Someone holding sizable assets within an IRA can use an irrevocable bypass trust to take advantage of the unified credit against possible federal estate taxes. A surviving spouse may receive income from that trust, and also may use trust principal under certain conditions. But, while potentially advantageous, setting things up correctly requires detailed analysis and discussion with a qualified estate planning and taxation attorney.

By David Braze (TMF Pixy)
August 14, 2000

Last week I discussed one facet of the complicated business of taking minimum required distributions and naming a beneficiary for your IRA. Most folks will elect to name their spouse as the primary IRA beneficiary. Given the size of many IRAs today, though, it's possible you may not wish to do that, particularly if the assets of both you and your spouse greatly exceed today's estate tax-free limit of $675,000.

I'm sure you know this stuff, but let's do a quick review anyway. When you die, you may leave your spouse an unlimited amount of assets free of federal estate taxes. That's called the marital deduction.

If you have no surviving spouse, this year anything you leave behind that exceeds a value of $675,000 will be subject to an estate tax by Uncle Sammy. The $675,000 is exempted from taxation through what's called a unified credit. This year, the unified credit is $220,550, which equates to the taxes due on an estate of $675,000. For estates valued above that amount, estate tax rates start at 37% and quickly escalate to 55%.

OK, assume for a moment that I have $900,000 in assets in my name. Mrs. Pixy, a right frugal woman with a saver's mentality, has $450,000 of assets in her name. I decide I've had enough of this world, so I depart the planet. I leave all I own to Mrs. Pixy and, because of the marital deduction, she receives it free of estate taxes. She now has $1,350,000 in assets, and can live like a pampered queen for the rest of her life.

Sadly, though, her end comes quickly. Filled with grief at my demise, two days after my departure she chokes on a bon bon while sobbing on her poolside chaise lounge. Tragically, she succumbs to asphyxiation and expires. Her assets now go to our daughters.

How much of the $1,350,000 do they get? Only what's left after an estate tax of $270,750, or $1,079,250. Had Mrs. Pixy and I done some better planning, though, they could have inherited the entire $1,350,000 free of estate taxes.

By using a bypass trust funded with $675,000 at my death, I could have left my children that amount. Then I could have left the remaining assets of $225,000 to Mrs. Pixy. Neither action would have resulted in federal estate taxes, even though I left assets worth $900,000 when I died. Further, Mrs. Pixy could receive the income in the bypass trust during her life, and could even tap into the principal when needed for her health, education, maintenance, and support.

Why no federal estate taxes at my death? What I leave to my spouse is untaxed because of the marital deduction, and the unified credit allows me to leave up to $675,000 to anyone else estate-tax-free. By combining the marital deduction and the unified credit, I avoid estate taxes on my assets when I die. I also ensure Mrs. Pixy has full use of those assets during her remaining life.

More importantly, though, I avoid estate taxes at Mrs. Pixy's death as well. Why? Because the $675,000 I left in trust for the children isn't counted as part of her estate. Instead, it's counted as part of mine. So when she dies, she only has $675,000 to leave behind, and that she passes on free of estate taxes because of the unified credit. Ain't life grand when you can escape the clutches of the tax man?

But, I've got a problem. Like many folks, most of my assets are in IRAs. To get $675,000 into a bypass trust for my daughters after I die means I would have to name the trust as my IRA beneficiary. Naming a trust as a beneficiary for an IRA can get tricky. When done incorrectly, it could lead to immediate income taxation of all IRA proceeds. Given the size of the IRAs involved, an error in that action could lead to a loss of up to 39.6% to income taxes.

But, there's some good news. If I meet certain conditions, I can ensure my heirs avoid that immediate tax hit. Specifically, I must ensure that:

1. The trust is valid under state law.
2. The trust is irrevocable on my death.
3. The beneficiaries are individuals (i.e., people instead of organizations).
4. The beneficiaries are readily identifiable in the trust document.
5. A copy of the trust and any subsequent amendment has been provided to my IRA administrator. (This requirement must be met before my death if minimum required distributions have begun, or within nine months after my death if MRDs have not yet started.)

The above requirements were effective in December 1997. They are more lenient than those of prior years, because now I may name a revocable living trust as the beneficiary of my IRA, as long as that trust becomes irrevocable at my death. Accordingly, it makes that trust an even more powerful document for those with large estates than it was before 1997.

With a bypass trust, after I die IRA distributions may be taken based on the life expectancy of the oldest trust beneficiary. In this case that would be Mrs. Pixy as the trust's income beneficiary. Therefore, she will receive needed income from those IRA distributions, and the income will be taxed at her rates rather than the trust rates, which will probably be higher. On her death, the children will receive whatever is left of the IRA. In effect, then, I can provide income to Mrs. Pixy while still taking advantage of my unified credit for estate tax purposes.

It all sounds good for those with large estates, and it might be. Still, get some expert advice before naming a trust as primary beneficiary of an IRA. It might be more Foolish to name your spouse as the primary beneficiary and the trust as a contingent beneficiary. That's because it's entirely possible for the continued income-tax deferral to outweigh the advantage gained by avoiding estate taxes through use of the unified credit. Only an analysis by a qualified tax expert at the time of the IRA owner's death would determine that.

If the trust is the IRA beneficiary, the IRA payouts -- and income taxation of those payouts -- must begin shortly after the IRA owner's death. A spousal beneficiary, though, may roll that IRA into his/her IRA and perhaps prolong those payouts. And, a spouse may always disclaim all rights to that IRA. The disclaimer would then allow the IRA to flow to the trust as if it had been the primary beneficiary all along.

As always, nothing is simple in the world of IRA beneficiaries and trusts. I personally like the flexibility of the spousal disclaimer, so my tendency would be to keep Mrs. Pixy as my primary beneficiary and the trust as the contingent. She can make the choice after I'm gone. And, if she predeceases me, the trust remains as my fallback. What's best for you? See your estate planner for that answer.

See you next week. As always, let's hear your comments on the Retired Fools board.

Best to all... Pixy