional general POA over the disclaimed IRA or qualified plan benefits, consider allocating any disclaimed benefits (including the reinvested proceeds from the same) to a separate share (or subtrust) of the bypass trust to allow the surviving spouse to retain a testamentary POA over the balance of the bypass trust assets. Here’s some sample bypass trust language, beginning with the preamble to the bypass trust article, followed by the testamentary POA language limiting the power to the non-IRA/401k portion of the trust.
The assets to be held in the trust estate with the income and principal administered and distributed pursuant to the provisions of this ARTICLE shall be held by the trustee as a separate trust estate, and the assets in said trust estate shall at all times during the term of the trust be divided into two separate trusts. Trust “One” shall consist solely of assets passing to the trust estate held under this ARTICLE as a result of disclaimer by the surviving spouse, or by the surviving spouse's legal representative, after the death of the deceased spouse, and Trust “Two” shall consist of all other assets. The assets of both Trust One and Trust Two shall be held in trust with the income and principal administered and distributed as follows:
Upon the death of the surviving spouse, and except as otherwise provided herein, the trustee shall distribute all of the assets remaining in Trust Two, including both principal and accumulated and undistributed income, to or among any of the grantors' descendants, in trust or otherwise, and in such proportions, as shall be designated by the surviving spouse in the surviving spouse's Last Will and Testament (having the most recent date of execution by the surviving spouse) and which is filed with the probate court of the relevant jurisdiction within six (6) months following the surviving spouse's death, but if such Last Will and Testament shall be contested within the aforementioned six (6) month period, then as shall be designated in the surviving spouse's Last Will and Testament which is finally admitted to probate after the period for contesting the surviving spouse's Last Will and Testament has expired, and referring specifically to this provision, excluding, however, the surviving spouse, the surviving spouse's estate, the surviving spouse's creditors and the creditors of the surviving spouse's estate."
Although again a complete discussion of the topic is beyond the scope of this article, a conditional general testamentary POA may also be added to Trust Two in an effort to achieve income tax basis step-up for all or a portion of the Trust Two appreciated assets at the surviving spouse’s death. The intentionally triggering the Delaware Tax Trap technique won’t be available for disclaimed IRA/401k proceeds in Trust One, however, because the IRC Section 2518 qualified disclaimer rules don’t permit any POA in the surviving spouse, testamentary or otherwise, in disclaimed assets.