Bypass Trust vs Portability: Do You Still Need One in 2026?

Robert and Diane, both 68 and married filing jointly, own a $4,000,000 estate — a paid-off home, brokerage accounts, and two IRAs — and live in Newton, Massachusetts. Their estate is comfortably under the federal $13.99M exemption, so they assumed federal portability had made the old “A-B trust” obsolete. It has, for federal purposes. But Massachusetts taxes estates over $2,000,000 and offers no portability. If Robert dies first and leaves everything to Diane, his $2M Massachusetts exemption vanishes. When Diane later dies with the full $4M, Massachusetts taxes the whole estate (its tax is computed on the full $4M, not just the amount over $2M) — about $140,000 in state estate tax that a bypass trust would have eliminated entirely. Their decision is not federal. It is a state-law decision about whether to fund a credit-shelter trust at the first death.

The short answer: portability solved the federal problem, not the state problem

For decades, married couples used “A-B” or “credit-shelter” trusts for one reason: without them, the first spouse to die wasted his or her estate-tax exemption. The 2010 portability rules — made permanent and now codified at IRC §2010(c) — fixed that at the federal level. A surviving spouse can now inherit the deceased spouse’s unused exemption (the DSUE) and stack it on top of his or her own.

In 2026 the federal exemption is $13.99M per person, so a married couple has a combined $27.98M federal shield — with no trust required. For the roughly 99.9% of estates below that threshold who also live in a no-estate-tax state, the bypass trust is obsolete. Portability is simpler, free, and — critically — preserves a second step-up in basis that a bypass trust gives up.

The trap is geography. Portability is a federal mechanism. Eighteen states impose their own estate or inheritance tax, and almost none of them offer state-level portability. In those states, relying on federal portability alone forfeits the first spouse’s state exemption — which is exactly what the bypass trust was invented to prevent.

How federal portability works (and the election you must not skip)

Portability transfers the deceased spousal unused exclusion amount (DSUE) to the surviving spouse. The mechanics:

1. First spouse dies. Suppose the estate uses only $2M of the $13.99M exemption. The remaining $11.99M is the DSUE.
2. The executor files a federal Form 706 and elects portability. This is mandatory even when no estate tax is owed — the election is the only way to preserve the DSUE. Under Rev. Proc. 2022-32, estates not otherwise required to file have 5 years from the date of death to make a late election.
3. The surviving spouse inherits the DSUE. Diane’s own $13.99M plus Robert’s $11.99M DSUE gives her a $25.98M federal exemption at her later death.

The single most common failure is skipping the Form 706 election because “the estate is too small to owe tax.” No filing means no DSUE means the first spouse’s federal exemption is gone. The election — not the size of the estate — is what preserves it.

Why state estate tax breaks the portability shortcut

A state that imposes an estate tax can do one of two things: tie its system to federal (and inherit federal portability) or run its own exemption with no portability (“decoupled” states). The five most common decoupled, no-portability estate-tax states are Oregon, Massachusetts, Illinois, Minnesota and Washington. In each, the first spouse’s state exemption is “use it or lose it.”

Connecticut is the standout exception. Its exemption matches the federal $13.99M and it follows federal portability, so a Connecticut couple under the combined $27.98M generally does not need a bypass trust for state purposes. Oregon is the opposite extreme: a $1M exemption with a 16% top rate means even a modestly affluent couple — a paid-off Portland home and a 401(k) — can blow past it, making the bypass trust the default.

Worked example: the $4M Massachusetts couple

Return to Robert and Diane in Newton. Their $4M estate is split so that Robert can fund a $2M bypass trust if they choose to. Compare the two paths at the second death.

Path A: rely on portability, no bypass trust

• Robert dies; everything passes to Diane under the unlimited marital deduction. No Massachusetts tax at the first death.
• Robert’s $2M Massachusetts exemption is wasted — Massachusetts has no portability.
• Diane dies with the full $4M. Massachusetts computes its tax on the entire $4M using the pre-2001 federal state-death-tax-credit table (Form M-706), not just the slice over $2M.
• The table tax on a $4M estate runs to roughly $240,000; Massachusetts then subtracts a uniform credit of $99,600 (the amount that zeroes out an estate at exactly $2M), leaving about $140,000 in net Massachusetts estate tax.

Path B: fund a $2M bypass trust at the first death

• Robert dies; $2M funds a credit-shelter trust that uses his $2M Massachusetts exemption. Diane is the lifetime beneficiary — she gets income and access for health, education, maintenance and support.
• The $2M in the trust is excluded from Diane’s taxable estate.
• Diane dies with $2M in her own name, fully covered by her own $2M Massachusetts exemption.
• Massachusetts estate tax: $0.

The bypass trust saves roughly $140,000 in Massachusetts estate tax. The cost is the second step-up: the $2M in the trust is valued at Robert’s date-of-death basis going forward and does NOT get re-stepped at Diane’s death, so appreciation inside the trust carries built-in capital-gains exposure for the heirs.

The hidden cost of the bypass trust: the lost second step-up

Under IRC §1014, inherited assets get a basis step-up to fair-market value at the owner’s death — one of the largest breaks in the code. Portability keeps everything in the surviving spouse’s estate, so the assets are re-stepped a second time when that spouse dies. A bypass trust deliberately removes assets from the survivor’s estate, which is exactly why it dodges the state estate tax — but that also forfeits the second step-up.

The math is a head-to-head between two taxes:

• State estate tax saved by the bypass trust — at 16% in MA/IL/MN/OR or 20% in WA on the sheltered amount.
• Future capital-gains tax cost from the lost second step-up — up to 23.8% federal (20% long-term capital gains plus the 3.8% net investment income tax under IRC §1411), plus state income tax, on the trust’s appreciation.

For high-basis assets that won’t be sold soon (a long-held home, low-turnover index funds), the lost step-up barely matters and the bypass trust wins. For low-basis assets the heirs intend to sell (concentrated stock with huge embedded gains), the second step-up can be worth more than the state estate tax saved — tilting toward portability. Run both numbers before funding.

What most people miss: portability doesn’t index, and assets keep growing

Two quiet facts trip up couples who default to portability:

1. The inherited DSUE is frozen — it does not grow with inflation. If Robert dies in 2026 leaving an $11.99M DSUE, that figure stays $11.99M until Diane dies, even if she lives 25 more years. Her own exemption keeps indexing up, but his transferred amount is locked at the day-of-death number. A bypass trust, by contrast, shelters not just the funded amount but all of its future appreciation — growth inside the trust is permanently outside the survivor’s estate.
2. State exemptions are far lower than federal and rarely indexed. Massachusetts ($2M) and Oregon ($1M) are not inflation-adjusted, so ordinary appreciation drags more estates into the tax each year. A couple safely under the line today can cross it through nothing more than a rising stock market and home value — and discover the wasted first-spouse exemption only at the second death, when it is too late to fix.

The appreciation point cuts hardest in no-portability states. Funding a $2M bypass trust in Massachusetts shelters that $2M and everything it earns. Relying on portability shelters only the frozen DSUE while the surviving spouse’s growing estate marches back toward the state threshold.

Disclaimer trust: the “decide later” option

You don’t have to choose today. A disclaimer trust leaves everything to the surviving spouse but gives that spouse nine months after the first death to “disclaim” (refuse) up to the state-exemption amount, which then flows into a credit-shelter trust. Under IRC §2518, a qualified disclaimer must be in writing, made within 9 months, and the disclaiming spouse cannot have accepted the assets or direct where they go (beyond being an income beneficiary).

This preserves flexibility: if state law, asset values, or the exemption have changed by the first death, the survivor decides then whether the bypass-trust shelter is worth the lost step-up. The trade-off is that it depends on the survivor acting correctly within nine months while grieving — so it favors couples who value optionality over certainty.

Your decision in four questions

The decision lever

The fork comes down to one comparison: the state estate tax your bypass trust eliminates versus the future capital-gains tax the lost second step-up creates. If you live in Connecticut or a no-estate-tax state and sit under the federal $13.99M exemption, skip the trust — file the federal Form 706 portability election at the first death, keep the second step-up, and keep your plan simple. If you live in Oregon, Massachusetts, Illinois, Minnesota or Washington and your combined estate clears the state exemption, fund the bypass trust up to that state amount with your highest-basis, slowest-appreciating assets — that captures the 16–20% state estate-tax saving where the lost step-up costs you least, and leaves the low-basis growth stock in the survivor’s estate to be re-stepped. The disclaimer trust is the move when you want to make that call at the first death rather than today.